Treasury Regulations · 26 CFR

§ 1.41-4. Qualified research for expenditures paid or incurred in taxable years ending on or after December 31, 2003.

In effect eCFR current as of October 15, 2026

Regulation text, no changes From the eCFR, current as of October 15, 2026. The eCFR is an authoritative but unofficial editorial compilation of the Code of Federal Regulations; the official text is the annual CFR on govinfo. Compare it with this section on ecfr.gov (external site) or the official annual CFR on govinfo (external site).

Regulation under 26 U.S.C. § 41

Cite as 26 CFR § 1.41-4

At a glance

Read from the text and its source citation. Not part of the regulation.

Status: In the current eCFR
Issued: January 3, 2001 by T.D. 8930
Last amended: November 3, 2016
Issued under: 26 U.S.C. § 41
Length: 12,661 words · about 55 min to read
Defines: 1 term
Cross-references: cites 3 Code sections and 4 regulations; cited by 3

¶(a) Qualified research—

¶(1) General rule. Research activities related to the development or improvement of a business component constitute qualified research only if the research activities meet all of the requirements of section 41(d)(1) and this section, and are not otherwise excluded under section 41(d)(3)(B) or (d)(4), or this section.

¶(2) Requirements of section 41(d)(1). Research constitutes qualified research only if it is research—

¶(i) With respect to which expenditures may be treated as expenses under section 174, see § 1.174-2;

¶(ii) That is undertaken for the purpose of discovering information that is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and

¶(iii) Substantially all of the activities of which constitute elements of a process of experimentation that relates to a qualified purpose.

¶(3) Undertaken for the purpose of discovering information—

¶(i) In general. For purposes of section 41(d) and this section, research must be undertaken for the purpose of discovering information that is technological in nature. Research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.

¶(ii) Application of the discovering information requirement. A determination that research is undertaken for the purpose of discovering information that is technological in nature does not require the taxpayer be seeking to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research. In addition, a determination that research is undertaken for the purpose of discovering information that is technological in nature does not require that the taxpayer succeed in developing a new or improved business component.

¶(iii) Patent safe harbor. For purposes of section 41(d) and paragraph (a)(3)(i) of this section, the issuance of a patent by the Patent and Trademark Office under the provisions of 35 U.S.C. 151 (other than a patent for design issued under the provisions of 35 U.S.C. 171) is conclusive evidence that a taxpayer has discovered information that is technological in nature that is intended to eliminate uncertainty concerning the development or improvement of a business component. However, the issuance of such a patent is not a precondition for credit availability.

¶(4) Technological in nature. For purposes of section 41(d) and this section, information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement.

¶(5) Process of experimentation—

¶(i) In general. For purposes of section 41(d) and this section, a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities. A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. A taxpayer may undertake a process of experimentation if there is no uncertainty concerning the taxpayer's capability or method of achieving the desired result so long as the appropriate design of the desired result is uncertain as of the beginning of the taxpayer's research activities. Uncertainty concerning the development or improvement of the business component (e.g., its appropriate design) does not establish that all activities undertaken to achieve that new or improved business component constitute a process of experimentation.

¶(ii) Qualified purpose. For purposes of section 41(d) and this section, a process of experimentation is undertaken for a qualified purpose if it relates to a new or improved function, performance, reliability or quality of the business component. Research will not be treated as conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal design factors.

¶(6) Substantially all requirement. In order for activities to constitute qualified research under section 41(d)(1), substantially all of the activities must constitute elements of a process of experimentation that relates to a qualified purpose. The substantially all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is satisfied only if 80 percent or more of a taxpayer's research activities, measured on a cost or other consistently applied reasonable basis (and without regard to section 1.41-2(d)(2)), constitute elements of a process of experimentation for a purpose described in section 41(d)(3). Accordingly, if 80 percent (or more) of a taxpayer's research activities with respect to a business component constitute elements of a process of experimentation for a purpose described in section 41(d)(3), the substantially all requirement is satisfied even if the remaining 20 percent (or less) of a taxpayer's research activities with respect to the business component do not constitute elements of a process of experimentation for a purpose described in section 41(d)(3), so long as these remaining research activities satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). The substantially all requirement is applied separately to each business component.

¶(7) Use of computers and information technology. The employment of computers or information technology, or the reliance on principles of computer science or information technology to store, collect, manipulate, translate, disseminate, produce, distribute, or process data or information, and similar uses of computers and information technology does not itself establish that qualified research has been undertaken.

¶(8) Illustrations. The following examples illustrate the application of paragraph (a)(5) of this section:

¶Example 1.

(i) Facts. X is engaged in the business of developing and manufacturing widgets. X wants to change the color of its blue widget to green. X obtains from various suppliers several different shades of green paint. X paints several sample widgets, and surveys X's customers to determine which shade of green X's customers prefer.

(ii) Conclusion. X's activities to change the color of its blue widget to green are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section because substantially all of X's activities are not undertaken for a qualified purpose. All of X's research activities are related to style, taste, cosmetic, or seasonal design factors.

¶Example 2.

(i) Facts. The facts are the same as in Example 1, except that X chooses one of the green paints. X obtains samples of the green paint from a supplier and determines that X must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints X has used. X obtains detailed data on the green paint from X's paint supplier. X also consults with the manufacturer of X's paint spraying machines. The manufacturer informs X that X must acquire a new nozzle that operates with the green paint X wants to use. X tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines.

(ii) Conclusion. X's activities to modify its painting process are a separate business component under section 41(d)(2)(A). X's activities to modify its painting process to change the color of its blue widget to green are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. X did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machines eliminated X's uncertainty regarding the modification of its painting process. X's activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control.

¶Example 3.

(i) Facts. X is engaged in the business of manufacturing food products and currently manufactures a large-shred version of a product. X seeks to modify its current production line to permit it to manufacture both a large-shred version and a fine-shred version of one of its food products. A smaller, thinner shredding blade capable of producing a fine-shred version of the food product, however, is not commercially available. Thus, X must develop a new shredding blade that can be fitted onto its current production line. X is uncertain concerning the design of the new shredding blade, because the material used in its existing blade breaks when machined into smaller, thinner blades. X engages in a systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a different material from that of its existing shredding blade and, if so, what material will best meet X's functional requirements.

(ii) Conclusion. X's activities to modify its current production line by developing the new shredding blade meet the requirements of qualified research as set forth in paragraph (a)(2) of this section. Substantially all of X's activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of the taxpayer's research activities. X identified uncertainties related to the development of a business component, and identified alternatives intended to eliminate these uncertainties. Furthermore, X's process of evaluating identified alternatives was technological in nature, and was undertaken to eliminate the uncertainties.

¶Example 4.

(i) Facts. X is in the business of designing, developing and manufacturing automobiles. In response to government-mandated fuel economy requirements, X seeks to update its current model vehicle and undertakes to improve aerodynamics by lowering the hood of its current model vehicle. X determines, however, that lowering the hood changes the air flow under the hood, which changes the rate at which air enters the engine through the air intake system, and which reduces the functionality of the cooling system. X's engineers are uncertain how to design a lower hood to obtain the increased fuel economy, while maintaining the necessary air flow under the hood. X designs, models, simulates, tests, refines, and re-tests several alternative designs for the hood and associated proposed modifications to both the air intake system and cooling system. This process enables X to eliminate the uncertainties related to the integrated design of the hood, air intake system, and cooling system, and such activities constitute eighty-five percent of X's total activities to update its current model vehicle. X then engages in additional activities that do not involve a process of evaluating alternatives in order to eliminate uncertainties. The additional activities constitute only fifteen percent of X's total activities to update its current model vehicle.

(ii) Conclusion. In general, if eighty percent or more of a taxpayer's research activities measured on a cost or other consistently applied reasonable basis constitute elements of a process of experimentation for a qualified purpose under section 41(d)(3)(A) and paragraph (a)(5)(ii) of this section, then the substantially all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is satisfied. Substantially all of X's activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of X's research activities. X identified uncertainties related to the improvement of a business component and identified alternatives intended to eliminate these uncertainties. Furthermore, X's process of evaluating the identified alternatives was technological in nature and was undertaken to eliminate the uncertainties. Because substantially all (in this example, eighty-five percent) of X's activities to update its current model vehicle constitute elements of a process of experimentation for a qualified purpose described in section 41(d)(3)(A), all of X's activities to update its current model vehicle meet the requirements of qualified research as set forth in paragraph (a)(2) of this section, provided that X's remaining activities (in this example, fifteen percent of X's total activities) satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4).

¶Example 5.

(i) Facts. X, a retail and distribution company, wants to upgrade its warehouse management software. X evaluates several of the alternative warehouse management software products available from vendors in the marketplace to determine which product will best serve X's technical requirements. X selects vendor V's software.

(ii) Conclusion. X's activities to select the software are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. X did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the development of a business component. X's evaluation of products available from vendors is not a process of experimentation.

¶Example 6.

(i) Facts. X wants to develop a new web application to allow customers to purchase its products online. X, after reviewing commercial software offered by various vendors, purchases a commercial software package of object-oriented functions from vendor Z that X can use in its web application (for example, a shopping cart). X evaluates the various object-oriented functions included in vendor Z's software package to determine which functions it can use. X then incorporates the selected software functions in its new web application software.

(ii) Conclusion. X's activities related to selecting the commercial software vendor with the object-oriented functions it wanted, and then selecting which functions to use, are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. In addition, incorporating the selected object-oriented functions into the new web application software being developed by X did not involve conducting a process of evaluating alternatives in order to eliminate uncertainty regarding the development of software. X's evaluation of products available from vendors and selection of software functions are not a process of experimentation.

¶Example 7.

(i) Facts. In order to be more responsive to user online requests, X wants to develop software to balance the incoming processing requests across multiple web servers that run the same set of software applications. Without evaluating or testing any alternatives, X decides that a separate server will be used to distribute the workload across each of the web servers and that a round robin workload distribution algorithm is appropriate for its needs.

(ii) Conclusion. X's activities to develop the software are activities relating to the development of a separate business component under section 41(d)(2)(A). X's activities to develop the load distribution function are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. X did not conduct a process of evaluating different load distribution alternatives in order to eliminate uncertainty regarding the development of software. X's selection of a separate server and a round robin distribution algorithm is not a process of experimentation.

¶Example 8.

(i) Facts. X must develop load balancing software across a server cluster supporting multiple web applications. X's web applications have high concurrency demands because of a dynamic, highly volatile environment. X is uncertain of the appropriate design of the load balancing algorithm, given that the existing evolutionary algorithms did not meet the demands of their highly volatile web environment. Therefore, X designs and systematically tests and evaluates several different algorithms that perform the load distribution functions.

(ii) Conclusion. X's activities to develop software are activities to develop a separate business component under section 41(d)(2)(A). X's activities involving the design, evaluation, and systematic testing of several new load balancing algorithms meet the requirements as set forth in paragraph (a)(5) of this section. X's activities constitute elements of a process of experimentation because X identified uncertainties related to the development of a business component, identified alternatives intended to eliminate those uncertainties, and evaluated one or more alternatives to achieve a result where the appropriate design was uncertain at the beginning of X's research activities.

¶Example 9.

(i) Facts. X, a multinational manufacturer, wants to install an enterprise resource planning (ERP) system that runs off a single database so that X can track orders more easily, and coordinate manufacturing, inventory, and shipping among many different locations at the same time. In order to successfully install and implement ERP software, X evaluates its business needs and the technical requirements of the software, such as processing power, memory, storage, and network resources. X devotes the majority of its resources in implementing the ERP system to evaluating the available templates, reports, and other standard programs and choosing among these alternatives in configuring the system to match its business process and reengineering its business process to match the available alternatives in the ERP system. X also performs some data transfer from its old system, involving routine programming and one-to-one mapping of data to be exchanged between each system.

(ii) Conclusion. X's activities related to the ERP software including the data transfer are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. X did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the development of software. X's activities in choosing between available templates, reports, and other standard programs and conducting data transfer are not elements of a process of experimentation.

¶Example 10.

(i) Facts. Same facts as Example 9 except that X determines that it must interface part of its legacy software with the new ERP software because the ERP software does not provide a particular function that X requires for its business. As a result, X must develop an interface between its legacy software and the ERP software, and X evaluates several data exchange software applications and chooses one of the available alternatives. X is uncertain as to how to keep the data synchronized between the legacy and ERP systems. Thus, X engages in systematic trial and error testing of several newly designed data caching algorithms to eliminate synchronization problems.

(ii) Conclusion. Substantially all of X's activities with respect to this ERP project do not satisfy the requirements for a process of experimentation. However, when the shrinking-back rule is applied, a subset of X's activities do satisfy the requirements for a process of experimentation. X's activities to develop the data caching software and keeping the data on the legacy and ERP systems synchronized meet the requirements of qualified research as set forth in paragraph (a)(2) of this section. Substantially all of X's activities to develop the specialized data caching and synchronization software constitute elements of a process of experimentation because X identified uncertainties related to the development of a business component, identified alternatives intended to eliminate those uncertainties, and evaluated alternatives to achieve a result where the appropriate design of that result was uncertain as of the beginning of the taxpayer's research activities.

¶(b) Application of requirements for qualified research—

¶(1) In general. The requirements for qualified research in section 41(d)(1) and paragraph (a) of this section, must be applied separately to each business component, as defined in section 41(d)(2)(B). In cases involving development of both a product and a manufacturing or other commercial production process for the product, research activities relating to development of the process are not qualified research unless the requirements of section 41(d) and this section are met for the research activities relating to the process without taking into account the research activities relating to development of the product. Similarly, research activities relating to development of the product are not qualified research unless the requirements of section 41(d) and this section are met for the research activities relating to the product without taking into account the research activities relating to development of the manufacturing or other commercial production process.

¶(2) Shrinking-back rule. The requirements of section 41(d) and paragraph (a) of this section are to be applied first at the level of the discrete business component, that is, the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer. If these requirements are not met at that level, then they apply at the most significant subset of elements of the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license. This shrinking back of the product is to continue until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. This shrinking-back rule is applied only if a taxpayer does not satisfy the requirements of section 41(d)(1) and paragraph (a)(2) of this section with respect to the overall business component. The shrinking-back rule is not itself applied as a reason to exclude research activities from credit eligibility.

¶(3) Illustration. The following example illustrates the application of this paragraph (b):

¶Example.

X, a motorcycle engine builder, develops a new carburetor for use in a motorcycle engine. X also modifies an existing engine design for use with the new carburetor. Under the shrinking-back rule, the requirements of section 41(d)(1) and paragraph (a) of this section are applied first to the engine. If the modifications to the engine when viewed as a whole, including the development of the new carburetor, do not satisfy the requirements of section 41(d)(1) and paragraph (a) of this section, those requirements are applied to the next most significant subset of elements of the business component. Assuming that the next most significant subset of elements of the engine is the carburetor, the research activities in developing the new carburetor may constitute qualified research within the meaning of section 41(d)(1) and paragraph (a) of this section.

¶(c) Excluded activities—

¶(1) In general. Qualified research does not include any activity described in section 41(d)(4) and paragraph (c) of this section.

¶(2) Research after commercial production—

¶(i) In general. Activities conducted after the beginning of commercial production of a business component are not qualified research. Activities are conducted after the beginning of commercial production of a business component if such activities are conducted after the component is developed to the point where it is ready for commercial sale or use, or meets the basic functional and economic requirements of the taxpayer for the component's sale or use.

¶(ii) Certain additional activities related to the business component. The following activities are deemed to occur after the beginning of commercial production of a business component—

¶(A) Preproduction planning for a finished business component;

¶(B) Tooling-up for production;

¶(C) Trial production runs;

¶(D) Trouble shooting involving detecting faults in production equipment or processes;

¶(E) Accumulating data relating to production processes; and

¶(F) Debugging flaws in a business component.

¶(iii) Activities related to production process or technique. In cases involving development of both a product and a manufacturing or other commercial production process for the product, the exclusion described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of this section applies separately for the activities relating to the development of the product and the activities relating to the development of the process. For example, even after a product meets the taxpayer's basic functional and economic requirements, activities relating to the development of the manufacturing process still may constitute qualified research, provided that the development of the process itself separately satisfies the requirements of section 41(d) and this section, and the activities are conducted before the process meets the taxpayer's basic functional and economic requirements or is ready for commercial use.

¶(iv) Clinical testing. Clinical testing of a pharmaceutical product prior to its commercial production in the United States is not treated as occurring after the beginning of commercial production even if the product is commercially available in other countries. Additional clinical testing of a pharmaceutical product after a product has been approved for a specific therapeutic use by the Food and Drug Administration and is ready for commercial production and sale is not treated as occurring after the beginning of commercial production if such clinical testing is undertaken to establish new functional uses, characteristics, indications, combinations, dosages, or delivery forms for the product. A functional use, characteristic, indication, combination, dosage, or delivery form shall be considered new only if such functional use, characteristic, indication, combination, dosage, or delivery form must be approved by the Food and Drug Administration.

¶(3) Adaptation of existing business components. Activities relating to adapting an existing business component to a particular customer's requirement or need are not qualified research. This exclusion does not apply merely because a business component is intended for a specific customer.

¶(4) Duplication of existing business component. Activities relating to reproducing an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information about the business component are not qualified research. This exclusion does not apply merely because the taxpayer examines an existing business component in the course of developing its own business component.

¶(5) Surveys, studies, research relating to management functions, etc. Qualified research does not include activities relating to—

¶(i) Efficiency surveys;

¶(ii) Management functions or techniques, including such items as preparation of financial data and analysis, development of employee training programs and management organization plans, and management-based changes in production processes (such as rearranging work stations on an assembly line);

¶(iii) Market research, testing, or development (including advertising or promotions);

¶(iv) Routine data collections; or

¶(v) Routine or ordinary testing or inspections for quality control.

¶(6) Internal use software—

¶(i) General rule. Research with respect to software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use is eligible for the research credit only if—

¶(A) The research with respect to the software satisfies the requirements of section 41(d)(1);

¶(B) The research with respect to the software is not otherwise excluded under section 41(d)(4) (other than section 41(d)(4)(E)); and

¶(C) The software satisfies the high threshold of innovation test of paragraph (c)(6)(vii) of this section.

¶(ii) Inapplicability of the high threshold of innovation test. This paragraph (c)(6) does not apply to the following:

¶(A) Software developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer for use in an activity that constitutes qualified research (other than the development of the internal use software itself);

¶(B) Software developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer for use in a production process to which the requirements of section 41(d)(1) are met; and

¶(C) A new or improved package of software and hardware developed together by the taxpayer as a single product (or to the costs to modify an acquired software and hardware package), of which the software is an integral part, that is used directly by the taxpayer in providing services in its trade or business. In these cases, eligibility for the research credit is to be determined by examining the combined hardware-software product as a single product.

¶(iii) Software developed primarily for internal use—

¶(A) In general. Except as otherwise provided in paragraph (c)(6)(vi) of this section, software is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use if the software is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. Software that the taxpayer develops primarily for a related party's internal use will be considered internal use software. A related party is any corporation, trade or business, or other person that is treated as a single taxpayer with the taxpayer pursuant to section 41(f).

¶(B) General and administrative functions. General and administrative functions are:

¶(1) Financial management. Financial management functions are functions that involve the financial management of the taxpayer and the supporting recordkeeping. Financial management functions include, but are not limited to, functions such as accounts payable, accounts receivable, inventory management, budgeting, cash management, cost accounting, disbursements, economic analysis and forecasting, financial reporting, finance, fixed asset accounting, general ledger bookkeeping, internal audit, management accounting, risk management, strategic business planning, and tax.

¶(2) Human resources management. Human resources management functions are functions that manage the taxpayer's workforce. Human resources management functions include, but are not limited to, functions such as recruiting, hiring, training, assigning personnel, and maintaining personnel records, payroll, and benefits.

¶(3) Support services. Support services are other functions that support the day- to-day operations of the taxpayer. Support services include, but are not limited to, functions such as data processing, facility services (for example, grounds keeping, housekeeping, janitorial, and logistics), graphic services, marketing, legal services, government compliance services, printing and publication services, and security services (for example, video surveillance and physical asset protection from fire and theft).

¶(iv) Software not developed primarily for internal use. Software is not developed primarily for the taxpayer's internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business, such as—

¶(A) Software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or

¶(B) Software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.

¶(v) Time and manner of determination. For purposes of paragraphs (c)(6)(iii) and (iv) of this section, whether software is developed primarily for internal use or not developed primarily for internal use depends on the intent of the taxpayer and the facts and circumstances at the beginning of the software development. For example, software will not be considered internal use software solely because it is used internally for purposes of testing prior to commercial sale, lease, or license. If a taxpayer originally develops software primarily for internal use, but later makes improvements to the software with the intent to hold the improved software to be sold, leased, licensed, or otherwise marketed to third parties, or to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system using the improved software, the improvements will be considered separate from the existing software and will not be considered developed primarily for internal use. Alternatively, if a taxpayer originally develops software to be sold, leased, licensed, or otherwise marketed to third parties, or to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system, but later makes improvements to the software with the intent to use the software in general and administrative functions, the improvements will be considered separate from the existing software and will be considered developed primarily for internal use.

¶(vi) Software developed for both internal use and to enable interaction with third parties (dual function software)—

¶(A) Presumption of development primarily for internal use. Unless paragraph (c)(6)(vi)(B) or (C) of this section applies, software developed by (or for the benefit of) the taxpayer both for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business and to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system (dual function software) is presumed to be developed primarily for a taxpayer's internal use.

¶(B) Identification of a subset of elements of software that only enables interaction with third parties. To the extent that a taxpayer can identify a subset of elements of dual function software that only enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data (third party subset), the presumption under paragraph (c)(6)(vi)(A) of this section does not apply to such third party subset, and such third party subset is not developed primarily for internal use as described under paragraph (c)(6)(iv)(B) of this section.

¶(C) Safe harbor for expenditures related to software developed for both internal use and to enable interaction with third parties. If, after the application of paragraph (c)(6)(vi)(B) of this section, there remains dual function software or a subset of elements of dual function software (dual function subset), a taxpayer may include 25 percent of the qualified research expenditures of such dual function software or dual function subset in computing the amount of the taxpayer's credit. This paragraph (c)(6)(vi)(C) applies only if the taxpayer's research activities related to the development or improvement of the dual function software or dual function subset constitute qualified research under section 41(d), without regard to section 41(d)(4)(E), and the dual function software or dual function subset's use by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10 percent of the dual function software or the dual function subset's use. An objective, reasonable method within the taxpayer's industry must be used to estimate the dual function software or dual function subset's use by third parties or by the taxpayer to interact with third parties. An objective, reasonable method may include, but is not limited to, processing time, amount of data transfer, and number of software user interface screens.

¶(D) Time and manner of determination. A taxpayer must apply this paragraph (c)(6)(vi) based on the intent of the taxpayer and the facts and circumstances at the beginning of the software development.

¶(E) Third party. For purposes of paragraphs (c)(6)(iv), (v), and (vi) of this section, the term third party means any corporation, trade or business, or other person that is not treated as a single taxpayer with the taxpayer pursuant to section 41(f). Additionally, for purposes of paragraph (c)(6)(iv)(B) of this section, third parties do not include any persons that use the software to support the general and administrative functions of the taxpayer.

¶(vii) High threshold of innovation test—

¶(A) In general. Software satisfies this paragraph (c)(6)(vii) only if the taxpayer can establish that—

¶(1) The software is innovative;

¶(2) The software development involves significant economic risk; and

¶(3) The software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the requirements of paragraphs (c)(6)(vii)(A)(1) and (2) of this section.

¶(B) Innovative. Software is innovative if the software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful. This is a measurable objective standard, not a determination of the unique or novel nature of the software or the software development process.

¶(C) Significant economic risk. The software development involves significant economic risk if the taxpayer commits substantial resources to the development and if there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period. The term “substantial uncertainty” requires a higher level of uncertainty and technical risk than that required for business components that are not internal use software. This standard does not require technical uncertainty regarding whether the final result can ever be achieved, but rather whether the final result can be achieved within a timeframe that will allow the substantial resources committed to the development to be recovered within a reasonable period. Technical risk arises from uncertainty that is technological in nature, as defined in paragraph (a)(4) of this section, and substantial uncertainty must exist at the beginning of the taxpayer's activities.

¶(D) Application of high threshold of innovation test. The high threshold of innovation test of paragraph (c)(6)(vii) of this section takes into account only the results anticipated to be attributable to the development of new or improved software at the beginning of the software development independent of the effect of any modifications to related hardware or other software. The implementation of existing technology by itself is not evidence of innovation, but the use of existing technology in new ways could be evidence of a high threshold of innovation if it resolves substantial uncertainty as defined in paragraph (c)(6)(vii)(C) of this section.

¶(viii) Illustrations. The following examples illustrate provisions contained in this paragraph (c)(6). No inference should be drawn from these examples concerning the application of section 41(d)(1) and paragraph (a) of this section to these facts.

¶Example 1.

Computer hardware and software developed as a single product—(i) Facts. X is a telecommunications company that developed high technology telephone switching hardware. In addition, X developed software that interfaces directly with the hardware to initiate and terminate a call, along with other functions. X designed and developed the hardware and software together.

(ii) Conclusion. The telecommunications software that interfaces directly with the hardware is part of a package of software and hardware developed together by the taxpayer that is used by the taxpayer in providing services in its trade or business. Accordingly, this paragraph (c)(6) does not apply to the software that interfaces directly with the hardware as described in paragraph (c)(6)(ii)(C) of this section, and eligibility for the research credit is determined by examining the combined software-hardware product as a single product.

¶Example 2.

Internal use software; financial management—(i) Facts. X, a manufacturer, self-insures its liabilities for employee health benefits. X develops its own software to administer its self-insurance reserves related to employee health benefits. At the beginning of the development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

(ii) Conclusion. The software is developed for use in a general and administrative function because reserve valuation is a financial management function under paragraph (c)(6)(iii)(B)(1) of this section. Accordingly, the software is internal use software because it is developed for use in a general and administrative function.

¶Example 3.

Internal use software; human resources management—(i) Facts. X, a manufacturer, develops a software module that interacts with X's existing payroll software to allow X's employees to print pay stubs and make certain changes related to payroll deductions over the internet. At the beginning of the development, X does not intend to develop the software module for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

(ii) Conclusion. The employee access software module is developed for use in a general and administrative function because employee access software is a human resources management function under paragraph (c)(6)(iii)(B)(2) of this section. Accordingly, the software module is internal use software because it is developed for use in a general and administrative function.

¶Example 4.

Internal use software; support services—(i) Facts. X, a restaurant, develops software for a Web site that provides information, such as items served, price, location, phone number, and hours of operation for purposes of advertising. At the beginning of the development, X does not intend to develop the Web site software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system. X intends to use the software for marketing by allowing third parties to review general information on X's Web site.

(ii) Conclusion. The software is developed for use in a general and administrative function because the software was developed to be used by X for marketing which is a support services function under paragraph (c)(6)(iii)(B)(3) of this section. Accordingly, the software is internal use software because it is developed for use in a general and administrative function.

¶Example 5.

Internal use software—(i) Facts. X, a multinational manufacturer with different business and financial systems in each of its divisions, undertakes a software development project aimed at integrating the majority of the functional areas of its major software systems (Existing Software) into a single enterprise resource management system supporting centralized financial systems, human resources, inventory, and sales. X purchases software (New Software) upon which to base its enterprise-wide system. X has to develop software (Developed Software) that transfers data from X's legacy financial, human resources, inventory, and sales systems to the New Software. At the beginning of the development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

(ii) Conclusion. The financial systems, human resource systems, inventory and sales systems are general and administrative functions under paragraph (c)(6)(iii)(B) of this section. Accordingly, the Developed Software is internal use software because it is developed for use in general and administrative functions.

¶Example 6.

Internal use software; definition of third party—(i) Facts. X develops software to interact electronically with its vendors to improve X's inventory management. X develops the software to enable X to interact with vendors and to allow vendors to initiate functions or review data on the taxpayer's system. X defines the electronic messages that will be exchanged between X and the vendors. X's software allows a vendor to request X's current inventory of the vendor's product, and allows a vendor to send a message to X which informs X that the vendor has just made a new shipment of the vendor's product to replenish X's inventory. At the beginning of development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties.

(ii) Conclusion. Under paragraph (c)(6)(vi)(E) of this section, X's vendors are not third parties for purposes of paragraph (c)(6)(iv) of this section. While X's software was developed to allow vendors to initiate functions or review data on the taxpayer's system, the software is not excluded from internal use software as set forth in paragraph (c)(6)(iv)(B) of this section because the software was developed to allow vendors to use the software to support X's inventory management, which is a general and administrative function of X.

¶Example 7.

Not internal use software; third party interaction—(i) Facts. X, a manufacturer of various products, develops software for a Web site with the intent to allow third parties to access data on X's database, to order X's products and track the status of their orders online. At the beginning of the development, X does not intend to develop the Web site software for commercial sale, lease, license, or to be otherwise marketed to third parties.

(ii) Conclusion. The software is not developed primarily for internal use because it is not developed for use in a general and administrative function. X developed the software to allow third parties to initiate functions or review data on the taxpayer's system as provided under paragraph (c)(6)(iv)(B) of this section.

¶Example 8.

Not internal use software; third party interaction—(i) Facts. X developed software that allows its users to upload and modify photographs at no charge. X earns revenue by selling advertisements that are displayed while users enjoy the software that X offers for free. X also developed software that has interfaces through which advertisers can bid for the best position in placing their ads, set prices for the ads, or develop advertisement campaign budgets. At the beginning of the development, X intended to develop the software to enable X to interact with third parties or to allow third parties to initiate functions on X's system.

(ii) Conclusion. The software for uploading and modifying photographs is not developed primarily for internal use because it is not developed for use in X's general and administrative functions under paragraph (c)(6)(iii)(A) of this section. The users and the advertisers are third parties for purposes of paragraph (c)(6)(iv) of this section. Furthermore, both the software for uploading and modifying photographs and the advertising software are not internal use software under paragraph (c)(6)(iv)(B) of this section because at the beginning of the development X developed the software with the intention of enabling X to interact with third parties or to allow third parties to initiate functions on X's system.

¶Example 9.

Not internal use software; commercially sold, leased, licensed, or otherwise marketed—(i) Facts. X is a provider of cloud-based software. X develops enterprise application software (including customer relationship management, sales automation, and accounting software) to be accessed online and used by X's customers. At the beginning of development, X intended to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties.

(ii) Conclusion. The software is not developed primarily for internal use because it is not developed for use in a general and administrative function. X developed the software to be commercially sold, leased, licensed, or otherwise marketed to third parties under paragraph (c)(6)(iv)(A) of this section.

¶Example 10.

Improvements to existing internal use software—(i) Facts. X has branches throughout the country and develops its own facilities services software to coordinate moves and to track maintenance requests for all locations. At the beginning of the development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system. Several years after completing the development and using the software, X consults its business development department, which assesses the market for the software. X determines that the software could be sold at a profit if certain technical and functional enhancements are made. X develops the improvements to the software, and sells the improved software to third parties.

(ii) Conclusion. Support services, which include facility services, are general and administrative functions under paragraph (c)(6)(iii)(B) of this section. Accordingly, the original software is developed for use in general and administrative functions and is, therefore, developed primarily for internal use. However, the improvements to the software are not developed primarily for internal use because the improved software was not developed for use in a general and administrative function. X developed the improved software to be commercially sold, leased, licensed, or otherwise marketed to third parties under paragraphs (c)(6)(iv)(A) and (c)(6)(v) of this section.

¶Example 11.

Dual function software; identification of a third party subset—(i) Facts. X develops software for use in general and administrative functions that facilitate or support the conduct of X's trade or business and to allow third parties to initiate functions. X is able to identify a third party subset. X incurs $50,000 of research expenditures for the software, 50% of which is allocable to the third party subset.

(ii) Conclusion. The software developed by X is dual function software. Because X is able to identify a third party subset, the third party subset is not presumed to be internal use software under paragraph (c)(6)(vi)(A) of this section. If X's research activities related to the third party subset constitute qualified research under section 41(d), and the allocable expenditures are qualified research expenditures under section 41(b), $25,000 of the software research expenditures allocable to the third party subset may be included in computing the amount of X's credit, pursuant to paragraph (c)(6)(vi)(B) of this section. If, after the application of paragraph (c)(6)(vi)(B) of this section, there remains a dual function subset, X may determine whether paragraph (c)(6)(vi)(C) of this section applies.

¶Example 12.

Dual function software; application of the safe harbor—(i) Facts. The facts are the same as in Example 11, except that X is unable to identify a third party subset. X uses an objective, reasonable method at the beginning of the software development to determine that the dual function software's use by third parties to initiate functions is reasonably anticipated to constitute 15% of the dual function software's use.

(ii) Conclusion. The software developed by X is dual function software. The software is presumed to be developed primarily for internal use under paragraph (c)(6)(vi)(A) of this section. Although X is unable to identify a third party subset, X reasonably anticipates that the dual function software's use by third parties will be at least 10% of the dual function software's use. If X's research activities related to the development or improvement of the dual function software constitute qualified research under section 41(d), without regard to section 41(d)(4)(E), and the allocable expenditures are qualified research expenditures under section 41(b), X may include $12,500 (25% of $50,000) of the software research expenditures of the dual function software in computing the amount of X's credit pursuant to paragraph (c)(6)(vi)(C) of this section.

¶Example 13.

Dual function software; safe harbor inapplicable—(i) Facts. The facts are the same as in Example 11, except X is unable to identify a third party subset. X uses an objective, reasonable method at the beginning of the software development to determine that the dual function software's use by third parties to initiate functions is reasonably anticipated to constitute 5% of the dual function software's use.

(ii) Conclusion. The software developed by X is dual function software. The software is presumed to be developed primarily for X's internal use under paragraph (c)(6)(vi)(A) of this section. X is unable to identify a third party subset, and X reasonably anticipates that the dual function software's use by third parties will be less than 10% of the dual function software's use. X may only include the software research expenditures of the dual function software in computing the amount of X's credit if the software satisfies the high threshold of innovation test of paragraph (c)(6)(vii) of this section and X's research activities related to the development or improvement of the dual function software constitute qualified research under section 41(d), without regard to section 41(d)(4)(E), and the allocable expenditures are qualified research expenditures under section 41(b).

¶Example 14.

Dual function software; identification of a third party subset and the safe harbor—(i) Facts. X develops software for use in general and administrative functions that facilitate or support the conduct of X's trade or business and to allow third parties to initiate functions and review data. X is able to identify a third party subset (Subset A). The remaining dual function subset of the software (Subset B) allows third parties to review data and provides X with data used in its general and administrative functions. X is unable to identify a third party subset of Subset B. X incurs $50,000 of research expenditures for the software, 50% of which is allocable to Subset A and 50% of which is allocable to Subset B. X determines, at the beginning of the software development, that the processing time of the third party use of Subset B is reasonably anticipated to account for 15% of the total processing time of Subset B.

(ii) Conclusion. The software developed by X is dual function software. Because X is able to identify a third party subset, such third party subset (Subset A) is not presumed to be internal use software under paragraph (c)(6)(vi)(A) of this section. If X's research activities related to the development or improvement of Subset A constitute qualified research under section 41(d), and the allocable expenditures are qualified research expenditures under section 41(b), the $25,000 of the software research expenditures allocable to Subset A may be included in computing the amount of X's credit pursuant to paragraph (c)(6)(vi)(B) of this section. Although X is unable to identify a third party subset of Subset B, 15% of Subset B's use is reasonably anticipated to be attributable to the use of Subset B by third parties. If X's research activities related to the development or improvement of Subset B constitute qualified research under section 41(d), without regard to section 41(d)(4)(E), and the allocable expenditures are qualified research expenditures under section 41(b), X may include $6,250 (25% × $25,000) of the software research expenditures of Subset B in computing the amount of X's credit, pursuant to paragraph (c)(6)(vi)(C) of this section.

¶Example 15.

Internal use software; application of the high threshold of innovation test—(i) Facts. X maintained separate software applications for tracking a variety of human resource (HR) functions, including employee reviews, salary information, location within the hierarchy and physical location of employees, 401(k) plans, and insurance coverage information. X determined that improved HR efficiency could be achieved by redesigning its disparate software applications into one employee-centric system, and worked to develop that system. X also determined that commercially available database management systems did not meet all of the requirements of the proposed system. Rather than waiting several years for vendor offerings to mature and become viable for its purpose, X embarked upon the project utilizing older technology that was severely challenged with respect to data modeling capabilities. The improvements, if successful, would provide a reduction in cost and improvement in speed that is substantial and economically significant. For example, having one employee-centric system would remove the duplicative time and cost of manually entering basic employee information separately in each application because the information would only have to be entered once to be available across all applications. The limitations of the technology X was attempting to utilize required that X attempt to develop a new database architecture. X committed substantial resources to the project, but could not predict, because of technical risk, whether it could develop the database software in the timeframe necessary so that X could recover its resources in a reasonable period. Specifically, X was uncertain regarding the capability of developing, within a reasonable period, a new database architecture using the old technology that would resolve its technological issues regarding the data modeling capabilities and the integration of the disparate systems into one system. At the beginning of the development, X did not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

(ii) Conclusion. The software is internal use software because it is developed for use in a general and administrative function. However, the software satisfies the high threshold of innovation test set forth in paragraph (c)(6)(vii) of this section. The software was intended to be innovative in that it would provide a reduction in cost or improvement in speed that is substantial and economically significant. In addition, X's development activities involved significant economic risk in that X committed substantial resources to the development and there was substantial uncertainty, because of technical risk, that the resources would be recovered within a reasonable period. Finally, at the time X undertook the development of the system, software meeting X's requirements was not commercially available for use by X.

¶Example 16.

Internal use software; application of the high threshold of innovation test—(i) Facts. X undertook a software project to rewrite a legacy mainframe application using an object-oriented programming language, and to move the new application off the mainframe to a client/server environment. Both the object-oriented language and client/server technologies were new to X. This project was undertaken to develop a more maintainable application, which X expected would significantly reduce the cost of maintenance, and implement new features more quickly, which X expected would provide both significant improvements in speed and reduction in cost. Thus, the improvements, if successful, would provide a reduction in cost and improvement in speed that is substantial and economically significant. X also determined that commercially available systems did not meet the requirements of the proposed system. X was certain that it would be able to overcome any technological uncertainties and implement the improvements within a reasonable period. However, X was unsure of the appropriate methodology to achieve the improvements. At the beginning of the development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

(ii) Conclusion. The software is internal use software because it is developed for use in a general and administrative function. X's activities do not satisfy the high threshold of innovation test of paragraph (c)(6)(vii) of this section. Although the software meets the requirements of paragraphs (c)(6)(vii)(A)(1) and (3) of this section, X's development activities did not involve significant economic risk under paragraph (c)(6)(vii)(A)(2) of this section. X did not have substantial uncertainty, because of technical risk, that the resources committed to the project would be recovered within a reasonable period.

¶Example 17.

Internal use software; application of the high threshold of innovation test—(i) Facts. X wants to expand its internal computing power, and is aware that its PCs and workstations are idle at night, on the weekends, and for a significant part of any business day. Because the general and administrative computations that X needs to make could be done on workstations as well as PCs, X develops a screen-saver-like application that runs on employee computers. When employees' computers have been idle for an amount of time set by each employee, X's application goes back to a central server to get a new job to execute. This job will execute on the idle employee's computer until it has either finished, or the employee resumes working on his computer. The ability to use the idle employees' computers would save X significant costs because X would not have to buy new hardware to expand the computing power. The improvements, if successful, would provide a reduction in cost that is substantial and economically significant. At the time X undertook the software development project, there was no commercial application available with such a capability. In addition, at the time X undertook the software development project, X was uncertain regarding the capability of developing a server application that could schedule and distribute the jobs across thousands of PCs and workstations, as well as handle all the error conditions that occur on a user's machine. X commits substantial resources to the project. X undertakes a process of experimentation to attempt to eliminate its uncertainty. At the beginning of the development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

(ii) Conclusion. The software is internal use software because it is developed for use in a general and administrative function. However, the software satisfies the high threshold of innovation test as set forth in paragraph (c)(6)(vii) of this section. The software was intended to be innovative because it would provide a reduction in cost or improvement in speed that is substantial and economically significant. In addition, X's development activities involved significant economic risk in that X committed substantial resources to the development and there was substantial uncertainty that because of technical risk, such resources would be recovered within a reasonable period. Finally, at the time X undertook the development of the system, software meeting X's requirements was not commercially available for use by X.

¶Example 18.

Internal use software; application of the high threshold of innovation test—(i) Facts. X, a multinational manufacturer, wants to install an enterprise resource planning (ERP) system that runs off a single database. However, to implement the ERP system, X determines that it must integrate part of its old system with the new because the ERP system does not have a particular function that X requires for its business. The two systems are general and administrative software systems. The systems have mutual incompatibilities. The integration, if successful, would provide a reduction in cost and improvement in speed that is substantial and economically significant. At the time X undertook this project, there was no commercial application available with such a capability. X is uncertain regarding the appropriate design of the interface software. However, X knows that given a reasonable period of time to experiment with various designs, X would be able to determine the appropriate design necessary to meet X's technical requirements and would recover the substantial resources that X commits to the development of the system within a reasonable period. At the beginning of the development, X does not intend to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X's system.

¶(7) Activities outside the United States, Puerto Rico, and other possessions—

¶(i) In general. Research conducted outside the United States, as defined in section 7701(a)(9), the Commonwealth of Puerto Rico and other possessions of the United States does not constitute qualified research.

¶(ii) Apportionment of in-house research expenses. In-house research expenses paid or incurred for qualified services performed both in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and outside the United States, the Commonwealth of Puerto Rico and other possessions of the United States must be apportioned between the services performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and the services performed outside the United States, the Commonwealth of Puerto Rico and other possessions of the United States. Only those in-house research expenses apportioned to the services performed within the United States, the Commonwealth of Puerto Rico and other possessions of the United States are eligible to be treated as qualified research expenses, unless the in-house research expenses are wages and the 80 percent rule of § 1.41-2(d)(2) applies.

¶(iii) Apportionment of contract research expenses. If contract research is performed partly in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and partly outside the United States, the Commonwealth of Puerto Rico and other possessions of the United States, only 65 percent (or 75 percent in the case of amounts paid to qualified research consortia) of the portion of the contract amount that is attributable to the research activity performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States may qualify as a contract research expense (even if 80 percent or more of the contract amount is for research performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States).

¶(8) Research in the social sciences, etc. Qualified research does not include research in the social sciences (including economics, business management, and behavioral sciences), arts, or humanities.

¶(9) Research funded by any grant, contract, or otherwise. Qualified research does not include any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity). To determine the extent to which research is so funded, § 1.41-4A(d) applies.

¶(10) Illustrations. The following examples illustrate provisions contained in paragraphs (c)(1) through (9) (excepting paragraphs (c)(6) of this section) of this section. No inference should be drawn from these examples concerning the application of section 41(d)(1) and paragraph (a) of this section to these facts. The examples are as follows:

¶Example 1.

(i) Facts. X, a tire manufacturer, develops a new material to use in its tires. X conducts research to determine the changes that will be necessary for X to modify its existing manufacturing processes to manufacture the new tire. X determines that the new tire material retains heat for a longer period of time than the materials X currently uses for tires, and, as a result, the new tire material adheres to the manufacturing equipment during tread cooling. X evaluates several alternatives for processing the treads at cooler temperatures to address this problem, including a new type of belt for its manufacturing equipment to be used in tread cooling. Such a belt is not commercially available. Because X is uncertain of the belt design, X develops and conducts sophisticated engineering tests on several alternative designs for a new type of belt to be used in tread cooling until X successfully achieves a design that meets X's requirements. X then manufactures a set of belts for its production equipment, installs the belts, and tests the belts to make sure they were manufactured correctly.

(ii) Conclusion. X's research with respect to the design of the new belts to be used in its manufacturing of the new tire may be qualified research under section 41(d)(1) and paragraph (a) of this section. However, X's expenses to implement the new belts, including the costs to manufacture, install, and test the belts were incurred after the belts met the taxpayer's functional and economic requirements and are excluded as research after commercial production under section 41(d)(4)(A) and paragraph (c)(2) of this section.

¶Example 2.

(i) Facts. For several years, X has manufactured and sold a particular kind of widget. X initiates a new research project to develop a new or improved widget.

(ii) Conclusion. X's activities to develop a new or improved widget are not excluded from the definition of qualified research under section 41(d)(4)(A) and paragraph (c)(2) of this section. X's activities relating to the development of a new or improved widget constitute a new research project to develop a new business component. X's research activities relating to the development of the new or improved widget, a new business component, are not considered to be activities conducted after the beginning of commercial production under section 41(d)(4)(A) and paragraph (c)(2) of this section.

¶Example 3.

(i) Facts. X, a computer software development firm, owns all substantial rights in a general ledger accounting software core program that X markets and licenses to customers. X incurs expenditures in adapting the core software program to the requirements of C, one of X's customers.

(ii) Conclusion. Because X's activities represent activities to adapt an existing software program to a particular customer's requirement or need, X's activities are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section.

¶Example 4.

(i) Facts. The facts are the same as in Example 3, except that C pays X to adapt the core software program to C's requirements.

(ii) Conclusion. Because X's activities are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section, C's payments to X are not for qualified research and are not considered to be contract research expenses under section 41(b)(3)(A).

¶Example 5.

(i) Facts. The facts are the same as in Example 3, except that C's own employees adapt the core software program to C's requirements.

(ii) Conclusion. Because C's employees' activities to adapt the core software program to C's requirements are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section, the wages C paid to its employees do not constitute in-house research expenses under section 41(b)(2)(A).

¶Example 6.

(i) Facts. X manufacturers and sells rail cars. Because rail cars have numerous specifications related to performance, reliability and quality, rail car designs are subject to extensive, complex testing in the scientific or laboratory sense. B orders passenger rail cars from X. B's rail car requirements differ from those of X's other existing customers only in that B wants fewer seats in its passenger cars and a higher quality seating material and carpet that are commercially available. X manufactures rail cars meeting B's requirements.

(ii) Conclusion. X's activities to manufacture rail cars for B are excluded from the definition of qualified research. The rail car sold to B was not a new business component, but merely an adaptation of an existing business component that did not require a process of experimentation. Thus, X's activities to manufacture rail cars for B are excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section because X's activities represent activities to adapt an existing business component to a particular customer's requirement or need.

¶Example 7.

(i) Facts. X, a manufacturer, undertakes to create a manufacturing process for a new valve design. X determines that it requires a specialized type of robotic equipment to use in the manufacturing process for its new valves. Such robotic equipment is not commercially available, and X, therefore, purchases the existing robotic equipment for the purpose of modifying it to meet its needs. X's engineers identify uncertainty that is technological in nature concerning how to modify the existing robotic equipment to meet its needs. X's engineers develop several alternative designs, and conduct experiments using modeling and simulation in modifying the robotic equipment and conduct extensive scientific and laboratory testing of design alternatives. As a result of this process, X's engineers develop a design for the robotic equipment that meets X's needs. X constructs and installs the modified robotic equipment on its manufacturing process.

(ii) Conclusion. X's research activities to determine how to modify X's robotic equipment for its manufacturing process are not excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section, provided that X's research activities satisfy the requirements of section 41(d)(1).

¶Example 8.

(i) Facts. An existing gasoline additive is manufactured by Y using three ingredients, A, B, and C. X seeks to develop and manufacture its own gasoline additive that appears and functions in a manner similar to Y's additive. To develop its own additive, X first inspects the composition of Y's additive, and uses knowledge gained from the inspection to reproduce A and B in the laboratory. Any differences between ingredients A and B that are used in Y's additive and those reproduced by X are insignificant and are not material to the viability, effectiveness, or cost of A and B. X desires to use with A and B an ingredient that has a materially lower cost than ingredient C. Accordingly, X engages in a process of experimentation to develop, analyze and test potential alternative formulations of the additive.

(ii) Conclusion. X's activities in analyzing and reproducing ingredients A and B involve duplication of existing business components and are excluded from the definition of qualified research under section 41(d)(4)(C) and paragraph (c)(4) of this section. X's experimentation activities to develop potential alternative formulations of the additive do not involve duplication of an existing business component and are not excluded from the definition of qualified research under section 41(d)(4)(C) and paragraph (c)(4) of this section.

¶Example 9.

(i) Facts. X, a manufacturing corporation, undertakes to restructure its manufacturing organization. X organizes a team to design an organizational structure that will improve X's business operations. The team includes X's employees as well as outside management consultants. The team studies current operations, interviews X's employees, and studies the structure of other manufacturing facilities to determine appropriate modifications to X's current business operations. The team develops a recommendation of proposed modifications which it presents to X's management. X's management approves the team's recommendation and begins to implement the proposed modifications.

(ii) Conclusion. X's activities in developing and implementing the new management structure are excluded from the definition of qualified research under section 41(d)(4)(D) and paragraph (c)(5) of this section. Qualified research does not include activities relating to management functions or techniques including management organization plans and management-based changes in production processes.

¶Example 10.

(i) Facts. X, an insurance company, develops a new life insurance product. In the course of developing the product, X engages in research with respect to the effect of pricing and tax consequences on demand for the product, the expected volatility of interest rates, and the expected mortality rates (based on published data and prior insurance claims).

(ii) Conclusion. X's activities related to the new product represent research in the social sciences (including economics and business management) and are thus excluded from the definition of qualified research under section 41(d)(4)(G) and paragraph (c)(8) of this section.

¶(d) Recordkeeping for the research credit. A taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. For the rules governing record retention, see § 1.6001-1. To facilitate compliance and administration, the IRS and taxpayers may agree to guidelines for the keeping of specific records for purposes of substantiating research credits.

¶(e) Effective/applicability dates. Other than paragraph (c)(6) of this section, this section is applicable for taxable years ending on or after December 31, 2003. Paragraph (c)(6) of this section is applicable for taxable years beginning on or after October 4, 2016. For any taxable year that both ends on or after January 20, 2015 and begins before October 4, 2016, the IRS will not challenge return positions consistent with all of paragraph (c)(6) of this section or all of paragraph (c)(6) of this section as contained in the Internal Revenue Bulletin (IRB) 2015-5 (see www.irs.gov/pub/irs-irbs/irb15-05.pdf). For taxable years ending before January 20, 2015, taxpayers may choose to follow either all of § 1.41-4(c)(6) as contained in 26 CFR part 1 (revised as of April 1, 2003) and IRB 2001-5 (see www.irs.gov/pub/irs-irbs/irb01-05.pdf) or all of § 1.41-4(c)(6) as contained in IRB 2002-4 (see www.irs.gov/pub/irs-irbs/irb02-04.pdf).

[T.D. 8930, 66 FR 290, Jan. 3, 2001, as amended by T.D. 9104, 69 FR 26, Jan. 2, 2004; T.D. 9786, 81 FR 68307, Oct. 4, 2016; 81 FR 76496, Nov. 3, 2016]

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third party § 1.41-4(c)(6)(vi)(E)

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November 3, 2016Amended (81 FR 76496)
October 4, 2016Amended by T.D. 9786 (81 FR 68307)
January 2, 2004Amended by T.D. 9104 (69 FR 26)
January 3, 2001Issued by T.D. 8930 (66 FR 290)

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§ 1.41-0 Table of contents.
§ 1.41-1 Credit for increasing research activities.
§ 1.41-2 Qualified research expenses.
§ 1.41-3 Base amount for taxable years beginning on or after January 3, 2001.
§ 1.41-4 Qualified research for expenditures paid or incurred in taxable years ending on or after December 31, 2003.
§ 1.41-4A Qualified research for taxable years beginning before January 1, 1986.
§ 1.41-5A Basic research for taxable years beginning before January 1, 1987.
§ 1.41-6 Aggregation of expenditures.
§ 1.41-7 Special rules.

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