Proposed Federal Regulations Provide Favorable Guidance on Research and Experimentation Expenditures

The U.S Department of the Treasury and the Internal Revenue Service (IRS) have issued proposed regulations that address several long-standing discrepancies between how taxpayers and the IRS interpret the tax code related to the Section 174 deduction for research and experimentation (R&E) expenditures. The new regulations clarify that the eligibility of R&E expenditures for the tax deduction is not impacted by the subsequent sale of the resulting tangible property, such as a prototype, created through the R&E process.

“Today’s proposed rules provide the tax certainty necessary to reward businesses that invest in innovation,” said Assistant Secretary for Tax Policy Mark J. Mazur. “Research and development are critical to addressing the challenges we face as a nation, and we will continue to pursue opportunities to clarify the tax code in a way that promotes economic growth and job creation.”

These regulations, which are proposed to apply to tax years ending on or after the date final regulations are published, also include a new “shrinking-back” provision and definition of the term “pilot model.” Specifically, the “shrinking- back” provision, which is similar to the research credit rule under Regulation Section 1.41-4(b)(2), addresses expense treatment in which the Section 174 requirements are met with respect to only a component of the larger product but not with respect to the product as a whole. Additionally, the proposed definition of “pilot model” as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product includes a fully functional representation or model, which thereby provides for a full-scale prototype to be eligible for the R&E deduction.

Due to the fact qualification for the Section 41 research credit requires meeting the Section 174 deduction requirements, the rules will also impact taxpayers claiming the Section 41 credit. While taxpayers who have followed related case law such as T.G. Missouri Company v. Commissioner may find portions of the proposed regulations to be as expected, taxpayers should, however, take the opportunity to review their procedures and documentation, particularly if they incur significant supply expense for building prototypes.

The rules state that taxpayers may rely on the proposed regulations until final regulations are released. A public hearing has been scheduled for January 8, 2014, and comments are requested within 90 days of the proposed regulations’ publication.