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ness. The expensing election permitted by section 174 is an exception to the general rule that a taxpayer must capitalize costs incurred to develop an asset which has a useful life that extend beyonds the taxable year.

In addition to the expensing election of section 174, section 44F allows a 25 percent tax credit for a certain portion of a taxpayer's "qualified research expenses." Creditable expenses include qualified R&E expenditures made directly by the taxpayers as well as 65 percent of the amount expended for contract research, and, in the case of corporate taxpayers, 65 percent of the amount contributed to universities and other qualifying organizations for research purposes.

The portion of a taxpayer's qualified R&E expenses that are eligible for the credit is limited to the lesser of (1) the excess of such expenses in the current year over the average amount of such expenses for the prior three-year period, or (2) 50 percent of qualified R&E expenses in the current year. Taxpayers may carry credits not usable in the current year back for three years and forward for fifteen.

Section 44F defines "qualified research” expenditures by reference to the term "research or experimental" under section 174. The legislative history of the R&E credit further indicates that the existing administrative interpretations under section 174 were also to apply for purposes of section 44F. Treasury regulations under section 174 define the term “research or experimental expenditures” to mean “research and development costs in the experimental or laboratory sense" and include costs incurred to develop an "experimental or pilot model, a plant process, a product, a formula, an invention, or similar property.” The regulations exclude from that definition costs incurred "for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotion.” Regulations proposed under section 174 subsequent to the enactment of section 44F also would exclude routine, periodic or cosmetic alteration or improvement of existing products, planning for commerical production and trial production runs, engineering follow-through or troubleshooting during commerical production and the adaptation of an existing product to a particular customer's requirements.

The current regulations under section 174 do not precisely identify the type of expenses qualifying as "research or experimental.” Under section 174, this lack of precision may not be critical, since many expenditures are deductible currently either as R&E expenses or as ordinary and necessary business expenses under section 162. The same imprecision in the definition of qualifying expenses is not acceptable for purposes of the credit, however, since it enables taxpayers to argue that virtually all preproduction costs associated with developing any product or process qualify for the credit. A definition which fails to focus on innovative R&E activities effectively dilutes the incentive for taxpayers to undertake innovative R&E.

II. EXPERIENCE WITH THE CREDIT Our experience with the credit is limited to 1981 and preliminary 1982 data. This data is presented in detail in the attached tables, and I will touch only on its highlights. At the outset, let me caution against drawing firm conclusions based on our experience over this limited period of time. We have only partial tax return data for 1982 and the data for 1981, though complete, represent only six months experience with the credit. Use of the credit

The available data does suggest that the R&E credit was claimed primarily by large corporations. The 12,000 corporate taxpayers claiming the credit in 1981 represented about 39 percent of total corporate assets and receipts, but less than one percent of all corporations filing 1981 returns. In the groups of corporations with assets of $10 billion or more, 70.2 percent (74.8 percent of total assets) had tentative credits, compared to 2.8 percent of corporations (with 3.7 percent of assets) with assets between $1 million and $10 million. The greater use of the R&E credit by large corporations is not surprising since such corporations would typically have more extensive R&E programs with relatively greater resources to devote to R&E.

The data also indicate that the corporations claiming the R&E credit were concentrated in a few industries. Corporations in four industry categories-metals and machinery, chemicals, motor vehicles and transportation, communications and utilities-accounted for more than three-fourths of qualifying R&E expenditures in 1981. As indicated in Table 2, these corporations account for less than one-half of total receipts of all corporations with tentative credits.

Within these four broad industry categories, businesses in fields typically associated with high technology (see Table 9) accounted for a major share of the reported R&E expenses. These corporations accounted for 44 percent of all qualifying R&E expenditures, but only 12 percent of total receipts of all corporations with tentative credits. Growth in R&E expenditures

Corporate taxpayers reported an average growth rate in R&E expenditures of 40.3 percent in 1981. Twenty percent of corporate returns with tentative R&E credits reported growth rates in R&E greater than 200 percent and an additional 18 percent reported growth rates between 100 and 200 percent. Three_industries reported growth in qualifying R&E expenditures exceeding 100 percent. The highest reported growth rates were 125 percent in services, 177 percent in contract construction, 111 percent in paper and printing, 86 percent in petroleum refining and 81 percent in trade. For the most part, however, the industries reporting relatively high increases in R&E expenses received a relatively small fraction of all R&E credits, averaging less than two percent each of the total tentative credits.

The growth in qualifying expenditures was greater for smaller corporations than for large corporations. In 1981, for example, qualifying R&E expenditures increased by 104.5 percent for corporations with assets between $1 million and $10 million, compared to an increase of 32.2 percent for corporations with assets greater than $10 billion. (See Tables 7 and 8).

Although tax return data for 1982 still do not reflect the returns of a number of very large corporations, preliminary indications are of a substantial increase in R&E expenditures over 1981. The average rate of growth in R&E expenditures may have slowed in 1982, however, the preliminary data indicating a decline from 40 to 38 percent. The final figures may indicate a more substantial drop, since the current data does not reflect the returns for larger corporations which we would expect to report lower than average rates of growth. Only R&E expenses in the services industry continued to grow at a rate in excess of 100 percent.

Data relating to the growth in R&E expenditures are obviously of critical interest, given the objective of the credit to encourage such expenditures. The preliminary indications of substantial growth in R&E expenditures reported by corporate taxpayers do not at this point, however, support firm conclusions about the effectiveness of the credit in promoting R&E. The increased R&E expenses reported by taxpayers may indicate that the credit is having the intended incentive effect, but it may also be that taxpayers have simply reclassified costs as R&E expenses in order to claim the R&E credit. Significant conclusions about the credit's effectiveness as a spur to technological innovation must await the collection of data from a number of years. Credit limitations

Careful scrutiny of the credit's effect on R&E expenditures must also take into account that the actual incentive supplied by the credit will vary among different taxpayers. The credit will be of maximum value only to those taxpayers which have a current tax liability or tax liabilities for prior years against which the credit could be carried back. For 1981, we estimate that taxpayers were not able to utilize approximately 23 percent of tentative credits either against 1981 tax liability or liabilities for the three previous years. Of course, taxpayers unable to utilize R&E credits fully in 1981 would be allowed to carry such credits forward for 15 years to apply against future years' tax liabilities.


The R&E credit is currently scheduled to expire on December 31, 1985. The Administration continues to support the R&E credit and favors its extension. Given our limited experience with the credit, however, and the uncertainty of the preliminary data, we oppose making the credit permanent at this time. Additional experience with the credit will enable us to make informed judgments about the credit's effectiveness in promoting technological innovation. The data currently available is simply inadequate to that task. In the meantime, we favor extending the R&E credit for an additional three years. Definition of qualifying R&E expenses

Although the Administration favors extending the R&E credit, we believe that as part of any such extension the range of expenses eligible for the R&E credit must be reexamined. In our view, the current definition of qualifying expenses does not adequately target the credit toward innovative R&E activities. The imprecision of the current law definition has permitted taxpayers unwarranted flexibility in classifying business costs as R&E expenditures.

The definition of qualifying expenses for purposes of the R&E credit must not only identify those innovative R&E activities which merit government support, but must also incorporate sufficiently objective standards for taxpayers to plan their activities with reasonable certainty about the credit's availability. A definition which satisfies these two criteria will more effectively encourage taxpayers to undertake innovative R&E activities.

We begin with the proposition that all costs incurred in conducting basic research should be creditable. The term basic research includes any original investigation for the advancement of scientific knowledge not having a specific commercial objective. For purposes of the credit, however, such term should continue to exclude basic research in the social sciences or humanities or basic research conducted outside the United States.

In identifying the expenses for commercial research that should receive the credit, we believe as a first principle that research entitled to the credit must be designed to produce a significant technological improvement in a business component. A useful definition incorporating that principle can be found in the Senate amendment to H.R. 4170 (the "Senate definition”). Althouth the conferees agreed to defer consideration of the R&E credit, the Senate definition targets technological innovation and provide taxpayers with relatively objective rules.

The Senate concluded that the definition derived from section 174 is too broad for purposes of the credit and allows taxpayers to claim the credit for virtually all preproduction expenses. The new Senate definition was developed by the Senate Finance Committee in consultation with Treasury and industry representatives. We believe that this joint effort resulted in a definition which responds both to our concerns that the credit target R&E activities leading to technological innovation and to industry's desire for a definition with relatively objective standards.

Under the Senate definition, a business component is "technologically new or improved" if the new or improved characteristics of the business component are technological in nature and substantially all of the development activities involve a process of experimentation relating to functional rather than stylistic, aspects of the business component. For this purpose, the term "technological” means activities pertaining to or predicated upon principles of the physical or biological sciences, or engineering or computer science. This requirement is designed to exclude non-technological activities, such as the development of financial products or activities relating to the provision of services.

The phrase "process of experimentation" generally is designed to encompass the evaluation of alternatives that involve a serious degree of uncertainty as to whether the desired result would be achieved. Experimentation does not include trial and error techniques where the method of reaching the desired objective is readily discernible.

In this context, the term "business component" means the most basic element or component part of a product or process with respect to which the R&E activities relate. If the R&E activities relate to an entire product or process, then the develop ment costs for the entire product are creditable. On the other hand, if the R&E activities relate only to a component part and the taxpayer incurred more than an insignificant amount of non-R&E development costs with respect to other aspects of the product or process, only the R&E costs related to the component will be eligible for the credit. Focusing on the particular component to which the R&E activities relate will prevent routine product development costs from qualifying for the R&E credit.

In order to exclude from the credit activities that would not by their nature result in technological innovation, the Senate definition also denies the credit for certain activities regardless of whether a new or improved business component is involved. Thus, the Senate definition excludes the costs of developing a business component if the predominant portion of the development costs is made up of duplication expenditures. Duplication is defined as any activity related to the reproduction of an existing business component from examining the component or from examining plans, blueprints, detailed specifications or publicly available information. This exclusion is designed, among other things, to prevent costs incurred in "reverse engineering" from qualifying for the credit.

In addition, the Senate definition specifically excludes activities relating to the adaptation of an existing product to the particular requirements of one customer. It also provides that any costs incurred with respect to a business component after the beginning of commercial production are not eligible for the credit. For this purpose, the term "beginning of commercial production” refers to the point where the busi

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ness component meets the taxpayer's basic functional and economic requirements or is ready for commercial sale or use. This exclusion is intended to prevent costs associated with certain port-research activities, such as debugging or retooling, from qualifying for the credit.

The Senate definition continues the current law's exclusion for research (1) conducted outside the United States, (2) in the social sciences, arts or humanities, or (3) funded by any grant, contract or otherwise, and for costs associated with ascertaining the existence, location, extent or quality of any deposit of ore or other mineral (including oil and gas). In addition, the definition excludes costs associated with efficiency surveys, management studies, management techniques, market research, market tests and quality control.

In summary, the Senate definition is an important effort to improve the effectiveness of the R&E credit. It more precisely targets the credit to innovative R&E activities while providing taxpayers with relatively objective standards for the credit's availability. Collateral R&E credit issues

In addition to the definition of qualifying R&E expenses, we suggest that certain other issues relating to the credit be considered as part of this review of the R&E credit. Some of these issues were addressed in the Senate amendment.

Start-up companies.-Current law provides that the R&E credit is available in connection with qualifying amounts paid or incurred in carrying on any trade or business of the taxpayer. This requirement is intended to serve two related purposes. First, it prevents tax shelters from receiving the benefit of the credit by denying it to entities conducting research and development for third parties. Second, it serves to protect the incremental feature of the credit: if any taxpayer could receive the credit, existing businesses would avoid the base period limitation by having research performed by other entities which had no base period R&E. We support retention of the requirement that R&E expenses are creditable only if incurred in connection with an ongoing trade or business.

The Senate amendment, however, adopted a special rule for corporate taxpayers designed to address, in part, the availability of the credit to start-up companies. In certain cases, new corporations and corporations beginning a new line of business can not claim the credit for qualifying R&E expenses because the expenses do not relate to an ongoing trade or business. Under the Senate amendment, any corporation, other than an S corporation, personal holding company or service organization, may claim the credit without regard to the trade or business test if the taxpayer intends to use the results of the research in the active conduct of a present or future trade or business. This approach would continue current law's denial of the credit to taxpayers which merely lease or license research results, but would extend the credit to research expenses of a start-up corporation not yet engaged in a trade or business or of an existing corporation entering a new business. We believe that such a modification of the trade or business requirement is worthwhile.

Incremental aspect of the credit.-Section 44F allows a 25 percent credit on a taxpayer's qualifying R&E expenses in excess of the average amount of such expenses during the three previous taxable years. Creditable expenses may not, however, exceed 50 percent of the taxpayer's qualifying R&E expenses for the current year. The base period limitation on qualifying R&E expenses makes the true value of the credit dependent on the relative growth or decline in the taxpayer's R&E expenses. For firms with a growth rate in qualifying R&E expenditures of between 0 and 100 percent, the credit provides a full 25 cent tax benefit for every dollar increase in R&E expenditures. On the other hand, as a firm's growth rate for R&E expenditures moves in excess of 100 percent, the 50 percent cap will gradually reduce the tax benefit from 25 cents to as little as 12.5 cents for every additional dollar expended. Moreover, due to the base period limitation, the credit provides no incentive for corporations with declining R&E expenditures to reduce their rate of decline.

The base period limitation on the R&E credit is appropriately intended to target the credit to new or additional R&E expenditures. Although the base period limitation may introduce some disparities in the incentive effect of the credit, we continue to support the incremental focus of the credit and believe that the base period limitation should be retained.

In addition, it may be desirable to refine the base period limitation to ensure that its incremental focus is not eroded by inflation. In an inflationary period, a portion of additional R&E expenditures will be attributable to inflation rather than to real increases in the level of R&E activity. A business that incurs qualified research expenses in year 1 and increases its costs in subsequent years only to keep pace with increased costs would receive an R&E credit even though it would have no real in

crease in R&E expenditures. We think it is appropriate to consider whether a taxpayer's base period research expenses should be indexed to account for the effect of inflation. In this way, the credit would be provided only for real increases in R&E expenditures.

University basic research.-Under current law, 65 percent of amounts which a corporation contributes to universities and certain other qualifying organizations to conduct basic research are treated as qualified research expenses eligible for the credit. We believe this aspect of the current R&E credit provides an important incentive for taxpayers to make contributions to fund university basic research and should be retained. However, we oppose creating a separate credit for contributions to universities to conduct basic research, as was proposed in the Senate amendment.

Although we do not favor creating additional tax incentives for contributions to universities for basic research, we believe the Committee should examine whether the current structure of the credit discourages corporations from entering into commitments with universities to fund multi-year basic research projects. As noted above, under current law the effective R&E credit available to a company that makes a multi-year funding commitment is much smaller than that available if the same funds are paid in a single year. A straight-forward change in the law could remove the effect that this aspect of the credit has on university contributions. It would provide that the total Ř&E credit allowed with respect to a binding multiyear funding commitment to a university would not be reduced below the amount of the credit that would have been available had the company made the contribution all in one year. Of course, the credit would not be allowed until the contribution was actually made.

IV. CONCLUSION The Administration continues to support the R&E credit, believing that it can provide an important incentive to the innovative R&E activities that are critical to this country's economic future. In order that the credit accomplish that objective in the most efficient manner possible, the definition of qualifying expenses should be modified so as to target the credit to innovative R&E activities. We look forward to working with the Subcommittee to improve and extend this important provision.



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Total. All corporations.

12,384 2,812,420





38.6 100.0

Source Office of the Secretary of the Treasury, Office of Tax Analysis, July 26, 1984.

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