Proposed Section 174 Regs Would Broaden Definition of R&D
(Parker's Federal Tax Bulletin: September 15, 2013)

Proposed regulations provide that if expenditures qualify as research or experimental expenditures, it is irrelevant whether a resulting product is ultimately sold or used in the taxpayer's trade or business. REG-124148-05 (9/6/13).

Code Sec. 174 allows taxpayers to elect to take a current deduction for research and experimental expenditures in the tax year they are paid or incurred or to defer certain research and experimental expenditures and amortize them. Since its enactment in 1954, Code Sec. 174(c) has provided that Code Sec. 174 does not apply to any expenditure for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation and of a character that is subject to depreciation or depletion. In 1957, the IRS issued Reg. Sec. 174-2(b)(1) and (b)(4) to implement this rule. This is referred to as the Depreciable Property Rule.

Practitioners have been questioning whether the sale of a product resulting from otherwise qualifying research or experimental expenditures should subsequently disqualify those expenditures from Code Sec. 174 treatment. The IRS had previously taken the position that Code Sec. 174(c) precluded Code Sec. 174 treatment in the case of a subsequent sale of a resulting product to a customer, because the sale gives rise to depreciable property in the hands of the customer. In T.G. Missouri Company v. Comm'r, 133 T.C. 278 (2009), the Tax Court rejected the IRS's argument that research or experimental expenditures were disqualified under Code Sec. 174 because the product resulting from research was sold to customers and was subject to depreciation in the customers' hands.

The IRS has now issued proposed regulations in which it proposes several substantive revisions to the current regulations and provides additional examples to further clarify how the rules work. First, to counter an interpretation that Code Sec. 174 eligibility can be reversed by a subsequent event, the proposed regulations provide that the ultimate success, failure, sale, or other use of the research or property resulting from research or experimentation is not relevant to a determination of eligibility under Code Sec. 174. Second, the proposed regulations amend Reg. Sec. 1.174-2(b)(4) to provide that the Depreciable Property Rule is an application of the general definition of research or experimental expenditures provided for in Reg. Sec. 1.174-2(a)(1) and should not be applied to exclude otherwise eligible expenditures.

Third, the proposed regulations define the term ``pilot model'' as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term includes a fully functional representation or model of the product or a component of a product (to the extent the shrinking-back provision described below applies). Fourth, the proposed regulations clarify the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible under Code Sec. 174 because these costs are not for research or experimentation. Finally, the proposed regulations provide a shrinking-back provision to address situations in which the requirements of Reg. Sec. 1.174-2(a)(1) are met with respect to only a component part of a larger product and are not met with respect to the overall product itself. The proposed regulations provide new examples applying these provisions.

These regulations are proposed to apply to any tax year ending on or after the date the regulations are finalized. Notwithstanding the prospective effective date, the IRS will not challenge return positions consistent with these proposed regulations. Therefore, taxpayers may rely on these proposed regulations until the date that the final regulations are published in the Federal Register.

For a discussion of the rules for deducting research and experimental expenditures, see Parker Tax ¶95,505.

Parker Tax Publishing Staff Writers

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