Research Expenditures, 42193-42197 [2014-16956]

Download as PDF Federal Register / Vol. 79, No. 139 / Monday, July 21, 2014 / Rules and Regulations (iii) Optional application of TD 9564. A taxpayer may choose to apply § 1.263A–1T(b)(14), the introductory phrase of § 1.263A–1T(c)(4), the last sentence of § 1.263A–1T(e)(2)(i)(A), the last sentence of § 1.263A–1T(e)(3)(ii)(E), § 1.263A–1T(l), and § 1.263A–1T(m)(2), as these provisions are contained in TD 9564 (76 FR 81060) December 27, 2011, to amounts paid (to acquire or produce property) in taxable years beginning on or after January 1, 2012, and before January 1, 2014. Martin V. Franks, Branch Chief, Publications and Regulations Branch, Legal Processing Division, Associate Chief Counsel (Procedure and Administration). [FR Doc. 2014–17080 Filed 7–18–14; 8:45 am] BILLING CODE 4830–01–P DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 9680] RIN 1545–BE64 Research Expenditures Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. AGENCY: This document contains final regulations to amend the definition of research and experimental expenditures under section 174 of the Internal Revenue Code (Code). In particular, these final regulations provide guidance on the treatment of amounts paid or incurred in connection with the development of tangible property, including pilot models. The final regulations will affect taxpayers engaged in research activities. DATES: Effective date: These regulations are effective July 21, 2014. Applicability date: For date of applicability see § 1.174–2(d). FOR FURTHER INFORMATION CONTACT: David McDonnell at (202) 317–4137 (not a toll-free number). SUPPLEMENTARY INFORMATION: tkelley on DSK3SPTVN1PROD with RULES SUMMARY: Summary of Proposed Regulations On September 6, 2013, a notice of proposed rulemaking (REG–124148–05) and a notice of public hearing were published in the Federal Register (78 FR 547896). The IRS and the Treasury Department proposed the following revisions to the current regulations: First, to counter an interpretation that section 174 eligibility can be reversed by a subsequent event, the proposed VerDate Mar<15>2010 16:01 Jul 18, 2014 Jkt 232001 regulations provided 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 section 174. Second, the proposed regulations amended § 1.174–2(b)(4) to provide that the Depreciable Property Rule (the rules in § 1.174–2(b)(1) and § 1.174–2(b)(4)) is an application of the general definition of research or experimental expenditures provided for in § 1.174– 2(a)(1) and should not be applied to exclude otherwise eligible expenditures. Third, the proposed regulations defined 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 included a fully-functional representation or model of the product or a component of a product (to the extent the shrinking-back rule applies). Fourth, the proposed regulations clarified 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 section 174 because these costs are not for research or experimentation. Finally, the proposed regulations provided a shrinking-back rule, similar to the rule provided in § 1.41–4(b)(2), to address situations in which the requirements of § 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 also provided new examples applying the foregoing provisions. Summary of Comments and Explanation of Provisions Several comments were received in response to the proposed regulations. Following is a discussion of significant comments. Certain other comments presented issues unrelated to the proposed regulations, and they are not adopted or discussed herein. Uncertainty Some commentators requested a definition of ‘‘uncertainty’’ because the examples rely on ‘‘elimination of uncertainty’’ as the point when research activities have concluded. Section 1.174–2(a)(1) provides that ‘‘[u]ncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.’’ Because the current regulations already PO 00000 Frm 00013 Fmt 4700 Sfmt 4700 42193 provide a sufficient definition of ‘‘uncertainty,’’ and the point at which uncertainty is eliminated (that is, information available to the taxpayer establishes the capability or method for developing or improving the product or the appropriate design of the product) is based on the taxpayer’s facts and circumstances, the final regulations do not provide additional guidance with respect to the definition of ‘‘uncertainty.’’ Some commentators requested a bright-line standard, such as the commencement of commercial production as in section 41(d)(4)(A), to determine when uncertainty is eliminated. Section 1.174–2(a)(1) of the proposed regulations provided that costs may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated. The point at which uncertainty is resolved is based on the taxpayer’s facts and circumstances, and therefore a bright-line standard is not appropriate under section 174. Some commentators requested that the regulations explicitly incorporate the rule of application regarding the discovering information requirement found in section 41(d)(1)(B) and § 1.41– 4(a)(3)(ii) (that is, there is no requirement that the taxpayer be seeking to obtain information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field, and there is no requirement that the taxpayer succeed in developing a new or improved business component). The IRS and the Treasury Department note that section 174 does not contain any provision defining research or experimentation. In contrast, section 41 provides a statutory definition for ‘‘qualified research,’’ which includes a requirement that the research be undertaken for the purpose of discovering information. In addition, neither the section 174 statute nor its legislative history suggest that a taxpayer must seek information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field in which the taxpayer is performing research. Section 1.174–2(a)(1) of the current regulations simply provides that ‘‘[e]xpenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.’’ Consequently, this comment is not adopted. E:\FR\FM\21JYR1.SGM 21JYR1 42194 Federal Register / Vol. 79, No. 139 / Monday, July 21, 2014 / Rules and Regulations Supplies Some commentators requested clarification that indirect or ancillary supplies used in research are eligible under section 174 although ineligible under section 41. Section 1.174–2(a)(1) of the current regulations provides that the term ‘‘research or experimental expenditures’’ ‘‘generally includes all such costs incident to the development or improvement of a product.’’ This statement is sufficiently broad to include indirect or ancillary supplies used in research that otherwise satisfies the requirements of section 174. Therefore, revisions to the proposed regulations are not needed to respond to the commentators’ concern. ‘‘test bed.’’ Furthermore, the commentator construed Example 2 and Example 3 of proposed regulation § 1.174–2(b)(5) to state that test beds are depreciable property excluded from section 174. As provided in proposed regulation § 1.174–2(a)(4), a pilot model means 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 proposed examples demonstrate the application of § 1.174–2(b)(1), (b)(2), and (b)(4) (that is, when expenditures for property may be research and experimental expenditures). The facts of the proposed examples do not demonstrate the existence of a pilot model nor do they foreclose the possibility that a test bed may be a pilot model if it meets the definition of a pilot model under proposed regulation § 1.174–2(a)(4). For example, if the taxpayer constructed a new test bed as a model test bed and the new test bed was produced to evaluate and resolve uncertainty concerning the test bed during its development or improvement, it could be a pilot model. Because these examples were not intended to illustrate pilot models, the final regulations do not adopt this comment. Pilot Model One commentator expressed concern regarding a proposed example demonstrating the application of the rules in the case of multiple pilot models. The commentator suggested that, under Example 5 of § 1.174– 2(a)(11) of the proposed regulations, the deductibility of section 174 expenses for multiple pilot models is permitted only if each pilot model is tested for a purpose that is different from any other pilot model. The definition of pilot model contained in § 1.174–2(a)(4) of the proposed regulations does not contain a requirement that the pilot model be used to test for a discrete purpose. A pilot model within the definition of § 1.174–2(a)(4) of the proposed regulations (including a component to the extent paragraph (a)(5) applies) is eligible for section 174, subject to satisfaction of the other requirements of section 174 and the regulations. The final regulations modify Example 5 to clarify that it is not necessary for each pilot model to be tested for a discrete purpose for the costs of multiple pilot models to qualify as research and experimental expenditures under section 174. One commentator requested clarification regarding the distinction between a section 174 eligible ‘‘pilot model’’ and a section 174 ineligible Shrinking-Back Rule Some commentators expressed concern that the shrinking-back rule in § 1.174–2(a)(5) of the proposed regulations may exclude from section 174 the cost of testing to eliminate uncertainty regarding the integration of an experimental component with a nonexperimental product. Section 1.174–2(a)(1) of the current regulations provides that the term ‘‘research or experimental expenditures’’ ‘‘generally includes all such costs incident to the development or improvement of a product.’’ This statement is sufficiently broad to encompass the cost of testing (other than testing specifically excluded under current § 1.174–1(a)(3) (quality control testing)) performed to eliminate uncertainty with respect to an experimental component and costs to resolve uncertainty regarding integration of an experimental component with a nonexperimental product when the requirements of § 1.174–2(a)(1) are not met for the product as a whole. Therefore, revisions to the proposed regulations are not needed to respond to the commentators’ concern. Some commentators requested that the shrinking-back rule in § 1.174– 2(a)(5) of the proposed regulations be eliminated. The commentators stated that the shrinking-back rule in § 1.41– tkelley on DSK3SPTVN1PROD with RULES Some commentators questioned how the substantially all requirement in section 41(d)(1)(C) and § 1.41–4(a)(6) (that is, 80 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) applies to section 174. Section 174 does not contain a similar ‘‘substantially all’’ requirement. Accordingly, the requirement in section 41(d)(1)(C) and § 1.41–4(a)(6) does not apply to section 174. VerDate Mar<15>2010 16:01 Jul 18, 2014 Jkt 232001 PO 00000 Frm 00014 Fmt 4700 Sfmt 4700 4(b)(2) is peculiar to section 41 and serves no purpose in section 174. As with business components under section 41, research or experimental expenditures may relate only to one or more components of a larger product. The shrinking-back rule in the proposed regulations was intended to ensure that section 174 eligibility is preserved in instances in which a basic design specification of the product may be established, but there is uncertainty with respect to certain components of the product, even if uncertainty arises after production of the product has begun. Therefore, the substance of the shrinking-back rule is retained in the final regulations. However, in response to commentator concerns, and to avoid any unintended confusion with the shrinking-back rule of § 1.41–4(b)(2), the rule in § 1.174–2(a)(5) of the proposed regulations has been renamed. Furthermore, the last sentence of § 1.174–2(a)(5) of the proposed regulations has been eliminated in response to commentator concerns that references to section 41 may imply that other requirements under section 41, such as the process of elimination requirement, apply to expenditures under section 174. The final regulations also modify Example 8 of the proposed regulations and include one additional example, Example 9, to demonstrate the application of section 174 to components of a product. Examples One commentator expressed concern about Example 7 of § 1.174–2(a)(11) of the proposed regulations, which described the development of ‘‘a new, experimental aircraft.’’ The commentator believes that the use of the words ‘‘new’’ and ‘‘experimental’’ in proposed Example 7 could be interpreted to establish a new, heightened standard for eligibility for section 174. Section 1.174–2(a)(1) of the current regulations provides the only qualitative criteria for eligibility for section 174 and provides that whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which they relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. Terms used in examples do not have substantive meaning that expand or reduce the meaning or application of terms used in the regulations; they are simply describing the facts of the example. Accordingly, the final regulations do not revise Example 7 to E:\FR\FM\21JYR1.SGM 21JYR1 Federal Register / Vol. 79, No. 139 / Monday, July 21, 2014 / Rules and Regulations remove the descriptive terms ‘‘new’’ or ‘‘experimental.’’ One commentator requested guidance revising § 1.174–2(c), regarding exploration expenditures for oil, gas, or minerals. This comment is outside the scope of the proposed regulations which did not propose changes to § 1.174–2(c). Therefore, the requested guidance is not adopted in the final regulations. Effective/Applicability Date These regulations apply to taxable years ending on or after the date of their publication as final regulations in the Federal Register. Taxpayers may apply the final regulations to taxable years for which the limitations for assessment of tax has not expired. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking that preceded these final regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business and no comments were received. Drafting Information The principal author of these regulations is David McDonnell of the Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the Treasury Department and the IRS participated in their development. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. tkelley on DSK3SPTVN1PROD with RULES Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: ■ Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * ■ Par. 2. Section 1.174–2 is amended: VerDate Mar<15>2010 16:01 Jul 18, 2014 Jkt 232001 1. In paragraph (a)(1), by adding a heading and by adding two sentences at the end. ■ 2. By removing paragraph (a)(7). ■ 3. By redesignating paragraphs (a)(8) and (9) as paragraphs (a)(10) and (11), respectively, and adding headings to them. ■ 4. By redesignating paragraphs (a)(3) through (6) as paragraphs (a)(6) through (9), respectively, and adding headings to them. ■ 5. By redesignating paragraph (a)(2) as paragraph (a)(3) and adding a heading to newly designated paragraph (a)(3). ■ 6. By adding new paragraphs (a)(2), (4) and (5). ■ 7. In newly redesignated paragraph (a)(7), by removing the language ‘‘(a)(3)(i)’’ and adding ‘‘(a)(6)(i)’’ in its place. ■ 8. In newly redesignated paragraph (a)(9), by removing the language ‘‘(a)(6)’’ and adding ‘‘(a)(9)’’ in its place. ■ 9. By revising newly redesignated paragraph (a)(11) introductory text. ■ 10. In Example 1 in newly redesignated paragraph (a)(11) by adding a heading. ■ 11. In Example 2 in newly redesignated paragraph (a)(11) by adding a heading, removing the language ‘‘X’’ and adding ‘‘S’’ in its place everywhere ‘‘X’’ appears, and removing the language ‘‘Y’’ and adding ‘‘T’’ in its place everywhere ‘‘Y’’ appears. ■ 12. In newly redesignated paragraph (a)(11) by adding Example 3 through Example 10. ■ 13. In paragraphs (b)(1) through (3) by adding headings. ■ 14. By revising paragraph (b)(4). ■ 15. By adding paragraph (b)(5). ■ 16. By adding paragraph (d). The revisions and additions read as follows: ■ § 1.174–2 Definition of research and experimental expenditures. (a) In general. (1) Research or experimental expenditures defined. * * * The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174. Costs may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated. (2) Production costs. Except as provided in paragraph (a)(5) of this section (the rule concerning the application of section 174 to components of a product), costs paid or incurred in the production of a product after the elimination of uncertainty concerning the development or PO 00000 Frm 00015 Fmt 4700 Sfmt 4700 42195 improvement of the product are not eligible under section 174. (3) Product defined. * * * (4) Pilot model defined. For purposes of this section, the term pilot model means 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, to the extent paragraph (a)(5) of this section applies, a component of the product. (5) Application of section 174 to components of a product. If the requirements of paragraph (a)(1) of this section are not met at the level of a product (as defined in paragraph (a)(3) of this section), then whether expenditures represent research and development costs is determined at the level of the component or subcomponent of the product. The presence of uncertainty concerning the development or improvement of certain components of a product does not necessarily indicate the presence of uncertainty concerning the development or improvement of other components of the product or the product as a whole. The rule in this paragraph (a)(5) is not itself applied as a reason to exclude research or experimental expenditures from section 174 eligibility. (6) Research or experimental expenditures—exclusions. * * * (7) Quality control testing. * * * (8) Expenditures for literary, historical, or similar research—cross reference. * * * (9) Research or experimental expenditures limited to reasonable amounts. * * * (10) Amounts paid to others for research or experimentation. * * * (11) Examples. The following examples illustrate the application of this paragraph (a). Example 1. Amounts paid to others for research or experimentation allowed as a deduction.* * * Example 2. Amounts paid to others not allowable as a deduction. * * * Example 3. Pilot model. U is engaged in the manufacture and sale of custom machines. U contracts to design and produce a machine to meet a customer’s specifications. Because U has never designed a machine with these specifications, U is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine. U incurs a total of $31,000 on the project. Of the $31,000, U incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate E:\FR\FM\21JYR1.SGM 21JYR1 tkelley on DSK3SPTVN1PROD with RULES 42196 Federal Register / Vol. 79, No. 139 / Monday, July 21, 2014 / Rules and Regulations design. U also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine. This $11,000 of costs represents research and development costs in the experimental or laboratory sense. After uncertainty is eliminated, U incurs $20,000 to produce the machine for sale to the customer based on the appropriate design. The model produced and used to evaluate and resolve uncertainty is a pilot model within the meaning of paragraph (a)(4) of this section. Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under section 174. However, section 174 does not apply to the $20,000 that U incurred to produce the machine for sale to the customer based on the appropriate design. See paragraph (a)(2) of this section (relating to production costs). Example 4. Product component redesign. Assume the same facts as Example 3, except that during a quality control test of the machine, a component of the machine fails to function due to the component’s inappropriate design. U incurs an additional $8,000 (including design retesting) to reconfigure the component’s design. The $8,000 of costs represents research and development costs in the experimental or laboratory sense. After the elimination of uncertainty regarding the appropriate design of the component, U incurs an additional $2,000 on its production. The reconfigured component produced and used to evaluate and resolve uncertainty with respect to the component is a pilot model within the meaning of paragraph (a)(4) of this section. Therefore, in addition to the $11,000 of research and experimental expenditures previously incurred, the $8,000 incurred on design activities to establish the appropriate design of the component qualifies as research or experimental expenditures under section 174. However, section 174 does not apply to the additional $2,000 that U incurred for the production after the elimination of uncertainty of the re-designed component based on the appropriate design or to the $20,000 previously incurred to produce the machine. See paragraph (a)(2) of this section (relating to production costs). Example 5. Multiple pilot models. V is a manufacturer that designs a new product. V incurs $5,000 to produce a number of models of the product that are to be used in testing the appropriate design before the product is mass-produced for sale. The $5,000 of costs represents research and development costs in the experimental or laboratory sense. Multiple models are necessary to test the design in a variety of different environments (exposure to extreme heat, exposure to extreme cold, submersion, and vibration). In some cases, V uses more than one model to test in a particular environment. Upon completion of several years of testing, V enters into a contract to sell one of the models to a customer and uses another model in its trade or business. The remaining models were rendered inoperable as a result of the testing process. Because V produced the models to resolve uncertainty regarding the appropriate design of the product, the models are pilot models under paragraph VerDate Mar<15>2010 16:01 Jul 18, 2014 Jkt 232001 (a)(4) of this section. Therefore, the $5,000 that V incurred in producing the models qualifies as research or experimental expenditures under section 174. See also paragraph (a)(1) of this section (ultimate use is not relevant). Example 6. Development of a new component; pilot model. W wants to improve a machine for use in its trade or business and incurs $20,000 to develop a new component for the machine. The $20,000 is incurred for engineering labor and materials to produce a model of the new component that is used to eliminate uncertainty regarding the development of the new component for the machine. The $20,000 of costs represents research and experimental costs in the experimental or laboratory sense. After W completes its research and experimentation on the new component, W incurs $10,000 for materials and labor to produce the component and incorporate it into the machine. The model produced and used to evaluate and resolve uncertainty with respect to the new component is a pilot model within the meaning of paragraph (a)(4) of this section. Therefore, the $20,000 incurred to produce the model and eliminate uncertainty regarding the development of the new component qualifies as research or experimental expenditures under section 174. However, section 174 does not apply to the $10,000 of production costs of the component because those costs were not incurred for research or experimentation. See paragraph (a)(2) of this section (relating to production costs). Example 7. Disposition of a pilot model. X is a manufacturer of aircraft. X is researching and developing a new, experimental aircraft that can take off and land vertically. To evaluate and resolve uncertainty during the development or improvement of the product and test the appropriate design of the experimental aircraft, X produces a working aircraft at a cost of $5,000,000. The $5,000,000 of costs represents research and development costs in the experimental or laboratory sense. In a later year, X sells the aircraft. Because X produced the aircraft to resolve uncertainty regarding the appropriate design of the product during the development of the experimental aircraft, the aircraft is a pilot model under paragraph (a)(4) of this section. Therefore, the $5,000,000 of costs that X incurred in producing the aircraft qualifies as research or experimental expenditures under section 174. Further, it would not matter if X sold the pilot model or incorporated it in its own business as a demonstration model. See paragraph (a)(1) of this section (ultimate use is not relevant). Example 8. Development of new component; pilot model. Y is a manufacturer of aircraft engines. Y is researching and developing a new type of compressor blade, a component of an aircraft engine, to improve the performance of an existing aircraft engine design that Y already manufactures and sells. To test the appropriate design of the new compressor blade and evaluate the impact of fatigue on the compressor blade design, Y produces and installs the compressor blade on an aircraft engine held by Y in its inventory. The costs of producing and PO 00000 Frm 00016 Fmt 4700 Sfmt 4700 installing the compressor blade component that Y incurred represent research and development costs in the experimental or laboratory sense. Because Y produced the compressor blade component to resolve uncertainty regarding the appropriate design of the component, the component is a pilot model under paragraph (a)(4) of this section. Therefore, the costs that Y incurred to produce and install the component qualify as research or experimental expenditures under section 174. See paragraph (a)(5) of this section (regarding the application of section 174 to components of a product). However, section 174 does not apply to Y’s costs of producing the aircraft engine on which the component was installed. See paragraph (a)(2) of this section (relating to production costs). Example 9. Variant product. T is a fuselage manufacturer for commercial and military aircraft. T is modifying one of its existing fuselage products, Class 20XX–1, to enable it to carry a larger passenger and cargo load. T modifies the Class 20XX–1 design by extending its length by 40 feet. T incurs $1,000,000 to develop and evaluate different designs to resolve uncertainty with respect to the appropriate design of the new fuselage class, Class 20XX–2. The $1,000,000 of costs represents research and development costs in the experimental or laboratory sense. Although Class 20XX–2, is a variant of Class 20XX–1, Class 20XX–2 is a new product because the information available to T as a result of T’s development of Class 20XX–1 does not resolve uncertainty with respect to T’s development of Class 20XX–2. Therefore, the $1,000,000 of costs that T incurred to develop and evaluate the Class 20XX–2 qualifies as research or experimental expenditures under section 174. Paragraph (a)(5) of this section does not apply, as the requirements of paragraph (a)(1) of this section are met with respect to the entire product. Example 10. New process development. Z is a wine producer. Z is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes. In order to test the effectiveness of the new method of crushing wine grapes, Z incurs $2,000 in labor and materials to conduct the test on this part of the new manufacturing process. The $2,000 of costs represents research and development costs in the experimental or laboratory sense. Therefore, the $2,000 incurred qualifies as research or experimental expenditures under section 174 because it is a cost incident to the development or improvement of a component of a process. (b) * * * (1) Land and other property. * * * (2) Expenditure resulting in depreciable property. * * * (3) Amounts paid to others for research or experimentation resulting in depreciable property. * * * (4) Deductions limited to amounts expended for research or experimentation. The deductions referred to in paragraphs (b)(2) and (3) of this section for expenditures in E:\FR\FM\21JYR1.SGM 21JYR1 Federal Register / Vol. 79, No. 139 / Monday, July 21, 2014 / Rules and Regulations tkelley on DSK3SPTVN1PROD with RULES connection with the acquisition or production of depreciable property to be used in the taxpayer’s trade or business are limited to amounts expended for research or experimentation within the meaning of section 174 and paragraph (a) of this section. (5) Examples. The following examples illustrate the application of paragraph (b) of this section. Example 1. Amounts paid to others for research or experimentation resulting in depreciable property. X is a tool manufacturer. X has developed a new tool design, and orders a specially-built machine from Y to produce X’s new tool. The machine is built upon X’s order and at X’s risk, and Y does not provide a guarantee of economic utility. There is uncertainty regarding the appropriate design of the machine. Under X’s contract with Y, X pays $15,000 for Y’s engineering and design labor, $5,000 for materials and supplies used to develop the appropriate design of the machine, and $10,000 for Y’s machine production materials and labor. The $15,000 of engineering and design labor costs and the $5,000 of materials and supplies costs represent research and development costs in the experimental or laboratory sense. Therefore, the $15,000 X pays Y for Y’s engineering and design labor and the $5,000 for materials and supplies used to develop the appropriate design of the machine are for research or experimentation under section 174. However, section 174 does not apply to the $10,000 of production costs of the machine because those costs were not incurred for research or experimentation. See paragraph (a)(2) of this section (relating to production costs) and paragraph (b)(4) of this section (limiting deduction to amounts expended for research or experimentation). Example 2. Expenditures with respect to other property. Z is an aircraft manufacturer. Z incurs $5,000,000 to construct a new test bed that will be used in the development and improvement of Z’s aircraft. No portion of Z’s $5,000,000 of costs to construct the new test bed represent research and development costs in the experimental or laboratory sense to develop or improve the test bed. Because no portion of the costs to construct the new test bed were incurred for research or experimentation, the $5,000,000 will be considered an amount paid or incurred in the production of depreciable property to be used in the taxpayer’s trade or business that are not allowable under section 174. However, the allowances for depreciation of the test bed are considered research and experimental expenditures of other products, for purposes of section 174, to the extent the test bed is used in connection with research or experimentation of other products. See paragraph (b)(1) of this section (depreciation allowances may be considered research or experimental expenditures). Example 3. Expenditure resulting in depreciable property. Assume the same facts as Example 2, except that $50,000 of the costs of the test bed relates to costs to resolve uncertainties regarding the new test bed design. The $50,000 of costs represents research and development costs in the VerDate Mar<15>2010 16:01 Jul 18, 2014 Jkt 232001 experimental or laboratory sense. Because $50,000 of Z’s costs to construct the new test bed was incurred for research and experimentation, the costs qualify as research or experimental expenditures under section 174. Paragraph (b)(2) of this section applies to $50,000 of Z’s costs for the test bed because they are expenditures for research or experimentation that result in depreciable property to be used in the taxpayer’s trade or business. Z’s remaining $4,950,000 of costs is not allowable under section 174 because these costs were not incurred for research or experimentation. * * * * * (d) Effective/applicability date. The eighth and ninth sentences of § 1.174– 2(a)(1); § 1.174–2(a)(2); § 1.174–2(a)(4); § 1.174–2(a)(5); § 1.174–2(a)(11) Example 3 through Example 10; § 1.174–2(b)(4); and § 1.174–2(b)(5) apply to taxable years ending on or after July 21, 2014. Taxpayers may apply the provisions enumerated in the preceding sentence to taxable years for which the limitations for assessment of tax has not expired. John Dalrymple, Deputy Commissioner for Services and Enforcement. Approved: June 27, 2014. Mark J. Mazur, Assistant Secretary of the Treasury (Tax Policy). [FR Doc. 2014–16956 Filed 7–18–14; 8:45 am] BILLING CODE 4830–01–P DEPARTMENT OF HOMELAND SECURITY Coast Guard 33 CFR Parts 100 and 165 [Docket Number USCG–2014–0095] RIN 1625–AA00, AA08 Special Local Regulations and Safety Zones; Recurring Marine Events and Fireworks Displays Within the Fifth Coast Guard District Coast Guard, DHS. Final rule. AGENCY: ACTION: This document adopts as a final rule, without change, an interim final rule amending the Coast Guard regulations established for recurring marine events and fireworks displays that take place within the Fifth Coast Guard District area of responsibility. Under that rule, the list of recurring marine events requiring special local regulations or safety zones is updated with revisions, additional events, and removal of events that no longer take place in the Fifth Coast Guard District. SUMMARY: PO 00000 Frm 00017 Fmt 4700 Sfmt 4700 42197 When these regulations are enforced, certain restrictions are placed on marine traffic in specified areas. This rulemaking project promotes efficiency by eliminating the need to produce a separate rule for each individual recurring event, and serves to provide notice of the known recurring events requiring a special local regulation or safety zone throughout the year. DATES: This rule is effective August 20, 2014. ADDRESSES: Documents mentioned in this preamble are part of docket [USCG– 2014–0095]. To view documents mentioned in this preamble as being available in the docket, go to https:// www.regulations.gov, type the docket number in the ‘‘SEARCH’’ box and click ‘‘SEARCH.’’ Click on Open Docket Folder on the line associated with this rulemaking. You may also visit the Docket Management Facility in Room W12–140 on the ground floor of the Department of Transportation West Building, 1200 New Jersey Avenue SE., Washington, DC 20590, between 9 a.m. and 5 p.m., Monday through Friday, except Federal holidays. FOR FURTHER INFORMATION CONTACT: If you have questions on this rule, call or email Dennis Sens, Fifth Coast Guard District, Prevention Division, (757) 398– 6204, Dennis.M.Sens@uscg.mil. If you have questions on viewing or submitting material to the docket, call Cheryl Collins, Program Manager, Docket Operations, telephone (202) 366–9826. SUPPLEMENTARY INFORMATION: Table of Acronyms AOR Area of Responsibility APA Administrative Procedure Act COTP Captain of the Port DHS Department of Homeland Security FR Federal Register NPRM Notice of Proposed Rulemaking A. Regulatory History and Information The Coast Guard published an interim final rule and request for comments on May 27, 2014 (79 FR 30025). The special local regulations listed in 33 CFR 100.501 and safety zones in 33 CFR 165.506 were last amended on May 21, 2013 (78 FR 29629). B. Basis and Purpose This rulemaking updates the list of permanent special local regulations at 33 CFR 100.501 and safety zones at 33 CFR 165.506, established for recurring marine events and fireworks displays at various locations within the Fifth Coast Guard District area of responsibility (AOR). The Fifth Coast Guard District AOR is defined in 33 CFR 3.25. Publishing these regulatory updates in a single rulemaking promotes efficiency E:\FR\FM\21JYR1.SGM 21JYR1

Agencies

[Federal Register Volume 79, Number 139 (Monday, July 21, 2014)]
[Rules and Regulations]
[Pages 42193-42197]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-16956]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9680]
RIN 1545-BE64


Research Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations to amend the 
definition of research and experimental expenditures under section 174 
of the Internal Revenue Code (Code). In particular, these final 
regulations provide guidance on the treatment of amounts paid or 
incurred in connection with the development of tangible property, 
including pilot models. The final regulations will affect taxpayers 
engaged in research activities.

DATES: Effective date: These regulations are effective July 21, 2014.
    Applicability date: For date of applicability see Sec.  1.174-2(d).

FOR FURTHER INFORMATION CONTACT: David McDonnell at (202) 317-4137 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Summary of Proposed Regulations

    On September 6, 2013, a notice of proposed rulemaking (REG-124148-
05) and a notice of public hearing were published in the Federal 
Register (78 FR 547896). The IRS and the Treasury Department proposed 
the following revisions to the current regulations:
    First, to counter an interpretation that section 174 eligibility 
can be reversed by a subsequent event, the proposed regulations 
provided 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 section 174.
    Second, the proposed regulations amended Sec.  1.174-2(b)(4) to 
provide that the Depreciable Property Rule (the rules in Sec.  1.174-
2(b)(1) and Sec.  1.174-2(b)(4)) is an application of the general 
definition of research or experimental expenditures provided for in 
Sec.  1.174-2(a)(1) and should not be applied to exclude otherwise 
eligible expenditures.
    Third, the proposed regulations defined 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 included a fully-functional 
representation or model of the product or a component of a product (to 
the extent the shrinking-back rule applies).
    Fourth, the proposed regulations clarified 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 section 174 because these costs are not for research or 
experimentation.
    Finally, the proposed regulations provided a shrinking-back rule, 
similar to the rule provided in Sec.  1.41-4(b)(2), to address 
situations in which the requirements of 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 also provided new examples applying the 
foregoing provisions.

Summary of Comments and Explanation of Provisions

    Several comments were received in response to the proposed 
regulations. Following is a discussion of significant comments. Certain 
other comments presented issues unrelated to the proposed regulations, 
and they are not adopted or discussed herein.

Uncertainty

    Some commentators requested a definition of ``uncertainty'' because 
the examples rely on ``elimination of uncertainty'' as the point when 
research activities have concluded. Section 1.174-2(a)(1) provides that 
``[u]ncertainty exists if the information available to the taxpayer 
does not establish the capability or method for developing or improving 
the product or the appropriate design of the product.'' Because the 
current regulations already provide a sufficient definition of 
``uncertainty,'' and the point at which uncertainty is eliminated (that 
is, information available to the taxpayer establishes the capability or 
method for developing or improving the product or the appropriate 
design of the product) is based on the taxpayer's facts and 
circumstances, the final regulations do not provide additional guidance 
with respect to the definition of ``uncertainty.''
    Some commentators requested a bright-line standard, such as the 
commencement of commercial production as in section 41(d)(4)(A), to 
determine when uncertainty is eliminated. Section 1.174-2(a)(1) of the 
proposed regulations provided that costs may be eligible under section 
174 if paid or incurred after production begins but before uncertainty 
concerning the development or improvement of the product is eliminated. 
The point at which uncertainty is resolved is based on the taxpayer's 
facts and circumstances, and therefore a bright-line standard is not 
appropriate under section 174.
    Some commentators requested that the regulations explicitly 
incorporate the rule of application regarding the discovering 
information requirement found in section 41(d)(1)(B) and Sec.  1.41-
4(a)(3)(ii) (that is, there is no requirement that the taxpayer be 
seeking to obtain information that exceeds, expands, or refines the 
common knowledge of skilled professionals in the particular field, and 
there is no requirement that the taxpayer succeed in developing a new 
or improved business component). The IRS and the Treasury Department 
note that section 174 does not contain any provision defining research 
or experimentation. In contrast, section 41 provides a statutory 
definition for ``qualified research,'' which includes a requirement 
that the research be undertaken for the purpose of discovering 
information. In addition, neither the section 174 statute nor its 
legislative history suggest that a taxpayer must seek information that 
exceeds, expands, or refines the common knowledge of skilled 
professionals in the particular field in which the taxpayer is 
performing research. Section 1.174-2(a)(1) of the current regulations 
simply provides that ``[e]xpenditures represent research and 
development costs in the experimental or laboratory sense if they are 
for activities intended to discover information that would eliminate 
uncertainty concerning the development or improvement of a product.'' 
Consequently, this comment is not adopted.

[[Page 42194]]

    Some commentators questioned how the substantially all requirement 
in section 41(d)(1)(C) and Sec.  1.41-4(a)(6) (that is, 80 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) applies to section 174. Section 174 does not 
contain a similar ``substantially all'' requirement. Accordingly, the 
requirement in section 41(d)(1)(C) and Sec.  1.41-4(a)(6) does not 
apply to section 174.

Supplies

    Some commentators requested clarification that indirect or 
ancillary supplies used in research are eligible under section 174 
although ineligible under section 41. Section 1.174-2(a)(1) of the 
current regulations provides that the term ``research or experimental 
expenditures'' ``generally includes all such costs incident to the 
development or improvement of a product.'' This statement is 
sufficiently broad to include indirect or ancillary supplies used in 
research that otherwise satisfies the requirements of section 174. 
Therefore, revisions to the proposed regulations are not needed to 
respond to the commentators' concern.

Pilot Model

    One commentator expressed concern regarding a proposed example 
demonstrating the application of the rules in the case of multiple 
pilot models. The commentator suggested that, under Example 5 of Sec.  
1.174-2(a)(11) of the proposed regulations, the deductibility of 
section 174 expenses for multiple pilot models is permitted only if 
each pilot model is tested for a purpose that is different from any 
other pilot model. The definition of pilot model contained in Sec.  
1.174-2(a)(4) of the proposed regulations does not contain a 
requirement that the pilot model be used to test for a discrete 
purpose. A pilot model within the definition of Sec.  1.174-2(a)(4) of 
the proposed regulations (including a component to the extent paragraph 
(a)(5) applies) is eligible for section 174, subject to satisfaction of 
the other requirements of section 174 and the regulations. The final 
regulations modify Example 5 to clarify that it is not necessary for 
each pilot model to be tested for a discrete purpose for the costs of 
multiple pilot models to qualify as research and experimental 
expenditures under section 174.
    One commentator requested clarification regarding the distinction 
between a section 174 eligible ``pilot model'' and a section 174 
ineligible ``test bed.'' Furthermore, the commentator construed Example 
2 and Example 3 of proposed regulation Sec.  1.174-2(b)(5) to state 
that test beds are depreciable property excluded from section 174. As 
provided in proposed regulation Sec.  1.174-2(a)(4), a pilot model 
means 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 proposed examples 
demonstrate the application of Sec.  1.174-2(b)(1), (b)(2), and (b)(4) 
(that is, when expenditures for property may be research and 
experimental expenditures). The facts of the proposed examples do not 
demonstrate the existence of a pilot model nor do they foreclose the 
possibility that a test bed may be a pilot model if it meets the 
definition of a pilot model under proposed regulation Sec.  1.174-
2(a)(4). For example, if the taxpayer constructed a new test bed as a 
model test bed and the new test bed was produced to evaluate and 
resolve uncertainty concerning the test bed during its development or 
improvement, it could be a pilot model. Because these examples were not 
intended to illustrate pilot models, the final regulations do not adopt 
this comment.

Shrinking-Back Rule

    Some commentators expressed concern that the shrinking-back rule in 
Sec.  1.174-2(a)(5) of the proposed regulations may exclude from 
section 174 the cost of testing to eliminate uncertainty regarding the 
integration of an experimental component with a nonexperimental 
product. Section 1.174-2(a)(1) of the current regulations provides that 
the term ``research or experimental expenditures'' ``generally includes 
all such costs incident to the development or improvement of a 
product.'' This statement is sufficiently broad to encompass the cost 
of testing (other than testing specifically excluded under current 
Sec.  1.174-1(a)(3) (quality control testing)) performed to eliminate 
uncertainty with respect to an experimental component and costs to 
resolve uncertainty regarding integration of an experimental component 
with a nonexperimental product when the requirements of Sec.  1.174-
2(a)(1) are not met for the product as a whole. Therefore, revisions to 
the proposed regulations are not needed to respond to the commentators' 
concern.
    Some commentators requested that the shrinking-back rule in Sec.  
1.174-2(a)(5) of the proposed regulations be eliminated. The 
commentators stated that the shrinking-back rule in Sec.  1.41-4(b)(2) 
is peculiar to section 41 and serves no purpose in section 174. As with 
business components under section 41, research or experimental 
expenditures may relate only to one or more components of a larger 
product. The shrinking-back rule in the proposed regulations was 
intended to ensure that section 174 eligibility is preserved in 
instances in which a basic design specification of the product may be 
established, but there is uncertainty with respect to certain 
components of the product, even if uncertainty arises after production 
of the product has begun. Therefore, the substance of the shrinking-
back rule is retained in the final regulations. However, in response to 
commentator concerns, and to avoid any unintended confusion with the 
shrinking-back rule of Sec.  1.41-4(b)(2), the rule in Sec.  1.174-
2(a)(5) of the proposed regulations has been renamed. Furthermore, the 
last sentence of Sec.  1.174-2(a)(5) of the proposed regulations has 
been eliminated in response to commentator concerns that references to 
section 41 may imply that other requirements under section 41, such as 
the process of elimination requirement, apply to expenditures under 
section 174.
    The final regulations also modify Example 8 of the proposed 
regulations and include one additional example, Example 9, to 
demonstrate the application of section 174 to components of a product.

Examples

    One commentator expressed concern about Example 7 of Sec.  1.174-
2(a)(11) of the proposed regulations, which described the development 
of ``a new, experimental aircraft.'' The commentator believes that the 
use of the words ``new'' and ``experimental'' in proposed Example 7 
could be interpreted to establish a new, heightened standard for 
eligibility for section 174. Section 1.174-2(a)(1) of the current 
regulations provides the only qualitative criteria for eligibility for 
section 174 and provides that whether expenditures qualify as research 
or experimental expenditures depends on the nature of the activity to 
which they relate, not the nature of the product or improvement being 
developed or the level of technological advancement the product or 
improvement represents. Terms used in examples do not have substantive 
meaning that expand or reduce the meaning or application of terms used 
in the regulations; they are simply describing the facts of the 
example. Accordingly, the final regulations do not revise Example 7 to

[[Page 42195]]

remove the descriptive terms ``new'' or ``experimental.''
    One commentator requested guidance revising Sec.  1.174-2(c), 
regarding exploration expenditures for oil, gas, or minerals. This 
comment is outside the scope of the proposed regulations which did not 
propose changes to Sec.  1.174-2(c). Therefore, the requested guidance 
is not adopted in the final regulations.

Effective/Applicability Date

    These regulations apply to taxable years ending on or after the 
date of their publication as final regulations in the Federal Register. 
Taxpayers may apply the final regulations to taxable years for which 
the limitations for assessment of tax has not expired.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. Therefore, a 
regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations, and because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, the notice of proposed rulemaking that 
preceded these final regulations was submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business and no comments were received.

Drafting Information

    The principal author of these regulations is David McDonnell of the 
Office of Associate Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the Treasury Department and 
the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

0
Par. 2. Section 1.174-2 is amended:
0
1. In paragraph (a)(1), by adding a heading and by adding two sentences 
at the end.
0
2. By removing paragraph (a)(7).
0
3. By redesignating paragraphs (a)(8) and (9) as paragraphs (a)(10) and 
(11), respectively, and adding headings to them.
0
4. By redesignating paragraphs (a)(3) through (6) as paragraphs (a)(6) 
through (9), respectively, and adding headings to them.
0
5. By redesignating paragraph (a)(2) as paragraph (a)(3) and adding a 
heading to newly designated paragraph (a)(3).
0
6. By adding new paragraphs (a)(2), (4) and (5).
0
7. In newly redesignated paragraph (a)(7), by removing the language 
``(a)(3)(i)'' and adding ``(a)(6)(i)'' in its place.
0
8. In newly redesignated paragraph (a)(9), by removing the language 
``(a)(6)'' and adding ``(a)(9)'' in its place.
0
9. By revising newly redesignated paragraph (a)(11) introductory text.
0
10. In Example 1 in newly redesignated paragraph (a)(11) by adding a 
heading.
0
11. In Example 2 in newly redesignated paragraph (a)(11) by adding a 
heading, removing the language ``X'' and adding ``S'' in its place 
everywhere ``X'' appears, and removing the language ``Y'' and adding 
``T'' in its place everywhere ``Y'' appears.
0
12. In newly redesignated paragraph (a)(11) by adding Example 3 through 
Example 10.
0
13. In paragraphs (b)(1) through (3) by adding headings.
0
14. By revising paragraph (b)(4).
0
15. By adding paragraph (b)(5).
0
16. By adding paragraph (d).
    The revisions and additions read as follows:


Sec.  1.174-2  Definition of research and experimental expenditures.

    (a) In general. (1) Research or experimental expenditures defined. 
* * * The ultimate success, failure, sale, or use of the product is not 
relevant to a determination of eligibility under section 174. Costs may 
be eligible under section 174 if paid or incurred after production 
begins but before uncertainty concerning the development or improvement 
of the product is eliminated.
    (2) Production costs. Except as provided in paragraph (a)(5) of 
this section (the rule concerning the application of section 174 to 
components of a product), costs paid or incurred in the production of a 
product after the elimination of uncertainty concerning the development 
or improvement of the product are not eligible under section 174.
    (3) Product defined. * * *
    (4) Pilot model defined. For purposes of this section, the term 
pilot model means 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, to the 
extent paragraph (a)(5) of this section applies, a component of the 
product.
    (5) Application of section 174 to components of a product. If the 
requirements of paragraph (a)(1) of this section are not met at the 
level of a product (as defined in paragraph (a)(3) of this section), 
then whether expenditures represent research and development costs is 
determined at the level of the component or subcomponent of the 
product. The presence of uncertainty concerning the development or 
improvement of certain components of a product does not necessarily 
indicate the presence of uncertainty concerning the development or 
improvement of other components of the product or the product as a 
whole. The rule in this paragraph (a)(5) is not itself applied as a 
reason to exclude research or experimental expenditures from section 
174 eligibility.
    (6) Research or experimental expenditures--exclusions. * * *
    (7) Quality control testing. * * *
    (8) Expenditures for literary, historical, or similar research--
cross reference. * * *
    (9) Research or experimental expenditures limited to reasonable 
amounts. * * *

    (10) Amounts paid to others for research or experimentation. * * *
    (11) Examples. The following examples illustrate the application of 
this paragraph (a).

    Example 1. Amounts paid to others for research or 
experimentation allowed as a deduction. * * *
    Example 2. Amounts paid to others not allowable as a deduction. 
* * *
    Example 3. Pilot model. U is engaged in the manufacture and sale 
of custom machines. U contracts to design and produce a machine to 
meet a customer's specifications. Because U has never designed a 
machine with these specifications, U is uncertain regarding the 
appropriate design of the machine, and particularly whether features 
desired by the customer can be designed and integrated into a 
functional machine. U incurs a total of $31,000 on the project. Of 
the $31,000, U incurs $10,000 of costs on materials and labor to 
produce a model that is used to evaluate and resolve the uncertainty 
concerning the appropriate

[[Page 42196]]

design. U also incurs $1,000 of costs using the model to test 
whether certain features can be integrated into the design of the 
machine. This $11,000 of costs represents research and development 
costs in the experimental or laboratory sense. After uncertainty is 
eliminated, U incurs $20,000 to produce the machine for sale to the 
customer based on the appropriate design. The model produced and 
used to evaluate and resolve uncertainty is a pilot model within the 
meaning of paragraph (a)(4) of this section. Therefore, the $10,000 
incurred to produce the model and the $1,000 incurred on design 
testing activities qualifies as research or experimental 
expenditures under section 174. However, section 174 does not apply 
to the $20,000 that U incurred to produce the machine for sale to 
the customer based on the appropriate design. See paragraph (a)(2) 
of this section (relating to production costs).
    Example 4. Product component redesign. Assume the same facts as 
Example 3, except that during a quality control test of the machine, 
a component of the machine fails to function due to the component's 
inappropriate design. U incurs an additional $8,000 (including 
design retesting) to reconfigure the component's design. The $8,000 
of costs represents research and development costs in the 
experimental or laboratory sense. After the elimination of 
uncertainty regarding the appropriate design of the component, U 
incurs an additional $2,000 on its production. The reconfigured 
component produced and used to evaluate and resolve uncertainty with 
respect to the component is a pilot model within the meaning of 
paragraph (a)(4) of this section. Therefore, in addition to the 
$11,000 of research and experimental expenditures previously 
incurred, the $8,000 incurred on design activities to establish the 
appropriate design of the component qualifies as research or 
experimental expenditures under section 174. However, section 174 
does not apply to the additional $2,000 that U incurred for the 
production after the elimination of uncertainty of the re-designed 
component based on the appropriate design or to the $20,000 
previously incurred to produce the machine. See paragraph (a)(2) of 
this section (relating to production costs).
    Example 5. Multiple pilot models. V is a manufacturer that 
designs a new product. V incurs $5,000 to produce a number of models 
of the product that are to be used in testing the appropriate design 
before the product is mass-produced for sale. The $5,000 of costs 
represents research and development costs in the experimental or 
laboratory sense. Multiple models are necessary to test the design 
in a variety of different environments (exposure to extreme heat, 
exposure to extreme cold, submersion, and vibration). In some cases, 
V uses more than one model to test in a particular environment. Upon 
completion of several years of testing, V enters into a contract to 
sell one of the models to a customer and uses another model in its 
trade or business. The remaining models were rendered inoperable as 
a result of the testing process. Because V produced the models to 
resolve uncertainty regarding the appropriate design of the product, 
the models are pilot models under paragraph (a)(4) of this section. 
Therefore, the $5,000 that V incurred in producing the models 
qualifies as research or experimental expenditures under section 
174. See also paragraph (a)(1) of this section (ultimate use is not 
relevant).
    Example 6. Development of a new component; pilot model. W wants 
to improve a machine for use in its trade or business and incurs 
$20,000 to develop a new component for the machine. The $20,000 is 
incurred for engineering labor and materials to produce a model of 
the new component that is used to eliminate uncertainty regarding 
the development of the new component for the machine. The $20,000 of 
costs represents research and experimental costs in the experimental 
or laboratory sense. After W completes its research and 
experimentation on the new component, W incurs $10,000 for materials 
and labor to produce the component and incorporate it into the 
machine. The model produced and used to evaluate and resolve 
uncertainty with respect to the new component is a pilot model 
within the meaning of paragraph (a)(4) of this section. Therefore, 
the $20,000 incurred to produce the model and eliminate uncertainty 
regarding the development of the new component qualifies as research 
or experimental expenditures under section 174. However, section 174 
does not apply to the $10,000 of production costs of the component 
because those costs were not incurred for research or 
experimentation. See paragraph (a)(2) of this section (relating to 
production costs).
    Example 7. Disposition of a pilot model. X is a manufacturer of 
aircraft. X is researching and developing a new, experimental 
aircraft that can take off and land vertically. To evaluate and 
resolve uncertainty during the development or improvement of the 
product and test the appropriate design of the experimental 
aircraft, X produces a working aircraft at a cost of $5,000,000. The 
$5,000,000 of costs represents research and development costs in the 
experimental or laboratory sense. In a later year, X sells the 
aircraft. Because X produced the aircraft to resolve uncertainty 
regarding the appropriate design of the product during the 
development of the experimental aircraft, the aircraft is a pilot 
model under paragraph (a)(4) of this section. Therefore, the 
$5,000,000 of costs that X incurred in producing the aircraft 
qualifies as research or experimental expenditures under section 
174. Further, it would not matter if X sold the pilot model or 
incorporated it in its own business as a demonstration model. See 
paragraph (a)(1) of this section (ultimate use is not relevant).
    Example 8. Development of new component; pilot model. Y is a 
manufacturer of aircraft engines. Y is researching and developing a 
new type of compressor blade, a component of an aircraft engine, to 
improve the performance of an existing aircraft engine design that Y 
already manufactures and sells. To test the appropriate design of 
the new compressor blade and evaluate the impact of fatigue on the 
compressor blade design, Y produces and installs the compressor 
blade on an aircraft engine held by Y in its inventory. The costs of 
producing and installing the compressor blade component that Y 
incurred represent research and development costs in the 
experimental or laboratory sense. Because Y produced the compressor 
blade component to resolve uncertainty regarding the appropriate 
design of the component, the component is a pilot model under 
paragraph (a)(4) of this section. Therefore, the costs that Y 
incurred to produce and install the component qualify as research or 
experimental expenditures under section 174. See paragraph (a)(5) of 
this section (regarding the application of section 174 to components 
of a product). However, section 174 does not apply to Y's costs of 
producing the aircraft engine on which the component was installed. 
See paragraph (a)(2) of this section (relating to production costs).
    Example 9. Variant product. T is a fuselage manufacturer for 
commercial and military aircraft. T is modifying one of its existing 
fuselage products, Class 20XX-1, to enable it to carry a larger 
passenger and cargo load. T modifies the Class 20XX-1 design by 
extending its length by 40 feet. T incurs $1,000,000 to develop and 
evaluate different designs to resolve uncertainty with respect to 
the appropriate design of the new fuselage class, Class 20XX-2. The 
$1,000,000 of costs represents research and development costs in the 
experimental or laboratory sense. Although Class 20XX-2, is a 
variant of Class 20XX-1, Class 20XX-2 is a new product because the 
information available to T as a result of T's development of Class 
20XX-1 does not resolve uncertainty with respect to T's development 
of Class 20XX-2. Therefore, the $1,000,000 of costs that T incurred 
to develop and evaluate the Class 20XX-2 qualifies as research or 
experimental expenditures under section 174. Paragraph (a)(5) of 
this section does not apply, as the requirements of paragraph (a)(1) 
of this section are met with respect to the entire product.
    Example 10. New process development. Z is a wine producer. Z is 
researching and developing a new wine production process that 
involves the use of a different method of crushing the wine grapes. 
In order to test the effectiveness of the new method of crushing 
wine grapes, Z incurs $2,000 in labor and materials to conduct the 
test on this part of the new manufacturing process. The $2,000 of 
costs represents research and development costs in the experimental 
or laboratory sense. Therefore, the $2,000 incurred qualifies as 
research or experimental expenditures under section 174 because it 
is a cost incident to the development or improvement of a component 
of a process.

    (b) * * *
    (1) Land and other property. * * *
    (2) Expenditure resulting in depreciable property. * * *
    (3) Amounts paid to others for research or experimentation 
resulting in depreciable property. * * *
    (4) Deductions limited to amounts expended for research or 
experimentation. The deductions referred to in paragraphs (b)(2) and 
(3) of this section for expenditures in

[[Page 42197]]

connection with the acquisition or production of depreciable property 
to be used in the taxpayer's trade or business are limited to amounts 
expended for research or experimentation within the meaning of section 
174 and paragraph (a) of this section.
    (5) Examples. The following examples illustrate the application of 
paragraph (b) of this section.

    Example 1. Amounts paid to others for research or 
experimentation resulting in depreciable property. X is a tool 
manufacturer. X has developed a new tool design, and orders a 
specially-built machine from Y to produce X's new tool. The machine 
is built upon X's order and at X's risk, and Y does not provide a 
guarantee of economic utility. There is uncertainty regarding the 
appropriate design of the machine. Under X's contract with Y, X pays 
$15,000 for Y's engineering and design labor, $5,000 for materials 
and supplies used to develop the appropriate design of the machine, 
and $10,000 for Y's machine production materials and labor. The 
$15,000 of engineering and design labor costs and the $5,000 of 
materials and supplies costs represent research and development 
costs in the experimental or laboratory sense. Therefore, the 
$15,000 X pays Y for Y's engineering and design labor and the $5,000 
for materials and supplies used to develop the appropriate design of 
the machine are for research or experimentation under section 174. 
However, section 174 does not apply to the $10,000 of production 
costs of the machine because those costs were not incurred for 
research or experimentation. See paragraph (a)(2) of this section 
(relating to production costs) and paragraph (b)(4) of this section 
(limiting deduction to amounts expended for research or 
experimentation).
    Example 2. Expenditures with respect to other property. Z is an 
aircraft manufacturer. Z incurs $5,000,000 to construct a new test 
bed that will be used in the development and improvement of Z's 
aircraft. No portion of Z's $5,000,000 of costs to construct the new 
test bed represent research and development costs in the 
experimental or laboratory sense to develop or improve the test bed. 
Because no portion of the costs to construct the new test bed were 
incurred for research or experimentation, the $5,000,000 will be 
considered an amount paid or incurred in the production of 
depreciable property to be used in the taxpayer's trade or business 
that are not allowable under section 174. However, the allowances 
for depreciation of the test bed are considered research and 
experimental expenditures of other products, for purposes of section 
174, to the extent the test bed is used in connection with research 
or experimentation of other products. See paragraph (b)(1) of this 
section (depreciation allowances may be considered research or 
experimental expenditures).
    Example 3. Expenditure resulting in depreciable property. Assume 
the same facts as Example 2, except that $50,000 of the costs of the 
test bed relates to costs to resolve uncertainties regarding the new 
test bed design. The $50,000 of costs represents research and 
development costs in the experimental or laboratory sense. Because 
$50,000 of Z's costs to construct the new test bed was incurred for 
research and experimentation, the costs qualify as research or 
experimental expenditures under section 174. Paragraph (b)(2) of 
this section applies to $50,000 of Z's costs for the test bed 
because they are expenditures for research or experimentation that 
result in depreciable property to be used in the taxpayer's trade or 
business. Z's remaining $4,950,000 of costs is not allowable under 
section 174 because these costs were not incurred for research or 
experimentation.
* * * * *
    (d) Effective/applicability date. The eighth and ninth sentences of 
Sec.  1.174-2(a)(1); Sec.  1.174-2(a)(2); Sec.  1.174-2(a)(4); Sec.  
1.174-2(a)(5); Sec.  1.174-2(a)(11) Example 3 through Example 10; Sec.  
1.174-2(b)(4); and Sec.  1.174-2(b)(5) apply to taxable years ending on 
or after July 21, 2014. Taxpayers may apply the provisions enumerated 
in the preceding sentence to taxable years for which the limitations 
for assessment of tax has not expired.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: June 27, 2014.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2014-16956 Filed 7-18-14; 8:45 am]
BILLING CODE 4830-01-P

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