Mixed design purposes may still satisfy the research-credit experimentation test

Plain-English summary

An apparel retailer claimed research credits for activities used to develop a new or revised business component. Examination disallowed the claim in part because it viewed the development work as directed to style, taste, cosmetics, or seasonal design, which Section 41(d)(3)(B) excludes. The IRS advised that some activities could nevertheless serve qualified purposes if they related to new or improved function, performance, reliability, or quality. Work undertaken for both qualified and nonqualified purposes can satisfy the process-of-experimentation test when at least 80 percent of the research activities for the business component constitute experimentation for a qualified purpose. The remaining activities must still satisfy the Section 41(d)(1)(A) requirements and avoid other exclusions. Because neither party's factual statement established whether the 80 percent threshold was met, the taxpayer needed documentation showing that substantially all relevant activities served a qualified purpose.

Ruling snapshot

• Question: Can research on a business component satisfy Section 41 when the development work includes both qualified performance purposes and excluded style or cosmetic purposes?
• Outcome: advice given
• Key authorities: IRC §§ 41(b), 41(d), 174; Treas. Reg. §§ 1.41-4(a)(2)(iii), 1.41-4(a)(6)

Full text (IRS public release)

                          INTERNAL REVENUE SERVICE
                NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                          April 12, 2023

                                                Third Party Communication: None
                                                Date of Communication: Not Applicable
Number:               202327015
Release Date:         7/7/2023
Index (UIL) No.:      41.00-00, 41.50-03
CASE-MIS No.:         TAM-105894-22

Appeals Team Case Leader
IRS Independent Office of Appeals

          Taxpayer's Name:                      --------------------------------
          Taxpayer's Address:                   -----------------------
                                                -------------------------------------------------
          Taxpayer's Identification No          ----------------
          Year(s) Involved:                     --------------
          Date of Conference:                   -----------------------



LEGEND:

Taxpayer                     =        --------------------------------------------
                             --------------------------

Project                      =        --------------------------

Brand 1                      =        ------------

Line 1                       =        -----------------------------

Business Component           =        ------------------------------------------------------------------------
                                      -----------------------------------------------------------------------

Location                     =        ----------------------------------

Year 1                       =        -------

Year 2                       =        -------
TAM-105894-22                 2

Year 3          =   -------

Year 4          =   -------

Year 5          =   -------

b               =   -------

c               =   ---

e               =   --

f               =   --

g               =   ---

h               =   ---

i               =   ---

j               =   ----

k               =   ---

l               =   ---

m               =   --

n               =   ---

o               =   ---

p               =   ---

q               =   --

r               =   ----

s               =   ---

t               =   --
TAM-105894-22                               3

ISSUES

1. Whether the research activities with respect to the development of the Business
Component are for a qualified purpose under § 41(d)(3)?

2. Whether research activities with respect to the development of the Business
Component may satisfy the process of experimentation test under § 41(d)(1)(C) if
Taxpayer undertook the activities for both qualified and non-qualified purposes under
§ 41(d)(3)?

CONCLUSIONS

1. Possibly. Certain research activities with respect to the development of the Business
Component may be for a qualified purpose under § 41(d)(3).

2. Yes. The research activities with respect to the development of the Business
Component may satisfy the process of experimentation test under § 41(d)(1)(C) if
Taxpayer undertook the activities for both qualified and non-qualified purposes under
§ 41(d)(3), if substantially all of the research activities for the Business Component
constitute elements of a process of experimentation for a qualified purpose described in
§ 41(d)(3)(A).

FACTS

Background

IRS Exam (“Exam”) entirely disallowed Taxpayer’s research credit claims for Year 1,
Year 2, Year 3, Year 4, and Year 5 (the “taxable years”). During the examination,
particular business components were selected to review that were identified as
representative of the business components for which research credits were claimed.
The development process for Project was selected as an example of a business
component for -----------. Exam issued a Notice of Proposed Adjustment that disallowed
Taxpayer’s claimed research credits for the Business Component, in part, because all of
Taxpayer’s development activities for the Business Component were non-qualified
activities undertaken for purposes of style, taste, cosmetics or season design factors.
Taxpayer protested the proposed disallowance to the IRS Independent Office of
Appeals (Appeals). Appeals tentatively agreed with Exam’s proposed disallowance.
Subsequently, Taxpayer sought technical advice from the Office of Associate Chief
Counsel (Passthroughs and Special Industries) with respect to the Business
Component.

Appeals and Taxpayer were not able to agree on all relevant facts. Therefore, each
party submitted its own statement of facts pursuant to section 7.06 of Rev. Proc 2022-2,
which allows a taxpayer and the IRS to each submit a separate statement of facts when
the parties cannot resolve their disagreement on the facts. CCDM 33.2.2.1.2 (3)
provides, in part, that if the Associate office chooses to issue technical advice, and the
TAM-105894-22                                            4

Associate office would rule the same way on either set of facts, then the technical
advice will be issued and will note that the factual dispute is immaterial. If the Associate
office would rule differently based on which specific set of facts is considered, the
technical advice will be issued describing the resolution based on each set of facts. The
conclusions in this technical advice memorandum are the same under both party’s
represented facts.

Facts submitted by Taxpayer

Taxpayer is a ---------apparel retail company, headquartered in Location with over b
stores ------------------. Taxpayer sells -------------------------------------------------------------------
----------------------------------------. Taxpayer’s sales consist primarily of its own private
label products. During the taxable years, Taxpayer’s products consisted of ----------------
------------------------------------------. The market in which Taxpayer operates is competitive
and saturated. Typically, Taxpayer has e to f seasons per year. For each season,
Taxpayer designs and develops new and/or revised product lines.

Taxpayer employs cross-functional product development teams to develop each of its
product lines. Taxpayer’s product development team personnel generally can be
categorized by their functional specialties within the product development process,
including --------------------------------------------------------------------------------------------------------
----------------------------------.

During Year 3 and Year 4, Taxpayer undertook the Project to develop the Business
Component. The Business Component would be part of Line 1 of -----------. Taxpayer
recognized that no product in the market was -------------------------- -----------------------------
----------------------------------. Taxpayer concluded that altering the ----------- Line 1 base
and specification formula, without compromising the product line’s fundamental
performance standards, created development challenges.

Taxpayer identified key performance standards at the inception of the Business
Component, requiring that ---------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------- Taxpayer
concluded that --------------------------------------------would meet its performance
requirements.

To establish a baseline, Taxpayer directed its --------------------------------------------------------
-------------------------------------------------------------------------------------------------------------------
and provide them to Taxpayer’s ----------------------- for testing. Taxpayer’s -------------------
TAM-105894-22                                            5

------- determined that it could not use its ------------------------------------because application
of the -------------------------------------------------------------h percent. Based on the testing
results and Taxpayer’s determination that there was no suitable -------------------------------
---------, Taxpayer’s ----------------------- concluded that it would have to develop -------------
---------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------

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

After using -------------------------------------------- products proved unsuccessful, Taxpayer’s
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------. At the direction of
Taxpayer’s product development team, ----------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------- sent these prototypes to Taxpayer’s product
development team for evaluation.

After a series of evaluations involving numerous ----------------------------------------------------
---------------------------------------------------------------------. Taxpayer evaluated i ----------------
------------------------------- from --------------------------before Taxpayer’s product
development team determined that, for the sample product, it needed to reduce -------- --
--- e percent, increase ---------------- j percent, and increase -------------------------- from k --
---------to l --------. Once -----------------------------for the sample product that met
Taxpayer’s standards had been approved, Taxpayer’s ----------------- worked with the ----
------------------------------- to create and send prototype -----------------to -------------------------
------, which the ---------------------then used to build prototypes for ----------------------.

Taxpayer’s ----------------------- team worked with --------------------------------------teams to
evaluate how various ---------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
The Business Component was developed ------------------------ Each ---------------------------
-------------------------------------------------------------------------------------------impacted the --------
----------------------------------------------- characteristics in different ways. Therefore,
Taxpayer needed to develop different ------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
exhibited consistent ----------------------------------- Separate -------------for each ---------------
--------------------------------- ensured that a consistent ----------------was established for
TAM-105894-22                                            6

each ------------------ Taxpayer evaluated how the different ---------------------------------------
--------------------------------------------------------------------and evaluated iterative ------------------
------------------------------------------------------------------------------------------------- exhibited
consistent -----------------------------------------------------conditions. Taxpayer referred to this
testing as -----------------------------

Thereafter, Taxpayer requested additional prototypes from -----------------------------.
Taxpayer’s -------------------------------------------these additional prototypes. Following ------
----- results for ------------prototypes constructed for each ---------------------- -------------------
------------------------------- selected what it determined were the optimal -------------------------
---------- As part of Taxpayer’s evaluation, Taxpayer used ----------------------------------------
prototypes to undertake different activities, and Taxpayer’s ----------------------------------
evaluated the ----------function before, during and after the activities using -------------------
------------------------------------------------- ------------------------------------------------------------------
-------------------------------------------------------------------------------------provided qualitative and
quantitative data regarding the Business Component’s --------------------------------------------
------------------ The ----------------------------interactively redesigned the ----------- based on
a technological, analytical process.

After Taxpayer’s -----------------------------------------completed ----------------- Taxpayer’s -----
------------------------------- requested additional prototypes from -------------------------- took
measurements, and made ----------------------- Revisions based on subsequent -------------
------- tests were incorporated into the final, approved product specifications.

Taxpayer’s ------------------------------ conducted m rounds of--------testing and
e rounds of----testing before settling on a final design for the Business Component.

Facts submitted by Appeals

Taxpayer is an apparel retailer that sells its own private label products. For the taxable
years, Taxpayer claimed research credits under § 41. To develop its products,
Taxpayer employs teams of professionals. Generally, these product development
teams consist of Taxpayer’s -------------------------------------------------------------------------------
---------------------------------- teams. Taxpayer included a portion of the wages paid to its
product development teams as qualified research expenses (“QREs”).

Taxpayer relied on the activity listings in its internal development calendars to determine
the wages includable in its QREs. For the taxable year ended Year 4, the majority (n
percent) of the QREs related to Taxpayer’s product development teams were
attributable to Taxpayer’s ----------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------teams.
Taxpayer reduced the amount of its wage QREs by g percent to account for any time
associated with style, taste, and cosmetic design.
TAM-105894-22                                            7

Taxpayer uses ----------------------------------- to build and test samples and prototypes.
Taxpayer did not include the costs attributable to its ----------------------------------- as
QREs.

Taxpayer identified projects it believes are representative of its product development
activities. For taxable year ended Year 4, one of these representative projects was the
Project. The purpose of the Project was to develop the Business Component.

Taxpayer began the Project after attending tradeshows at which the latest -------- trends
were exhibited. Taxpayer’s observations at these tradeshows led it to conclude that ----
------------were going to be in vogue for the upcoming ---------- seasons, and Taxpayer
decided to introduce -----------------------------------------------------------------------------------------
-------- To maintain ------------Taxpayer’s existing suite ---------------------------------------------
--------------------- the Business Component needed to exhibit g percent ---------------
Taxpayer also needed a suitable ------------------------------------------------------------------------
-------------------------------------------- The Business Component needed to meet --------------
industry standards -------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------. --------------
--------------------------performed the testing for --------------industry standards.

---------- Taxpayer’s existing ----------------------------------------------------reduced ----------------
---------------from g percent to h percent, and as a result,-------------------------------------------
-------------------------- Taxpayer worked face-to-face with the -------------------------------------
------------------------------------------------------------------------------------------------------------------
and gave recommendations on the best -------------------------for the Business
Component, and the -------------------------------also conducted their own research. Over
the course of the Project, i samples/------------------- were produced. The --------for the
Project consisted of o percent --------, p percent ------------, and q percent ------------
Taxpayer’s existing --------------------------------- consisted of r percent --------- s percent ----
------------- and t percent -----------.

With respect to the -----------for the Business Component, Taxpayer provided its -----------
--------------------------advice on what would not work but largely relied on these --------------
--------------------------to develop the ----------- After deciding on the --------and -----------for
the Business Component, Taxpayer had the ----------------------------------- produce ----------
----------- prototypes based on ------------------ prepared by Taxpayer. Taxpayer
conducted --------------- testing on these prototypes. Taxpayer provided the -----------------
------------------ with -------------feedback consisting of notations to the prototype
specifications, indicating whether certain -------------------- should be increased or
decreased. Also, Taxpayer provided the ----------------------------------- with --------------------
--------------------------------------------------------------------------------------------------------------------
that primarily concerned ------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------- The -------testing conducted by Taxpayer was not a chemical
TAM-105894-22                                            8

or empirical test; ----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------

Taxpayer has not provided a complete description of the activities its product
development teams undertook as part of the Project, and Taxpayer has not identified
which activities undertaken as part of the Project it considers qualified for purposes of
§ 41.

Taxpayer identified certain activities from its ------------------------------------------ that it
classified as qualified; these activities include, but are not limited to ---------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------

LAW

Section 41(a)(1)1 provides, in part, that the research credit for the taxable year is an
amount equal to the sum of 20 percent of the excess (if any) of the qualified research
expenses for the taxable year over the base amount. Section 41(b)(1) provides that the
term "qualified research expenses" means the sum of the in-house research expenses
and contract research expenses that are paid or incurred by the taxpayer during the
taxable year in carrying on any trade or business of the taxpayer. Under § 41(b)(2)(A),
the term “[i]n-house research expenses” means, (i) any wages paid or incurred to an
employee for qualified services performed by such employee, (ii) any amount paid or
incurred for supplies used in the conduct of qualified research, and (iii) under
regulations prescribed by the Secretary, any amount paid or incurred to another person
for the right to use computers in the conduct of qualified research.

Under § 41(b)(2)(B), the term “qualified services” means services consisting of (i)
engaging in qualified research, or (ii) engaging in the direct supervision or direct support
of research activities which constitute qualified research. Section 41(b)(3)(A) defines
the term “contract research expenses” as 65 percent of any amount paid or incurred by
the taxpayer to any person (other than an employee of the taxpayer) for qualified
research.

Under § 41(d)(1) the term “qualified research” means research (A) with respect to which
expenditures that may be treated as expenses under § 174, (B) which is undertaken for
the purpose of discovering information which is technological in nature and the
application of which is intended to be useful in the development of a new or improved
business component of the taxpayer, and (C) substantially all of the activities of which


1 The applicable law in this case is the law that applied prior to applicability of the amendments made by

the Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13206, 131 Stat. 2111, 2113 (2017).
TAM-105894-22                                            9

constitute elements of a process of experimentation for a purpose described in
§ 41(d)(3).

Section 41(d)(3)(A) provides that for purposes of § 41(d)(1)(C), research is conducted
for a qualified purpose if it relates to a new or improved function, performance, or
reliability or quality. However, § 41(d)(3)(B) provides that research shall in no event be
treated as conducted for a purpose described in § 41(d)(3) if it relates to style, taste,
cosmetic, or seasonal design factors.

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

Therefore, research with respect to a taxpayer’s business component can be qualified
research under § 41(d) if at least 80 percent of Taxpayer’s research activities for the
business component is for a qualified purpose relating to new or improved function,
performance, or reliability or quality under § 41(d)(3)(A), and 20 percent or less of
Taxpayer’s activities are for purposes that relate to style, taste, cosmetic or seasonal
design factors.

ANALYSIS

The statements of facts provided by Taxpayer and Appeals, suggest that certain
research activities undertaken by Taxpayer as part of Project may have been for a
qualified purpose under § 41(d)(3), while certain research activities may have been for a
purpose that does not qualify under § 41(d)(3).

According to Taxpayer’s statement of facts, the Business Component had four main
performance standards: ------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
TAM-105894-22                                            10

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

Appeals’ statement of facts provided that the Business Component needed to maintain -
---------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------ Taxpayer also needed
---------------------------------------------------------------------------------------------------------------------
-----------

Particular research activities undertaken by Taxpayer with respect to the development
of the Business Component may have been for a qualified purpose. For example, such
activities appear to include ensuring that the Business Component met ----------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------. However, to the extent that
these activities did not relate to a new or improved function, performance, or reliability or
quality; the activities were not for a qualified purpose.

The mere fact that a taxpayer engaged in activities with respect to the Business
Component that were not for a qualified purpose under § 41(d)(3), does not preclude
that taxpayer from satisfying the process of experimentation test under § 41(d)(1(C)).
So long as substantially all of Taxpayer’s activities for Business Component constitute
elements of a process of experimentation for a qualified purpose described in
§ 41(d)(3)(A).

While both statements of fact provided by Taxpayer and Appeals describe research
activities that may be for a qualified purpose and others that may be for a non-qualified
purpose, neither statement establishes whether substantially all of Taxpayer’s activities
were for a qualified purpose. To meet the process of experimentation test, Taxpayer
must provide sufficient documentation to show that substantially all of Taxpayer’s
activities related to the Business Component are for a qualified purpose. See, Max v.
Commissioner, T.C. Memo 2021-37 at 43.

Except as specifically set forth above, no opinion is expressed concerning the federal
tax consequences of the facts described under any other provision of the Code. Further,
except for the discussion concerning the application of § 41(d)(3), no opinion is
expressed concerning whether Taxpayer qualifies for the research credit under § 41.

CAVEATS
TAM-105894-22                             11


A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.