Tax Research

TAX RESEARCH

Research Problem: 7/5

Facts

The responsibilities of design department of Rocky Sole, Inc. are as follows:

* drawing ideas for new products

* producing drawings for improvements on existing products

* evaluating the appropriate manufacturing process, when agreement is reached on a new design

* doing no internal testing to determine how the hiking boots will perform.

Issue

What is the possibility of Rocky Sole, Inc., claiming all of the costs incurred by the design department as research and experimental expenditures under §174?

Conclusion

Based on the facts provided, RSI cannot claim all of the costs, but only the expenses of producing drawings with ideas for new products and improvements on existing products incurred by the design department as research and experimental expenditures.

Rationales

* Federal Regulation §1.174-2(a)(1) defines the term research or experimental expenditures used in §174 and provides that the term generally includes all the costs, in the experimental or laboratory sense, incident to the development or improvement of a product. The costs of producing drawings containing ideas for new products and improvements on existing products are for activities intended to discover information, so, that would eliminate uncertainty of the development or improvement of products [Reg. §1.174-2(a)(1)]. These costs are qualified as research or experimental expenditures.

* Federal Regulation §1.174-2(a)(3)( i) provides that the term research or experimental expenditures does not include expenses for the ordinary inspection of materials or products for quality control testing. Although quality control testing does not include testing to determine whether the design of the product is appropriate [Reg. §1.174-2(a)(4)], the design department does no internal testing to determine how the hiking boots will perform. Therefore, the valuation on the appropriate manufacturing process incidents to the process of producing the developed or improved product, but does not incident to any activities concerning the development or improvement of a product. This would result in that the costs of valuating the appropriate manufacturing process cannot be claimed as research or experimental expenditures.