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Statement of the Problem

Many businesses in the commercial world spend vast amounts of money

annually on the research and development of products and services. These

entities do this with the intention of developing a product or service that will, in

future periods, provide significant amounts of income for years to come. But

then, these businesses are faced with the dilemma on the proper treatment of

Research and Development Expenditures incurred in the development

particularly on tangible property whether it is deductible or not for income tax

purposes under the Internal Revenue Service (IRS) of the United States of

America. This article depicts the proposed regulation changes to research and

development expenditures. In connection with this, it discusses also the

expenditures on the acquisition or improvement of property connected with the

research and experimentation.

Actions/Decisions Taken to Solve the Problem

First, we define what we mean by research as well as development. Research is

original and planned investigation, undertaken with the prospect of gaining

new scientific or technical knowledge and understanding. An example of

research could be a company in the pharmaceuticals industry undertaking

activities or tests aimed at obtaining new knowledge to develop a new vaccine.

The company is researching the unknown, and therefore, at this early stage, no

future economic benefit can be expected to flow to the entity. On the other

hand, development is the application of research findings or other knowledge to


a plan or design for the production of new or substantially improved materials,

devices, products, processes, systems, or services, before the start of

commercial production or use. An example of development is a car

manufacturer undertaking the design, construction, and testing of a pre-

production model.

Generally, under the IRS, a taxpayer may treat research or experimental

expenditures which are paid or incurred during the taxable year in connection

with its trade or business as expenses which are not chargeable to capital

account as deductible expenses for income tax purposes. Under section 174 of

the IRS, the expenditure must meet the following criteria: (1) be incurred in

connection with the taxpayer’s trade or business, and (2) represent a research

and development cost in the experimental or laboratory sense. Expenditures

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. Uncertainty 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.

Whether expenditures qualify as research or experimental expenditures

depends on the nature of the activity to which the expenditures relate, not the

nature of the product or improvement being developed or the level of

technological advancement the product or improvement represents.


Section 174 treatment is allowed only to the extent that the amount is

reasonable under the circumstances. Expenditures for land and depreciable

property are not allowed under section 174, although in certain cases,

depreciation may be treated as a section 174 expense. Exploration

expenditures do not qualify as section 174 expenses. Furthermore, the

provisions of section 174 are not applicable to any expenditure paid or incurred

for the purpose of ascertaining the existence, location, extent, or quality of any

deposit of ore, oil, gas, or other mineral.

The proposed regulations of the IRS provide the following guidelines that

settled the questions in the proper treatment of Research & Development

Expenditures:

1. No distinction between a new product's failure or success


If your business incurs expenses or resources to build a prototype or

pilot model and those expenditures meet the IRS’s Research and

Development criteria, they qualify under Section 174 regardless of the

prototype’s outcome or final use—in other words, whether it succeeds or

fails or whether you end up using it in your business or selling it to

external customers.
Let us first define what is a pilot model or a prototype. A pilot model or a

prototype is 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. Further, the term can refer

to either a fully functional representation or model of the product or a

component of the product.


A good example for this is when a business designs and manufactures an

aircraft that can take off and land vertically. In an effort to remove

uncertainty and evaluate different designs, the company develops a

working pilot model at a cost of $5 million. Whether the company later

sells that prototype or uses it as a demo model in its business, the $5

million in costs the company incurred qualify as Research and

Development expenditures and are thus eligible for deduction under

Section 174.

2. Material and labor costs are eligible


An illustration would be the case of a winery. If the company researches

and develops a new method for crushing grapes and incurs $1,000 of

labor and material costs to test the effectiveness of this new method,

those costs are now considered Research and Development expenditures

and are eligible under Section 174.

3. The final product


If, after a process of research and experimentation, the company incurs

resources to build a final product that is a replica of the finalized

prototype, those expenditures will not be considered Research and

Development costs. In the IRS’s view, all uncertainty has been eliminated

by that point and the expenses incurred to build the final product aren’t

eligible under Section 174.

4. Component parts
If the company incurs qualifying Research and Development costs to add

a new component to an existing product, the costs associated with that


particular component may qualify under Section 174—but not the costs

associated with the original product. This proposed regulation preserves

Section 174 eligibility for certain component Research and Development

costs even though the entire product may not be new. The IRS refers to

this as the “shrinking-back rule."


An example of this is when a company manufactures aircraft engines

and it researches and develops a new type of blade to improve an

engine’s performance. To test the new blade’s design, it produces and

installs the blade on one of the existing engine designs. Because the

blade design is new and it incurred research and experimentation costs

to resolve uncertainty about its function, it’s considered a pilot model

under Section 174 and is eligible for deduction. However, the costs of

producing the engine (in which it tested the blade) aren’t eligible, since

uncertainty had already been removed from its development.

Conclusion

In the commercial world, it is a must for a company to find ways to provide

their customers/clients with the best products and services in order to surpass

their competitors. This is the reason why most companies persistently invest in

Research and Development projects especially nowadays where the pace of

technology is accelerating. It is a crucial factor in determining the


competitiveness of a company in the marketplace – both nationally and

internationally. But then, research is costly and has a high chance of failure.

Therefore, in deciding what Research and Development projects to undertake,

the company should review it thoroughly to ensure that it is in line with the

main business activity of the company. Furthermore, the company should also

review its proper treatment on Research and Development expenditures to

ensure that it is in accordance with pertinent rules and regulations regarding

Research and Development expenditures.

Reaction

In undertaking research and development projects, there is no assurance that

every project will provide future economic benefits to the company. Moreover, it

often involves large amount of cash outlay that may or may not be recovered in

the future. These factors therefore necessitate the need for clear-cut guidelines

on the proper treatment of Research and Development Expenditures.

If, in the future, economic benefit is expected to flow to the company as a result

of incurring Research and Development costs, it can be argued that these costs

should be treated as an asset, as they meet the definition of an asset

prescribed by both the Statement of Principles and the IASB Framework for the

Preparation and Presentation of Financial Statements. Equally, the argument

exists that it may be impossible to predict whether or not a project will give rise

to future income. As a result, accountants are now faced with the problem on
when to record Research and Development expenditures as an asset and when

to record it as an expense.

In order to clarify this situation, international accounting regulating bodies

have provided accountants with more detailed information and guidelines

regarding Research and Development Expenditures. Among these is the

recently proposed regulations change by the IRS under Section 174. The

proposed regulations would settle some unresolved issues regarding Research

and Development expenditures especially on costs incurred in connection with

the development of intangible property, including pilot models. With these

proposed regulations, there will be no more distinction as to the treatment of

Research and Development expenditures incurred in building prototype

whether it succeeds or not or whether the business will use it or sell it to

external customers. These have settled the question of whether the sale of

product resulting from research and experimental expenditures will disqualify

it as Research and Development expenditures. Additionally, the IRS is now

proposing the “shrinking back” rule which will address the situations in which

a particular component may qualify as a Research and Development

expenditure but not the overall product itself. Such proposed regulations will

definitely make an impact in the accounting for Research and Development

expenditures.

Finally, research and development plays a very crucial role in every industry.

This will create a boon or bane to their chosen products and services. Every

company should carefully evaluate and analyze their undertakings with regard
to research and development. Companies should also consider the laws in

which they operate especially tax laws, treaties and international trade

agreements between countries.