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1995

PLR/TAM 9522057 - 9522001

TAM 9522001 -- IRC Sec(s). 41, 6/02/1995

Technical Advice Memoranda

Technical Advice Memorandum 9522001, 6/02/1995, IRC Sec(s). 41

UIL No. 0041.51-03

Headnote:

Reference(s): Code Sec. 41;

The Service has ruled in technical advice that firm's activities relating to developing and improving food products

and food manufacturing techniques may constitute qualified research under section 41.

Copyright 1995, Tax Analysts.

Full Text:

Date: December 21, 1994

Control No.: TR-32-222-94

Taxpayer's Name : ***

Taxpayer's Address : ***

Taxpayer's Identification No. : ***

Years Involved : ***

Date of Conference : ***

LEGEND:

Taxpayer = ***



x = ***

y = ***

z = ***

ISSUE

Are Taxpayer's research activities related to the development of new food products and manufacturing

techniques, and the improvement of existing food products and manufacturing techniques excluded from

qualifying for the credit for increasing research activities because research relating to style, taste, cosmetic, or

seasonal design factors is ineligible for the credit under section 41(d)(3)(B)?

FACTS

Taxpayer develops and manufactures food products. During the tax years x, y, and z, Taxpayer's research and

development department engaged in various activities aimed at developing new food products and manufacturing

techniques, and improving existing food products and manufacturing techniques. The goal of Taxpayer's various

research activities was to develop finished food products, with acceptable taste and nutritional value, for use as a

source of energy.

Taxpayer provided an example of its research activities to develop a product. In the example, Taxpayer had an

idea for a target product but did not know how the various components of the product would interact when

Taxpayer tried to produce the product on a large scale. The objectives of the project were to develop the

functional design specifications of the target food product and to develop the manufacturing processes for the

target food product.

In order to develop the functional design specifications and the manufacturing process for the target food product,

Taxpayer conducted various experiments to determine the proper processing conditions for the product and its

various components, and to determine how the various product ingredients interacted. Taxpayer used food

chemistry principles to determine the order that the ingredients must be added together. Taxpayer made

formulation modifications in order to use some existing equipment to manufacture the target product. However,

Taxpayer also developed some new equipment to use in the manufacturing process. In addition, Taxpayer

conducted various experiments to determine a proper heat transfer rate for the product and built a customized

oven to be used in the product manufacturing process.

In assembling the target product, Taxpayer developed new equipment and techniques. Taxpayer built some

prototype units and tested the prototypes in a pilot plant. After acceptable equipment designs were developed,

full-scale production units were built.

On its tax returns for x, y, and z, Taxpayer treated these activities as qualified research and claimed the credit for

increasing research activities. On examination, the Internal Revenue Service (Service) proposed to disallow some

of the Taxpayer's credit for increasing research activities on the theory that any research related to sensory taste

does not qualify for the research credit under section 41(d)(3)(B). The Service has not yet completed its

examination of whether the activities that the Taxpayer treated as qualified research activities satisfied the other

components of the definition of “qualified research” in section 41(d)(1). Thus, for purposes of this technical advice



request, we assume Taxpayer's research activities satisfy the other components of the section 41(d)(1) definition

of “qualified research.” In addition, market research, consumer surveys, or other types of costs described in

section 41(d)(4)(D) are not at issue in this technical advice request because Taxpayer apparently did not include

those types of costs in its qualified research expenses.

LAW

Section 41 provides a credit against tax for increasing research activities. The credit is an incremental credit

equal to the sum of 20 percent of the excess of the taxpayer's qualified research expenses for the taxable year,

over a base amount, and 20 percent of the taxpayer's basic research payments.

The term “qualified research expenses” is defined in section 41(b). Qualified research expenses include in-house

expenses and contract research expenses which are paid or incurred by the taxpayer during the taxable year in

carrying on any trade or business of the taxpayer. The term “in-house research expenses” means any wages

paid or incurred to an employee in the conduct of qualified research or in the direct support or supervision of

qualified research and any supplies used in the conduct of qualified research. The term “contract research

expenses” means 65 percent of any amount paid or incurred by the taxpayer to another person (other than an

employee of the taxpayer) for qualified research.

Section 41(d)(1) defines the term “qualified research” as research (A) with respect to which expenditures may be

treated as expenses under section 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 constitute

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

Under section 41(d)(3)(A), research is conducted for a purpose described in this paragraph if it relates to a new or

improved function, performance, or reliability or quality. However, section 41(d)(3)(B) provides that research shall

in no event be treated as conducted for an eligible purpose if it relates to style, taste, cosmetic, or seasonal

design factors.

The tests under section 41(d)(1) are to be applied separately to each business component. Section 41(d)(2)(A).

The term business component includes any product, process, computer software, technique, formula, or

invention which is to be used by the taxpayer in a trade or business of the taxpayer. Section 41(d)(2)(B).

ANALYSIS

The issue in this technical advice request is whether Taxpayer's research activities related to the development of

new food products and manufacturing techniques, and the improvement of existing food products and

manufacturing techniques are excluded from qualifying for the credit for increasing research activities because

research relating to style, taste, cosmetic, or seasonal design factors is ineligible for the credit under section

41(d)(3)(B). It is our view that the term “taste” as used in section 41(d)(3)(B) means individual or consumer

preference not sensory taste. Thus, Taxpayer's research activities in developing new food products and

manufacturing techniques, and improving existing food products and manufacturing techniques may not be

excluded from the definition of the term “qualified research” under section 41(d)(3)(B).

To be entitled to the credit for increasing research activities under section 41, Taxpayer must be engaged in



“qualified research” as defined in section 41(d)(1) and Taxpayer's activities must not be excluded from the

definition of the term “qualified research” under section 41(d)(4). The tests under section 41(d)(1) are applied

separately to each business component. Section 41(d)(2). Therefore, a plant process, machinery, or technique

for commercial production is treated as a different business component than the product being produced. H.R.

Conf. Rep. No. 841, 99th Cong., 2d Sess. 11-73 (1986), 1986-3 (Vol. 4) C.B. 73.

As defined in section 41(d)(1), the term “qualified research” means research: (A) with respect to which

expenditures may be treated as research and experimental expenditures under section 174, (B) which is

undertaken for the purpose of discovering information that is technological in nature and the application of which

is intended to be useful in developing a new or improved business component of the taxpayer, and (C)

substantially all of the activities of the research constitute a process of experimentation for an eligible purpose.

Under section 41(d)(3)(A), research is conducted for an eligible purpose if it relates to a new or improved function,

performance, or reliability or quality. However, under section 41(d)(3)(B), research is not conducted for an eligible

purpose if it relates to style, taste, cosmetic, or seasonal design factors.

The term “taste” has several different meanings depending on the context in which it is used. Webster's Ninth

New Collegiate Dictionary provides the following definition of the term “taste”:

1 obs : test 2 a obs : the act of tasting b : a small amount tasted c : a small amount : BIT; esp : a

sample of experience (her first taste of success) 3 : the one of the special senses that perceives

and distinguishes the sweet, sour, bitter, or salty quality of a dissolved substance and is mediated

by the taste buds on the tongue 4 : the objective sweet, sour, bitter, or salty quality of a dissolved

substance as perceived by the sense of taste 5 a : a sensation obtained from a substance in the

mouth that is typically produced by the stimulation of the sense of taste combined with those of

touch and smell : FLAVOR b : the distinctive quality of an experience (the attempt to cheat left a

bad taste in my mouth) 6 : individual preference : INCLINATION 7 a : critical judgement,

discernment, or appreciation b : manner or aesthetic quality indicative of such discernment or

appreciation.

As used in section 41(d)(3)(B), we believe that the term “taste” is intended to mean individual preference or

critical judgement, discernment, or appreciation. This interpretation is consistent with the meanings of the other

ineligible purposes enumerated in section 41(d)(3)(B). When read together, we believe that the exclusions for

research related to style, taste, cosmetic, and seasonal design factors exclude research activities that relate to

matters of individual and consumer preference rather than functional aspects, including flavor or sensory taste, of

a business component.

In the case of food products, new product development and improvements to existing products may relate to

texture, smell, and flavor. These characteristics affect taste in the sensory context. To the extent that a food

product developer tries to develop products with a new or improved function, performance, or reliability or quality

including new or improved textures, smells, or flavors, the research activities to develop the products may relate

to functional aspects of a business component as required in section 41(d)(1) and (3)(A). Thus, the research

activities conducted for purposes described in section 41(d)(3)(A) and otherwise satisfying the definition of

“qualified research” in section 41(d)(1) would not be treated as conducted for an ineligible purpose under section

41(d)(3)(B).



In developing its new products, Taxpayer conducted research into the physical properties of the target products'

component parts and the composite products. In addition, Taxpayer conducted research to develop and improve

manufacturing techniques and equipment. Because the tests under section 41(d)(1) are to be applied separately

to each business component which is to be used by the taxpayer in its trade or business, Taxpayer's research

activities related to new or improved manufacturing techniques and equipment should be considered

independently from Taxpayer's research activities related to the target product for purposes of section 41(d)(1).

Research activities related to new or improved manufacturing techniques and equipment are not treated as being

conducted for an ineligible purpose under section 41(d)(3)(B) and excluded from qualifying for the credit for

increasing research activities merely because the techniques and equipment are intended to be used in food

production. These techniques and equipment may be developed for purposes described in section 41(d)(3)(A). If

the research activities are performed for an eligible purpose in section 41(d)(3)(A) and otherwise meet the

requirements in section 41(d)(1), the research activities may constitute “qualified research” for section 41.

CONCLUSION

Although Taxpayer is in the business of developing and manufacturing food products, all of Taxpayer's research

activities are not excluded from the definition of the term “qualified research” because section 41(d)(3)(B) of the

Internal Revenue Code excludes research that relates to taste. We believe that the word “taste” as used in

section 41(d)(3)(B) means individual or consumer preference. Therefore, Taxpayer's activities related to the

development and improvement of the functional aspects of a target product may constitute qualified research. In

addition, research in developing or improving manufacturing techniques and equipment may constitute qualified

research.

Except as specifically set forth above, no opinion is expressed concerning the federal tax consequences of the

facts described above under any other provision of the Code. Except as to the application of section 41(d)(3)(B),

no opinion is expressed as to whether Taxpayer's activities constitute qualified research under section 41(d).

A copy of this technical advice memorandum is to be given to the Taxpayer. Section 6110(j)(3) of the Code

provides that it may not be used or cited as precedent. Temporary or final regulations pertaining to one or more of

the issues addressed in this memorandum have not yet been adopted. Therefore, this memorandum will be

modified or revoked by the adoption of temporary or final regulations to the extent the regulations are inconsistent

with any conclusion in the memorandum. See section 16.03 of Rev. Proc. 94-2, 1994-1 C.B. 428, 442. However,

a technical advice memorandum involving a continuing transaction generally is not revoked or modified

retroactively if the taxpayer can demonstrate that the criteria in section 16.04 of Rev. Proc. 94-2 are satisfied.

END OF DOCUMENT -

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