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3. The Seven Tests
The parties agree that the combination of section 41 and the
conference report accompanying the TRA 1986 results in a total of
seven tests that taxpayers must satisfy to obtain the R&E credit
with respect to qualified research in the development of internal
use software:34
(1) The section 174 test (the research expenditures must
qualify as expenses under section 174);35
(2) the discovery test (the research must be undertaken for
the purpose of discovering information which is technological in
nature);
(3) the business component test (the research must be
undertaken for the purpose of discovering information the
application of which is intended to be useful in the development of
a new or improved business component of the taxpayer);
(4) the process of experimentation test (substantially all of
the activities which constitute elements of a process of
experimentation must relate to a new or improved function,
performance, reliability, or quality);
(5) the innovativeness test (the software must be innovative
(as where the software results in a reduction in cost, or
improvement in speed, that is substantial and economically
significant));
34 Tax credits are a matter of legislative grace, and the
taxpayer bears the burden of proving entitlement to the credits.
Rule 142(a); Interstate Transit Lines v. Commissioner, 319 U.S.
590, 593 (1943); Segel v. Commissioner, 89 T.C. 816, 842 (1987).
35 Sec. 41(d)(1)(A) provides that "qualified research"
means research "with respect to which expenditures may be treated
as expenses under section 174". We believe that the statutory
phrase "may be treated as expenses under section 174" means that
the expenditures must "qualify" for the deduction under sec. 174.
See infra.
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