- 74 -
respect to a product, etc. but are met with respect to
one or more elements thereof, the term business component
means the most significant set of elements of such
product, etc. with respect to which all requirements are
met.
Thus, the requirements are applied first at the
level of the entire product, etc. to be offered for sale,
etc. by the taxpayer. If all aspects of such
requirements are not met at that level, the test applies
at the most significant subset of elements of the
product, etc. This "shrinking back" of the product is to
continue until either a subset of elements of the product
that satisfies the requirements is reached, or the most
basic element of the product is reached and such element
fails to satisfy the test. Treasury regulations may
prescribe rules for applying these rules where a research
activity relates to more than one business component.
H. Conf. Rept. 99-841 (Vol. II), supra at II-72 through II-73,
1986-3 C.B. (Vol. 4) at 72-73. We conclude that the shrinking back
test must be examined on a case-by-case basis to determine which
activities are part of the same product or process, and which are
so discrete as to warrant a separate evaluation.
E. The Innovativeness Test
The innovativeness test requires that the software be
innovative "as where the software results in a reduction in cost,
or improvement in speed, that is substantial and economically
significant". Id. at II-73, 1986-3 C.B. (Vol. 4) at 73. The
parties disagree over the meaning of the innovativeness test.
Respondent contends that the legislative history of section 41
mandates that we require a "high threshold of innovation", the
phrase that appears in the House and Senate reports accompanying
the TRA 1986, S. Rept. 99-313, at 694-695 (1986), 1986-3 C.B. (Vol.
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