Understanding the R&D Tax Credit Adaptation Exclusion

A current trend in both federal and state R&D Credit examinations is increased scrutiny of business components under the §1.41-4(c)(3) Adaptation Exclusion. The regulations state:

Adaptation of existing business components. Activities relating to adapting an existing business component to a particular customer’s requirement or need are not qualified research. This exclusion does not apply merely because a business component is intended for a specific customer.

In order to qualify a business component that is related to an existing product or process, a business must be able to distinctly identify the technical uncertainties and elements that make the current project a new or improved business component. These project elements can include added functionalities, measurable improvements, or a new application that requires certain enhancements to meet that purpose.

Along with identifying the technical uncertainties related to a new or improved project, a business must also be able to clearly identify their process of experimentation. This process of experimentation must rely upon the scientific method by evaluating one or more alternatives to resolve the uncertainty.

If the level of technical uncertainty in the customer-specific project does not rise to the level where experimentation is required to eliminate it, then the project would be subject to the adaption exclusion. Examples of non-qualified adaptations and modifications include:

• Adjusted layouts or sizing
• Scaling up of manufacturing processes
• Utilizing new materials that a taxpayer is familiar with
• Changes for aesthetic or stylistic purposes
• Customization of data sets for a particular customer

As stated in the regulations, when a project is intended for a specific customer, it does not mean that the adaptation exclusion applies. When a business must enhance or add to an existing business component or create a new product or process to meet the customer’s needs, qualified research may be taking place. While the adaptation exclusion is not the only consideration to make when evaluating a potential R&D Credit claim, correct interpretation is a key point for building a defendable claim.

As the guidance for R&D Tax Credit claims evolves, it is important to have an experienced and trusted advisor to assist in calculating and preparing the claims. If you would like to discuss or have any questions, don’t hesitate to contact us.