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State of California Franchise Tax Board

Four Tests for Qualified Research

Pursuant to California Revenue and Taxation Code sections 17052.12 and 23609, in order for an activity or project to qualify for the research credit, the taxpayer must show that it meets all of the requirements in Internal Revenue Code section 41(d).

To be California qualified research, the research activity must be conducted within California, and must satisfy a four-part test:

  1. The section 174 test: Internal Revenue Code section 41(d)(1)(A) -- First, expenditures connected with the research activity must be eligible for treatment as expenses under IRC section 174. Section 174 allows "research or experimental expenditures" for expenditures incurred in connection with the taxpayer's trade or business that represent research costs in the experimental or laboratory sense.
  2. The technological information test: Internal Revenue Code section 41(d)(1)(B)(i) -- Second, the research activity must be undertaken for the purpose of discovering technological information, that is, it must rely upon "hard sciences" such as physics, chemistry, and biology.
  3. The business component test: Internal Revenue Code section 41(d)(1)(B)(ii), (2) -- Third, the taxpayer must intend that the information to be discovered will be useful in the development of a new or improved business component of the taxpayer. The four-part test must be applied separately to each business component of the taxpayer. A "business component" includes a product or process that the taxpayer either holds for sale, lease, or license, or uses in its trade or business.
  4. The process of experimentation test: Internal Revenue Code section 41(d)(1)(C), (3) -- Fourth, substantially all of the research activities must constitute elements of a scientific method-style process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality. A process of experimentation requires formation of one or more hypotheses, a methodical plan to test those hypotheses, actual testing and evaluation of the hypotheses, analysis of the results of the testing, and either the refinement of the hypotheses or discarding and repeating the previous steps.

If the research activity fails any one of the four parts, then the activity fails the four-part test, and the activity is not considered "qualified research." An activity that fails the four-part test is not eligible for the research credit.

California Research Credit

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