To qualify an activity, the taxpayer must meet a threshold test known as the “4-Part Test” under the Internal Revenue Code.
The 4-Part Test includes the following components:
Activities related to points 2 thru 4 are typically, and most easily, relate-able to the Scientific Method. Based upon basic and fundamental scientific principles, the scientific method constructs a hypothetical statement in response to a problem and through the course of an analytic process, determines if the hypothesis is true or not.
The Scientific Method as illustrated below may be nostalgic to many as this is the basic teachings in high school science classes. Depending on the outcome of the work, adjustments may be made to the hypothesis, and testing is done in an iterative fashion. It is very clear how this method is qualified and meets the required 4-Part Test.
Figure 1 – Scientific Method Illustrated
But what about engineering-related activities – where the outcome isn’t a statement about a hypothesis, but rather a working tangible item? The luxury of simply proving or disproving the hypothesis is not available when designing a piece of equipment or process, especially when a strict timeline is in place. One cannot simply say “it is not possible” and re-formulate a hypothesis to start again. Thus, does this type of activity qualify?
Figure 2- Engineering Method Illustrated
The Engineering method is analogous to the Scientific Method and therefore does qualify under the RD tax credit definitions.
Instead of a hypothesis, a design is proposed. Often termed “FEED” (Front End Engineering and Design), this involves conducting analysis through mathematical calculations (i.e. thermal capacity) or modelling (i.e. FEA / CAE) to determine the most viable conceptual design with which to proceed. This meets the Process of Experimentation Test, as virtual or computer modelling demonstrates the iterative nature of the analysis.
If during prototyping and testing (i.e. commissioning), the existing design does not work, then design modifications are proposed. Modelling can again occur, followed by installation and trials / test runs. This continues as necessary in an iterative process with data analysis conducted throughout. Again, this satisfies the Process of Experimentation Test.
The final statement of the Engineering Method is not a statement about the validity of the hypothesis, but rather a definitive statement comparing the current state to the specifications laid out at the beginning of the project. The statement involves outlining what the capability of the equipment has been proven to be; with possible recommendations for further modifications if required.
There are a number of benefits of qualifying projects that follow the Engineering Method, including, but not limited to, the following;
A) Depending on the uniqueness of the item, component costs can also be captured as qualified research expenses.
- Typical expenses include wages (engineers, facilities, operational personnel) and subcontractor costs (engineering firms or simulation testing firms) and supplies (materials consumed during experimentation).
B) Existing corroborative records are often sufficient in demonstrating the qualifying nature of the project and how all four aspects of the statutory 4-Part Test is satisfied.
BGI’s technical team can efficiently determine the qualification of engineering-type projects, and are highly skilled at qualifying the costs associated with them. Using industry experienced Scientists and Engineers, our team has helped Companies to qualify and quantify these types of large Engineering initiatives and projects for inclusion in the R&D Tax Credit.
If only parts of the project or initiative are determined to be qualified, our staff skillfully applies the shrink-back rule to capture only the strong qualifying elements that are both defendable and auditable.