A common question is how duplication and reverse engineering are treated under the R&D tax credit. The short answer is that duplication of an existing business component is excluded from qualified research under Section 41(d)(4)(C). Reverse engineering to copy an existing product generally is not qualified research, but work that develops genuinely new or improved functionality may warrant review. This page explains the framework in general terms. It is educational and is not individualized advice. For the foundational framework, see our page on qualified research.
The Duplication Exclusion
Under Section 41(d)(4)(C), research relating to reproducing an existing business component (in whole or in part) is excluded from qualified research. The Treasury Regulations (§1.41-4(c)(4)) address this exclusion. The basic idea is that copying or duplicating an existing product generally does not constitute qualified research. For more, see our page on qualified research.
Reverse Engineering
Reverse engineering — analyzing an existing product to understand how it works — can raise questions. Reverse engineering to copy an existing product generally is not qualified research, because the purpose is duplication, not development or improvement. However, reverse engineering that goes beyond copying — for example, using the analysis to identify failure modes, understand principles, and develop an improved business component — may warrant review if it involves a technical uncertainty and a process of experimentation. For more on using testing of existing products to develop improvements, see our page on product comparison testing.
Developing Genuinely New or Improved Functionality
The distinction is between duplication and developing genuinely new or improved functionality:
- Duplication — reproducing an existing business component from a physical examination, plans, blueprints, or publicly available information. This is excluded.
- Developing new or improved functionality — using analysis of existing products to develop a new or improved business component that goes beyond duplication, where there is a technical uncertainty and a process of experimentation. This may warrant review.
The line is fact-specific. Work that simply copies an existing product is duplication. Work that uses analysis of existing products to develop something new or improved may go beyond duplication.
The Exclusion Does Not Apply to All Evaluation of Existing Products
It is important to note that the exclusion does not apply merely because a taxpayer evaluates another's business component in the course of developing its own. The regulations provide that the exclusion does not apply merely because a taxpayer evaluates another's business component. The exclusion applies to duplication — reproducing an existing component — not to all evaluation of existing products.
Hypothetical Example
Consider a manufacturer that reverse engineers a competitor's product to copy its design. The work is directed at reproducing the existing product, not at developing a new or improved product. This is duplication, and it is excluded from qualified research.
By contrast, if the manufacturer analyzes the competitor's product to identify its failure modes, uses the analysis to design an improved product, and tests the improved design through a process of experimentation, the work may go beyond duplication and may warrant review as qualified research.
These examples are illustrative only and do not state whether any particular activity qualifies.
Documentation That May Help
Records that can help support the duplication analysis include records showing whether the work was duplication of an existing component or development of a new or improved component, records of the technical uncertainty (if any), and records of the process of experimentation (if any). For more, see our page on R&D tax credit documentation.
Key Takeaway
Duplication of an existing business component is excluded from qualified research under Section 41(d)(4)(C). Reverse engineering to copy an existing product generally is not qualified research, but work that develops genuinely new or improved functionality may warrant review. Because the distinction is fact-specific, professional review is appropriate.