96 T.C. 903">*904 In his notice of deficiency, respondent determined the following deficiencies in petitioner's Federal corporate income tax:

1991 U.S. Tax Ct. LEXIS 57">*58 The deficiencies at issue for petitioner's taxable years ending September 30, 1977, 1978, and 1979, result from respondent's disallowance of tentatively allowed refunds caused by carrybacks of unused tax credits from petitioner's fiscal year ending September 30, 1980. The deficiency at issue for petitioner's taxable year ending September 30, 1980, results from respondent's disallowance of a portion of a tentatively allowed refund caused by a net operating loss carryback from petitioner's taxable year ending June 30, 1983. The deficiency at issue for petitioner's taxable year ending June 30, 1981, results from respondent's disallowance of a portion of a tentatively allowed refund caused by a net operating loss carryback and a carryback of unused research credit from petitioner's taxable year ending June 30, 1983. The deficiency at issue for petitioner's taxable 96 T.C. 903">*905 year ending June 30, 1982, results in part from respondent's disallowance of a research credit claimed on petitioner's corporate income tax return for its taxable year ending June 30, 1982, in part from respondent's disallowance of a tentatively allowed refund caused by a carryback of unused research credit from1991 U.S. Tax Ct. LEXIS 57">*59 petitioner's fiscal year ending June 30, 1983, and in part from respondent's disallowance of a portion of a tentatively allowed refund caused by a net operating carryback and a carryback of unused research credit from petitioner's taxable year ending June 30, 1984.

Following a concession by respondent, the only issue for decision is whether expenditures incurred by petitioner for creating, developing, and writing games, game-related products, and game-related books and magazines constitute "qualified research expenses" for purposes of the credit for increasing research activities under section 44F. ¹

1991 U.S. Tax Ct. LEXIS 57">*60 FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference.

Petitioner is a corporation organized and existing under the laws of the State of Wisconsin. At the time of filing its petition, petitioner's principal place of business was located in Lake Geneva, Wisconsin.

Petitioner filed Federal corporate income tax returns (Form 1120) for the taxable years ending June 30, 1982, 1983, and 1984, with the Internal Revenue Service Center at Kansas City, Missouri. Petitioner subsequently filed amended Federal corporate income tax returns (Form 1120X) for the taxable years ending June 30, 1982, 1983, and 1984, with the Internal Revenue Service Center at Kansas City, Missouri. Petitioner also filed applications for tentative refund (Form 1139) with respect to its taxable 96 T.C. 903">*906 years ending September 30, 1980, June 30, 1983, and June 30, 1984.

Petitioner is most noted for the development and sale of the fantasy role-playing game "Dungeons & Dragons." "Dungeons & Dragons" involves role-playing adventures in which the players of the game imagine that they are characters involved in various adventures1991 U.S. Tax Ct. LEXIS 57">*61 that occur in a medieval, mythological setting. "Dungeons & Dragons" was developed in the early 1970s. Petitioner also sells books, games, and accessories that are related to "Dungeons & Dragons."

Petitioner has also developed and sells other role-playing adventures under the themes of: (1) Spies, soldiers, and super heroes; (2) future science; and (3) legends, lore, and myth.

A role-playing game is usually played without a board or map, with most of the playing being a verbal exchange between players and a narrator or moderator who uses a programmed adventure with hidden map and an explanatory keyed text made for the narrator's eyes only. Each game is unique and has a specific player objective or purpose. Players do not play against the narrator.

During the period at issue, petitioner developed and sold other products including historical simulation and strategy games, game books, toys and white metal miniatures, ² calendars, comic annuals, various gifts and collectibles, and periodicals including Dragon Magazine and Amazing Stories Magazine.

1991 U.S. Tax Ct. LEXIS 57">*62 Many of the games sold by petitioner are of the adventure gaming variety. Adventure gaming falls into three categories: (1) Traditional board games; (2) fantasy role-playing games; and (3) historical simulation strategy games.

The products developed by petitioner during the years in issue were developed primarily by petitioner's new products development division. Petitioner developed and introduced approximately 125 new products each year during the years at issue. Employees of the various departments within the new products development division worked individually on specific topics within their area of responsibility. These 96 T.C. 903">*907 employees also worked together on the general concepts of the game in order to integrate their individual efforts into a working game. Eventually, a prototype product was developed. If the product was a new game or game module, ³ the new products development division also play tested (e.g., played the game or game module to determine if it would be popular with petitioner's consumers) the product. The games and game modules produced by petitioner consisted primarily of written materials.

1991 U.S. Tax Ct. LEXIS 57">*63 The principal market segment for many of petitioner's products consists of males between the ages of 12 and 20 and, more specifically, in the age group 14 to 16 years old. These consumers of petitioner's products are usually of above average intelligence, live in urban or suburban areas, and are from families in the middle and upper-middle income levels. In addition, certain of petitioner's products -- such as the historical and military simulation and strategy games -- appeal to players of older ages.

Petitioner's new products development division was responsible for supplying the company with an adequate supply of new products. The new products development division was divided into five functions: 3-D products, game-related publishing, editorial services, graphic arts services, and product design and packaging.

The 3-D products function was responsible for the product design and development of the line of white metal miniatures, other toy-related lines, and miscellaneous hobby and craft lines. In addition, this department was responsible for the casting or mold-making for the white metal miniatures, paper engineering, and sculpture related products, and acted as a liaison for1991 U.S. Tax Ct. LEXIS 57">*64 TSR Far East, apparently a foreign subsidiary of petitioner.

The game-related publishing function was responsible for the design and development of games and game-related products. It was made up of game designers and their editors. Its activities consisted primarily of researching a new product idea suggested by petitioner's marketing department and developing this idea into a new game or 96 T.C. 903">*908 game module. As part of the development process of new games and game modules, members of this department researched the topic upon which the game or game module was based, translated this research into the working mechanics of the game, and then played the prototype of the game and adjusted the principles upon which the game is based. These adjustments were made in order to enhance the play.

The editorial services function was responsible for writing, editing, and developing books, book-related products, and other written materials published by petitioner. This department also translated petitioner's products into foreign languages and acquired transcripts from free-lance writers.

The graphic arts services function was responsible for the visual development of products and promotional1991 U.S. Tax Ct. LEXIS 57">*65 material. Employees of this department developed artwork which was available to petitioner's consumers and which helped the consumers visualize the action that was taking place in games. Employees of this department were also responsible for typesetting of products and promotional material, keylining of products and promotional material, proofreading, development of prototypes, and camera work for printing preparation.

The product design and packaging function developed the packaging and promotional materials for the product lines. Employees of this department also developed product layouts and formats and computerized production scheduling and monitoring.

Many of the adventure gaming games and game-related accessories require the participants to imagine themselves in a particular setting. For instance, the "Dungeons & Dragons" players imagine that they are characters on an adventure in a medieval setting. Similarly, the players of petitioner's "Gang Busters" game imagine themselves as characters in a 1920s prohibition, "cops and robbers" setting, and the players of petitioner's "Boot Hill" game imagine themselves as characters in the American West during the 1800s.

One objective1991 U.S. Tax Ct. LEXIS 57">*66 of the new products development division was to produce a game that was accurate in technical detail and historical facts. This was important because the people 96 T.C. 903">*909 who played petitioner's games became immersed in the various aspects of the subject matter and setting of the game. If the game was based on inaccurate information, word would spread among the people who played the game that the game was not realistic, and the game's sales would suffer. Consequently, the game-related publishing function thoroughly researched the historical and technical information upon which the game was based.

In conducting its research, the game-related publishing function employees consulted their own personal libraries, petitioner's library, government documents, museums, and other sources in their effort to collect information relevant to the game. This information was incorporated into the mechanics of the game. The result was an adventure game which was based on accurate information. For example, the players of "Dungeons & Dragons" who imagined that they were on an adventure in a medieval European setting availed themselves of items from the medieval European time period. The game 1991 U.S. Tax Ct. LEXIS 57">*67 designers identified these items and made them available (in an imaginary sense) to the game players. They also determined the consequences of acquiring and possessing a particular item. For instance, a "Dungeons & Dragons" player might acquire a long bow. Petitioner's employees determined how hard it was to obtain a long bow in medieval Europe, how much a long bow would cost, and how effective a long bow was as a weapon. The employees incorporated this information into the game mechanics by mathematical formulas. The mathematical formulas helped to determine the relative strengths and weaknesses conferred on a player by the acquisition of the item so that these strengths and weaknesses could be measured relative to other items acquired by other players. Consequently, the player acquiring the long bow enjoyed the benefits as well as endured the burdens of the acquisition. Petitioner conducted similar research with respect to petitioner's other games and game modules.

For historical simulation games, such as the "World War II" game developed during the years at issue, the game designers researched various military weaponry, specifications for air and naval craft, examined such1991 U.S. Tax Ct. LEXIS 57">*68 aspects as speed, fire power, personnel capacity, and range of the items 96 T.C. 903">*910 studied. This type of research involved the use of governmental reports and other publications, various textbooks, published research materials, product catalogues of weapon manufacturers, and maps. This research also included visits to libraries, museums, and other relevant sites, such as a civil war battlefield.

Once the data for the game was collected and the basic game format was established, petitioner's employees "play tested" the new game. This involved playing the game and making adjustments to enhance its entertainment value. For instance, if information that was incorporated into a game gave one character such an advantage that that character consistently prevailed over other characters, the weight attached to this information was diminished so that the players would be balanced and the outcome of the game would be determined by the individual player's skill and decision making.

In addition to the games and game modules developed by petitioner during the years in issue, petitioner also developed other types of game-related products. These products included toy models of various characters1991 U.S. Tax Ct. LEXIS 57">*69 involved in the games, paints and glues for the models, special dice for the games, educational adaptations of petitioner's games, computer versions of petitioner's games, and solo games that an individual could play.

Petitioner obtained copyrights on virtually all of its products including books, magazines, games, game modules, magic-viewer modules, minigames, game accessories, and needlecraft designs. The game accessories for which copyrights were obtained included game screens, monster cards, 3-D dragon tiles, character reference sheets, bendable toys, character miniatures, blister packs, and metal miniatures.

The costs claimed by petitioner as research expenses include the cost of taking a product from its idea or concept to the creation of a final prototype. The costs of manufacturing the product for commercial distribution are not included as costs of new product development.

The following schedule summarizes the expenses claimed by petitioner as the basis of the research credit. 96 T.C. 903">*911

1991 U.S. Tax Ct. LEXIS 57">*70 Petitioner reflected total research expenses of $ 972,423, $ 1,469,371, and $ 1,446,225 on its income tax returns for its taxable years ended June 30, 1982, 1983, and 1984, respectively. ⁴

Based on the total research expenses stated above, petitioner claimed research credits in the amounts of $ 121,553, $ 183,671, and $ 149,907 for its taxable years ended June 30, 1982, 1983, and 1984, respectively. These amounts total $ 455,131.

96 T.C. 903">*912 Respondent disallowed all of the above-stated amounts of research credit in the notice of deficiency issued to petitioner on May 29, 1987.

OPINION

The amounts for which petitioner claimed a credit under section 44F were spent for new product development. Respondent contends, however, that the type of new product development activity1991 U.S. Tax Ct. LEXIS 57">*71 conducted by petitioner is not the type of research which qualifies for the section 44F credit. Therefore, we must determine whether the expenses incurred by petitioner's new products development division in connection with the development of new products constitute "qualified research expenses" as described in section 44F.

Section 44F provides a credit against the tax imposed in an amount equal to 25 percent of the excess (if any) of: (1) The qualified research expenses for the taxable year, over (2) the base period research expenses. Sec. 44F(a). Qualified research expenses are defined as the sum of: (1) In-house research expenses; and (2) contract research expenses which are paid or incurred by the taxpayer during the taxable year. Sec. 44F(b). Base period research expenses are defined as the average of the qualified research expenses incurred or paid by the taxpayer in the 3 years immediately preceding the year in which the credit is being taken. Sec. 44F(c). For tax years ending after June 30, 1981, and before June 30, 1982, base period research expenses equal qualified research expenses incurred in the year immediately preceding the year in which the section 44F credit1991 U.S. Tax Ct. LEXIS 57">*72 is claimed. For tax years ending after June 30, 1982, and before June 30, 1983, base period research expenses equal the average of qualified research expenses incurred in the 2 years immediately preceding the year in which the section 44F credit is claimed. Sec. 44F(c)(2)(B).

Petitioner contends that all of its alleged qualified research expenses are attributable to in-house research expenses. In-house research expenses are defined as: (1) Any wages paid or incurred to an employee for qualified services performed by such employee; (2) any amount paid or incurred for supplies used in the conduct of qualified 96 T.C. 903">*913 research; and (3) any amount paid or incurred to another person for the right to use personal property in the conduct of qualified research. Sec. 44F(b)(2)(A). Qualified services are defined as services consisting of engaging in qualified research, or engaging in the direct supervision or direct support of research activities which constitute qualified research. Sec. 44F(b)(2)(B).

In order to determine whether the expenses incurred by petitioner constitute qualified research expenses within the meaning of section 44F, we examine the plain and ordinary meaning of1991 U.S. Tax Ct. LEXIS 57">*73 key phrases used in the statute and relevant regulations, the legislative history of section 44F, and the 1986 amendment to the definition of "qualified research." This examination indicates that Congress intended for the section 44F credit to apply to expenditures for research in the areas of natural, physical, or applied sciences or research which is technological in nature, and that Congress did not intend for the credit to apply to other types of research.

A. Plain and Ordinary Meaning

For the years in issue, section 44F(d) defined "qualified research" in the following manner:

SEC. 44F(d). Qualified Research. -- For purposes of this section the term "qualified research" has the same meaning as the term research or experimental has under section 174, except that such term shall not include --

(1) qualified research conducted outside the United States,

(2) qualified research in the social sciences or humanities, and

(3) qualified research to the extent funded by any grant, contract, or otherwise by another person (or any governmental entity).