The Process of Experimentation test is a legal and regulatory requirement mandating that qualified research must involve a systematic evaluation of design alternatives to resolve technical uncertainties through structured methods like modeling, simulation, or trial and error. Within the specific context of the New Mexico Technology Jobs and Research and Development Tax Credit, this test requires that substantially all of the activities—typically interpreted as 80 percent or more—must constitute such an evaluative process to justify state-level tax incentives.

The detailed analysis of the Process of Experimentation (POE) test requires an understanding of its position as the final and arguably most rigorous leg of the “Four-Part Test” used to define qualified research. While federal standards under Internal Revenue Code (IRC) Section 41 provide the bedrock for this definition, New Mexico’s application through the Technology Jobs and Research and Development Tax Credit Act introduces local administrative layers and specific economic priorities. This test is not merely a formality but a qualitative gatekeeper that distinguishes innovative, high-risk research from routine engineering or standard product development. For an activity to pass the POE test, it must be established that the taxpayer identified a technical uncertainty concerning the design, capability, or method of a business component and subsequently conducted a methodical process to evaluate alternatives intended to eliminate that uncertainty. In New Mexico, this requirement is underscored by a commitment to fostering a “favorable tax climate” for technology-based businesses, yet it is simultaneously constrained by strict auditor guidelines and judicial precedents that demand rigorous contemporaneous documentation.

The Statutory and Legislative Framework in New Mexico

The New Mexico Technology Jobs and Research and Development Tax Credit Act, codified under NMSA 1978, §§ 7-9F-1 to 7-9F-13, serves as the primary legislative vehicle for incentivizing technological growth within the state. Originally established as the Technology Jobs Tax Credit Act in 2000, the program underwent a significant transformation during the 2015 legislative session. House Bill 230, introduced by Representative Carl Trujillo, renamed the act to explicitly include “Research and Development,” reflecting a shift toward aligning state incentives more closely with the federal definitions of innovation.

The intent of the legislature in crafting this act was to encourage businesses to perform experimental or laboratory activities to develop or improve products, manufacturing processes, or software at qualified facilities within the state. A “qualified facility” is defined as a factory, mill, plant, building, or complex of buildings in New Mexico where research is conducted, excluding facilities operated for the federal government. The statutory definition of “qualified research” under Section 7-9F-3(I) explicitly requires that research meet three criteria: it must be undertaken to discover technological information, the application must be useful for a business component, and substantially all activities must constitute elements of a process of experimentation.

Legislative Evolution and State Revenue Impact

The 2015 amendments were pivotal not only for the nomenclature but also for the financial benefit provided to taxpayers. The basic and additional credit rates were increased from 4 percent to 5 percent of qualified expenditures. Furthermore, the legislation introduced higher incentives for facilities located in rural areas, effectively doubling the credit rates to 10 percent. This regional differentiation reflects a targeted economic strategy to address the lagging growth in New Mexico’s rural communities, which often face greater barriers to attracting high-tech investment.

The fiscal implications of these credits are substantial. In fiscal year 2024, New Mexico provided approximately $11.2 million in state support through the credit, representing a 125 percent increase over the previous three-year average. Despite the state forgoing significant revenue—with an estimated annual return in revenue of -81 percent—the economic return on investment (ROI) is estimated at 92 percent, indicating that for every dollar spent on the credit, the state economy grows by 92 cents. This growth is primarily driven by the creation of high-wage jobs and the stabilization of technology clusters in urban centers like Albuquerque and Santa Fe.

The Process of Experimentation Test as Part of the Four-Part Test

The Process of Experimentation test does not exist in isolation; it is the culmination of a four-stage inquiry that must be applied to every “business component” for which a taxpayer claims a credit. A business component is defined as any product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s trade or business.

Stage 1: The Section 174 Test (Elimination of Uncertainty)

Before experimentation can occur, there must be a foundational uncertainty that makes the research necessary. Under Section 174 of the Internal Revenue Code, which New Mexico adopts, expenditures represent R&D costs in the “experimental or laboratory sense” if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer at the start of the project does not establish the capability of achieving the result, the method of achieving it, or the appropriate design of the result.

It is critical to note that the Section 174 test focuses on the presence of uncertainty, while the POE test focuses on the method used to resolve it. Recent federal court rulings adopted by state practice clarify that generic uncertainty inherent in manufacturing—such as whether a machine will work as intended—is insufficient. The uncertainty must relate to the functional, performance, reliability, or quality aspects of the component.

Stage 2: The Technological in Nature Test

The research activities must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science. This requirement, often called the “hard science” test, excludes research based on the social sciences, humanities, or business management. In the context of New Mexico’s specialized economy, this test is often met by firms operating in the aerospace, biotechnology, and renewable energy sectors. For example, a company developing a new alloy for satellite brackets must rely on materials science and mechanical engineering, thereby satisfying this stage.

Stage 3: The Business Component Test

The taxpayer must intend to apply the information discovered through research to develop a new or improved business component. This requirement ensures that the state is not subsidizing purely academic or basic research that has no commercial application within the taxpayer’s enterprise.

Stage 4: The Process of Experimentation Test

The final stage requires that substantially all activities constitute elements of a process of experimentation. This is an evaluative process designed to evaluate one or more alternatives to achieve a result where the capability, method, or appropriate design is uncertain at the outset. The process must be systematic and follow a scientific trajectory of hypothesis formulation, testing, analysis, and refinement.

Deep Dive into the Elements of the Process of Experimentation

To satisfy the POE test in an audit by the New Mexico Taxation and Revenue Department (TRD), a taxpayer must demonstrate a structured methodology. The federal regulations and the Internal Revenue Service (IRS) Audit Techniques Guide, which TRD auditors frequently reference, break the process into three core elements.

Identification of the Target Uncertainty

The taxpayer must define exactly what technical problem they were trying to solve. This cannot be a generalized goal like “making a better product.” Instead, it must be specific: for instance, “determining if a 3D-printed titanium lattice can withstand high-frequency vibrations without structural fatigue”. If a taxpayer knows at the beginning that a standard design or existing knowledge will solve the problem, there is no qualified uncertainty, and any subsequent work is merely routine testing or quality control.

Identification of Design Alternatives

A true process of experimentation must evaluate more than one alternative. If a company simply proceeds with the only possible solution, it may fail the POE test because no evaluative “choice” was made between different technical paths. In software development, this might involve comparing different data exchange protocols or encryption algorithms to see which one provides the best balance of security and latency.

Conduct of an Evaluative Process

This is the “doing” part of the test. The taxpayer must employ one of several recognized scientific methods:

• Iterative Modeling: Incrementally revising designs based on theoretical results from computer-aided design (CAD) or finite element analysis (FEA) software.
• Simulations: Using software environments to replicate real-world conditions, such as thermal expansion in space or fluid dynamics in a manufacturing process.
• Systematic Trial and Error: A methodical plan of trials where each failure informs the next attempt. This is distinct from haphazard “playing around” with variables.
• Scientific Method: The classic progression of hypothesis, experiment, data collection, and conclusion.

The “Substantially All” Rule and the 80 Percent Threshold

The phrase “substantially all” in both the New Mexico statute and the federal code has a precise mathematical meaning: 80 percent or more. This threshold is applied separately to each business component. If less than 80 percent of the research activities for a product involve a process of experimentation, the credit for that entire component is typically disallowed unless the “shrink-back rule” can be successfully applied.

Calculating the 80 Percent Fraction

The determination of whether the 80 percent requirement is satisfied is based on a cost ratio:

POE % = (Costs of activities constituting elements of a Process of Experimentation) / (Total costs associated with the development of the business component)

The numerator of this fraction includes only those expenses associated with the “evaluative” stages of the project. The denominator includes all otherwise qualified research expenses (QREs), such as wages, supplies, and contract research.

The Shrink-Back Rule

If a business component fails the 80 percent test at the highest level, the taxpayer may “shrink back” to the next most significant subcomponent. For example, if a company is developing a new aircraft but only the engine required a true process of experimentation (while the fuselage used standard designs), the company would fail the test for the aircraft as a whole. However, by shrinking back, they can isolate the engine as the business component and claim the credit based solely on the engine-related research activities.

Local Administrative Guidance: New Mexico Taxation and Revenue Department

The New Mexico Taxation and Revenue Department (TRD) provides specific guidance for claiming the credit through publications, bulletins, and specialized forms. Taxpayers must navigate a two-stage process that is more administratively rigorous than the federal “self-claim” model.

FYI-106 and Regulatory Compliance

Publication FYI-106, “Claiming Business-Related Tax Credits for Individuals and Businesses,” is the primary administrative guide for New Mexico taxpayers. Updated as recently as February 2025, it summarizes the procedure for applying for and claiming the Technology Jobs and R&D credit. The TRD emphasizes that credits can only be claimed against tax liabilities designated by law and that the department cannot consider claims filed after the one-year statute of limitations.

Mandatory Pre-Approval and Forms

Unlike the federal credit, which is often claimed directly on an income tax return, the New Mexico credit requires pre-approval certification.

Taxpayers must provide detailed descriptions of the research and development performed during the first application. If the nature of the research changes in subsequent years, a description of the change must be provided. Failure to provide a technical narrative that substantiates the process of experimentation can lead to immediate denial of the application.

Recapture and Ceasing Operations

New Mexico law includes a “recapture” provision to ensure that the state’s investment remains within the local economy. If a taxpayer or their successor ceases operations in New Mexico for at least 180 consecutive days within a two-year period after claiming the credit, the credit is extinguished. The taxpayer must repay any approved amounts within 30 days of the cessation of operations.

Basic vs. Additional Credit: The Payroll Growth Benchmark

The New Mexico credit is uniquely structured into two components: the Basic Credit and the Additional Credit. Both are equal to 5 percent of qualified expenditures (10 percent in rural areas), but the Additional Credit is contingent on employment impacts.

The $75,000 Threshold

To qualify for the Additional Credit, a taxpayer must increase their annual payroll expense at the qualified facility by at least $75,000 over the “base payroll expense”. The base payroll is typically the wages paid in the year prior to the application, adjusted for inflation according to the Consumer Price Index (CPI). For every $1 million in qualified expenditures claimed, the company must show a corresponding $75,000 increase in payroll.

Defining “Wages” for Credit Eligibility

The TRD provides specific guidance on what constitutes “wages” for these calculations. Wages are defined as remuneration for services performed by an employee in New Mexico. Specifically, they must be the amounts included in Box 1 of the employee’s W-2 form. This definition excludes non-taxable benefits such as employer-paid health insurance, retirement plan contributions, or the value of certain employee stock options.

Small Business Provisions and Refundability

New Mexico offers significantly more favorable terms for “qualified research and development small businesses”. A small business is defined as a taxpayer that employed no more than 50 employees and had total qualified expenditures of no more than $5 million in the tax year for which the credit is claimed.

The Refundability Tiers

While the Basic Credit is non-refundable and must be carried forward for up to three years, the Additional Credit is refundable for small businesses if the amount exceeds their income tax liability. The amount of the refund is subject to a declining scale based on total qualified expenditures.

This structure is designed to provide immediate cash flow to early-stage startups and small technology firms that may not yet have sufficient taxable income to utilize the credit through traditional offsets.

Cost Accounting Methodology: The PESCO Precedent

A critical and often litigated aspect of the New Mexico R&D credit is the requirement for a consistent cost accounting methodology. Under Section 7-9F-3(G), if a qualified expenditure is an allocation of a larger expenditure (such as an employee’s time split between research and administration), the cost accounting methodology used for that allocation must be the same as the one used by the taxpayer in their other business activities.

Process Equipment and Service Company (PESCO) v. TRD (2023)

In the landmark case Process Equipment and Service Company, Inc. v. New Mexico Taxation and Revenue Department, the New Mexico Court of Appeals addressed the definition of “cost accounting methodology” for the first time. PESCO, a company designing components for the oil and gas industry, attempted to recoup R&D costs using a methodology that the TRD disputed. The court ruled that a “cost accounting method” is a system for capturing a company’s total cost of production by assessing variable costs at each step of the process. This case established that taxpayers must have a principled, systematic way to track time and resources; retrospective “estimates” that are not backed by a pre-existing accounting system are likely to be disallowed on appeal.

Judicial Trends and Audit Realities in POE Testing

Auditors from both the TRD and the IRS have intensified their focus on the Process of Experimentation test, largely due to recent victories in federal courts that have set a high bar for documentation.

Little Sandy Coal Co. v. Commissioner (2023)

This case is frequently cited by auditors to disqualify claims where the taxpayer relies on the “novelty” of the product rather than the “nature” of the activities. The court emphasized that generalized descriptions of uncertainty and assertions of novelty are not enough. The Seventh Circuit affirmed that “vague estimates of what portion of employees’ wages were for experimentation-related activities are insufficient to substantiate the credit claimed”. The takeaway for New Mexico businesses is that they must document research activities for subcomponents if they cannot prove a POE for the entire business component.

Phoenix Design Group, Inc. v. Commissioner

The court in Phoenix Design highlighted the failure to demonstrate technical uncertainty at the outset. It specifically noted that “receiving feedback from a fit model and enlarging a too-tight armhole” is a normal business practice in fashion, not a scientific process of experimentation. This ruling underscores the “Aesthetics Exclusion”—activities related to style, taste, cosmetic, or seasonal design factors are expressly non-qualified under both federal and New Mexico law.

Documentation Standards for Audit Readiness

To survive an audit of the POE test, a company must maintain “contemporaneous” records—meaning they were created at the time the work was done. TRD auditors look for:

• Engineering Notebooks and Test Logs: Dated records showing the progression of hypotheses and trial results.
• Metadata Proof: Electronic files with timestamps that prove they were not created retrospectively during tax season.
• Time-Tracking by Business Component: Documentation that ties specific employee hours to specific technical uncertainties.
• Failed Alternatives: Proving that multiple paths were considered and evaluated. A project where every trial was a success is often viewed with skepticism by auditors.

Illustrative Example: Satellite Component Engineering in Albuquerque

To clarify the application of the POE test to New Mexico law, consider the case of “High-Desert Aerospace,” a mid-sized firm located in a qualified Albuquerque facility.

The Technical Challenge

High-Desert Aerospace is developing a “thermal management casing” for a new generation of nano-satellites. The casing must protect sensitive electronics from extreme temperature fluctuations in low-Earth orbit while weighing less than 500 grams. At the start of the project, the engineers are uncertain whether a carbon-fiber composite or a ceramic-matrix composite (CMC) is the appropriate design to achieve the required thermal dissipation at that weight.

The Process of Experimentation

The team follows a structured evaluative process:

1. Hypothesis Formulation: The engineers hypothesize that a CMC casing with a specific internal fin geometry will provide superior thermal conductivity.
2. Modeling and Simulation: They create CAD models of three FIN geometries and use thermal simulation software to predict heat transfer rates.
3. Prototype Testing: Based on simulation data, they fabricate two CMC finned prototypes and put them through vacuum-chamber thermal cycling tests in a laboratory.
4. Analysis and Refinement: One FIN geometry fails due to stress fractures during rapid cooling. The team analyzes the failure, adjusts the Finite Element Analysis (FEA) model, and tests a revised fin thickness.

Regulatory Application

High-Desert Aerospace keeps detailed logs of the simulation parameters, dated photographs of the fractured Fin, and a comprehensive record of the code changes made during the modeling phase. They determine that 85 percent of the project time was spent on these iterative evaluative activities.

• Qualified Expenditures: They identify $1,200,000 in QREs (wages for engineers, CMC materials, and FEA software upgrades).
• Payroll Benchmark: They show a payroll increase of $150,000 over the prior year, exceeding the required $75,000 per $1 million spent.
• Credit Calculation: They are approved for a 5 percent Basic Credit ($60,000) and a 5 percent Additional Credit ($60,000), totaling $120,000 in tax benefits.

Industry-Specific Impact and Statistics in New Mexico

New Mexico’s economy is characterized by high-tech specialization, much of which revolves around the research conducted at the state’s three major research universities and two national laboratories.

The Dominance of Biosciences

Bioscience activities account for more than one-half of all R&D conducted in New Mexico. This sector benefits heavily from technology transfer initiatives from Los Alamos and Sandia National Laboratories. Experimentation in this field often involves clinical trials, informatics tool development, and the testing of new materials or reagents in manufacturing processes.

The Clean Energy Surge

New Mexico’s clean energy sector is an increasingly vital component of the innovation landscape. In 2024, clean energy jobs grew fifteen times faster than the rest of the state’s economy. Programs like the Technology Readiness Credit against Gross Receipts Tax encourage national laboratories to assist small businesses in achieving technology maturation, providing up to $150,000 per business assisted.

Summary of Performance for the Technology Jobs and R&D Credit

The following data illustrates the scale and impact of the credit based on the most recent state reports:

The marked increase in FY2024 expenditures—a 125 percent rise over historical averages—suggests that New Mexico businesses are becoming more aggressive in claiming these credits, but it also signals that state auditors are likely to increase their scrutiny of the technical justifications provided.

Challenges and Exclusions in POE Testing

A major hurdle for taxpayers is the “Exclusionary Rules” defined under federal and state law. Even if a project is technically difficult, it may be disqualified if it falls into one of several categories.

Research after Commercial Production

Qualified research does not include any activities conducted after the beginning of commercial production. A business component is considered ready for production when it has been developed to the point where it meets basic functional and economic requirements. High-risk activities for an audit include preproduction planning, tooling up, or troubleshooting faults in production equipment. If High-Desert Aerospace continues to tweak the fin geometry after they have already delivered the first 10 satellites to a customer, those subsequent costs are non-qualified.

The Adaptation and Duplication Exclusions

The credit excludes research related to adapting an existing business component to a particular customer’s requirement. For example, if a software company modifies its existing dashboard to change the color scheme for a specific client, this is adaptation, not innovation. Similarly, “reverse engineering” or duplicating a competitor’s product from public information or physical examination is strictly non-qualified.

Internal Use Software (IUS) and the Heightened Test

Software developed primarily for the taxpayer’s own internal use (e.g., an internal payroll or inventory system) must pass a “Heightened Three-Part Test” in addition to the standard Four-Part Test.

1. Innovativeness: The software must result in a reduction in cost or improvement in speed that is substantial.
2. Significant Economic Risk: The taxpayer must commit substantial resources where the recovery of those resources is uncertain.
3. Commercial Unavailability: The software cannot be purchased “off-the-shelf” or modified easily to meet the needs.

The Future of Compliance: Real-Time Documentation

The regulatory landscape is shifting away from retrospective “R&D Studies” and toward real-time project tracking. The IRS recently modified Form 6765 to include a new “Section G,” requiring taxpayers to identify each business component by name and type and separately allocate wages for conducting, supervising, or supporting research. This 2025 requirement is likely to be mirrored by New Mexico’s TRD, which has already flagged data reliability issues in its Gentax system and implemented more extensive drop-down menus for deduction codes.

Businesses are advised to utilize automated tools to log their process of experimentation as it happens. This includes capturing:

• Hypothesis Tracking: Clearly defining what technical uncertainty was identified on Day 1.
• Alternative Identification: Documenting the options that were not chosen and why.
• Quantitative Allocation: Using a systematic “cost accounting methodology” to track time logs and iterative testing results rather than arbitrary allocations.

Final Thoughts

The Process of Experimentation test represents the definitive technical barrier that businesses must cross to secure the significant tax benefits offered by the state of New Mexico. It moves the legal inquiry beyond the simple “newness” of a product and into the rigorous domain of methodical, scientific investigation. For a state with a unique economic reliance on high-tech exports and national laboratory partnerships, this test ensures that tax incentives are directed toward activities with the highest potential for genuine technological advancement and sustainable job growth.

Success in claiming the Technology Jobs and R&D Tax Credit requires more than just innovative engineering; it demands a sophisticated integration of technical data and precise tax accounting. As auditors at both the state and federal levels increasingly reject “shortcut estimates” and demand contemporaneous narratives of failure and refinement, the burden on the taxpayer has never been higher. By understanding the judicial definitions of technical uncertainty and maintaining a principled cost accounting methodology, New Mexico firms can turn the administrative challenge of the POE test into a powerful strategic asset that fuels their next generation of breakthroughs.