IRS Finalizes Regulations on Internal Use Software for Purposes of the Research Credit

(Parker Tax Publishing October 2016)

The IRS has finalized regulations clarifying the meaning of "internal use software" for purposes of the Code Sec. 41 research credit. Generally, unless such software meets a three part "high threshold of innovation test," development costs do not qualify for the credit. However, the final regulations provide a safe-harbor for expenditures related to software that is developed for both internal and third-party use (dual use software). The regulations are effective October 4, 2016. T.D. 9786 (10/4/16).

Background

Under Code Sec. 41, taxpayers may take a credit for increasing expenditures on qualified research activities (research credit). Computer software that is developed by (or for the benefit of) the taxpayer primarily for its own internal use (internal use software) is generally excluded from the research credit pursuant to Code Sec. 41(d)(4)(E). Internal use software may, however, be eligible for the credit if the research undertaken to create the software meets a three-part "high threshold of innovation" test.

Determining whether software falls within the "internal use" definition and (if so) whether it passes the high threshold of innovation test has been a persistent source of controversy since the research credit was added to the Code in 1986. Two previous sets of proposed regulations released in 1997 and 2001 respectively had done little to settle the matter. On January 20, 2015, the IRS released a new set of proposed regulations to address the uncertainty surrounding internal use software. These new proposed regulations have been finalized, with some modifications made in response to practitioner comments.

Definition of Internal Use Software

The final regulations provide that software is developed for internal use if the software is developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. "General and administrative functions" are limited to financial management, human resource management, and support services functions. Financial management functions involve the financial management of the taxpayer and the supporting recordkeeping. Human resource management functions assist in managing the taxpayer's workforce. Support services functions support the day-to-day operations of the taxpayer, such as data processing or facilities services. Such functions generally fall within the realm of those commonly thought of as back-office operations.

Observation: The IRS noted that the characterization of a function as back-office may depend on the taxpayer's industry. For example, tax preparation software used in the tax services industry is not used in a general and administrative function, whereas the same software used in other industries would be considered as being used for general and administrative purposes.

In addition, the final regulations provide that whether or not software is developed primarily for internal use depends on the intent of the taxpayer at the beginning of the software development. However, if the taxpayer later makes improvements to the existing software, those improvements will be considered separate from the existing software and the internal use software rules will be applied to the improvements.

Non-Internal Use Software

The proposed regulations provided that software is not developed primarily for internal use if it is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties, or if it is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.

Example: A manufacturer of various products develops software for a website that allows third parties to order products and track the status of their orders online. Under these facts, the software is not developed primarily for internal use because the software allows third parties to initiate functions or review data as provided.

After consideration of practitioner comments, the final regulations clarify that software is not developed primarily for the taxpayer's internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. In addition, software that is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties and software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system are examples of software that is not developed primarily for the taxpayer's internal use.

Safe Harbor for Certain Dual Function Software

The final regulations provide that software developed both for use in the taxpayer's general and administrative functions and for use by or with third-parties (dual function software) is presumed to be developed primarily for a taxpayer's internal use. However, this presumption does not apply if a taxpayer can identify a subset of elements of the dual function software that only enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data (third party subset). Such third party subsets are not considered developed primarily for internal use.

Example: A taxpayer develops computer software that the taxpayer uses in general and administrative functions that support the conduct of the taxpayer's trade or business and that allows third parties to initiate functions. The taxpayer is able to identify the third party subset and the taxpayer incurs $50,000 of research expenditures for the computer software, 50 percent of which is allocable to the third party subset. Under these facts, the computer software developed by the taxpayer is dual function computer software. Because the taxpayer is able to identify the third party subset, such third party subset is not presumed to be internal use software.

The final regulations incorporate a safe harbor for expenditures related to dual function software if, after the taxpayer has identified any third party subsets, there remains dual function software or a subset of elements of dual function software (dual function subset). The safe harbor allows a taxpayer to include 25 percent of the qualified research expenditures of the dual function subset in computing the amount of the taxpayer's credit, provided that the taxpayer's research activities related to the dual function subset constitute qualified research and the use of the dual function subset by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10 percent of the dual function subset's use.

Final Regulations Modify High Threshold of Innovation Test and Application

The proposed regulations provided that certain internal use software is eligible for the research credit if the software satisfies the high threshold of innovation test, the three parts of which are:

(1) software is innovative, meaning that that the software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful;

(2) software development involves significant economic risk, meaning that the taxpayer commits substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period; and

(3) software is not commercially available for use by the taxpayer, meaning in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.

The proposed regulations further provided that, for purposes of the significant economic risk test, substantial uncertainty exists if, at the beginning of the taxpayer's activities, the information available to the taxpayer does not establish the capability or method for developing or improving the software.

Practitioners requested that the final regulations include design uncertainty in the definition of technical risk for purposes of meeting the significant economic risk. Practitioners also raised concerns that the statute and regulations do not define the concepts of capability, methodology, and design uncertainty. The IRS noted that while there may be design uncertainty in the development of internal use software, substantial uncertainty generally exists only when there is also uncertainty in regard to the capability or method of achieving the intended result. The IRS said that the appropriate design uncertainty of internal use software may be inextricably linked to substantial uncertainty regarding capability or method, but that it is difficult to delineate the types of technical uncertainties and that the focus of the significant economic risk test should be on the level of uncertainty that exists and not the types of uncertainty. For those reasons, the final regulations remove the references to capability and method uncertainty, but otherwise retain the high threshold of innovation test under the proposed regulations.

The final regulations also clarify that the high threshold of innovation test does not apply to:

(1) software developed for use in an activity that constitutes qualified research;

(2) software developed for use in a production process to which the requirements of Code Sec. 41(d)(1) are met; and

(3) a new or improved package of software and hardware developed together by the taxpayer as a single product.

Accordingly, under the final regulations, the high threshold of innovation test applies only to the software developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business, and to dual function software.

Effective Date

The final regulations are prospective, and generally apply to tax years beginning on or after October 4, 2016. However, the IRS stated that software not developed for internal use under the final regulations may or may not have been internal use software under prior law.

For tax years ending before January 20, 2015, taxpayers may choose to follow either the rules in final regulations (T.D. 8930) published on January 3, 2001 or the rules contained in proposed regulations (REG-112991-01) published on December 26, 2001. In addition, for any tax year that both ends on or after January 20, 2015 - the date the 2015 proposed regulations (REG-153656-03) were published - and begins before October 4, 2016, the IRS will not challenge return positions consistent either with the 2015 proposed regulations or the final regulations.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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