An In-Depth Look: Proposed IRS Regs Clarify Research Credit for Internal Use Software.

(Parker Tax Publishing January 31, 2015)

Last week, the IRS released proposed regulations clarifying the meaning of "internal use software" for purposes of the Code Sec. 41 research credit, and providing additional guidance regarding the three-part "high threshold of innovation" test such software must pass in order to qualify for the credit. REG-153656-03 (1/20/2015).

The proposed regulations also provide guidance on software that is developed for both internal and non-internal use (dual function computer software), including a safe harbor for determining if any of the expenditures with respect to dual function computer software are qualified research expenditures.

Although the proposed regulations are not effective until finalized, the IRS will not challenge return positions consistent with these proposed regulations for taxable years ending on or after January 20, 2015.

Background

Under Code Sec. 41, taxpayers may take a credit for increasing expenditures on qualified research activities. Code Sec. 41(d)(4)(E) generally excludes from the credit research with respect to computer software that is developed by the taxpayer primarily for its own internal use ("internal use software"). 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 which requires that:

(1) the software is innovative;

(2) the software development involves significant economic risk; and

(3) the software is not commercially available for use by the taxpayer.

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 have done little to settle the matter.

The 1997 proposed regulations required an evaluation of "all relevant facts and circumstances" to determine whether software was primarily for internal use. The proposed rules referenced the 1986 legislative history's identification of software used in general and administrative functions or used in providing noncomputer services as generally not eligible for the research credit. The 1997 proposed regulations also incorporated the legislative history's three-part high threshold of innovation test.

The 2001 proposed regulations continued to distinguish between software that provides computer services and software that provides noncomputer services, but departed from the language used in the 1986 legislative history and provided a bright-line presumption that software is developed primarily for internal use, unless the software is developed to be commercially sold, leased, licensed, or otherwise marketed for separately stated consideration to unrelated third parties. The 2001 proposed regulations also modified the innovation component of the three-part high threshold of innovation test to state that software is innovative if intended to be unique or novel and is different, in a significant and inventive way, from prior software implementations or methods.

In 2004, IRS issued an advance notice of proposed rulemaking, inviting comments regarding the 2001 proposed regulations and specifically requesting comments concerning the definition of internal use software and whether final rules relating to internal use software should have retroactive effect. More than decade later, the IRS has released a new set of proposed regulations to address the uncertainty surrounding internal use software.

Definition of Internal Use Software

The proposed 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. Software that the taxpayer develops primarily for a related party's internal use will be considered internal use software. In a departure from the past approach, the proposed regulations also eliminate the distinction between software developed to deliver computer and noncomputer services.

"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 notes the characterization of a function as back-office may depend upon 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.

Non-Internal Use Software

The proposed regulations provide 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.

Examples of such software include software developed for third parties to execute banking transactions, track the progress of delivery of goods, search a taxpayer's inventory for goods, store and retrieve a third party's digital files, purchase tickets for transportation or entertainment, and receive services over the internet. Additionally, software that is intended to be developed for commercial sale, lease, or license will not be considered internal use merely because the taxpayer tests the software by using it internally.

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.

The determination of whether software is developed primarily for internal use depends upon 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 be considered separate from the existing software and the internal use software rules will only be applied to the improvements.

Dual Function Computer Software

The proposed regulations provide that software developed for both general and administrative functions and for other purposes (dual function computer 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 dual function computer 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). The proposed regulations provide that if the taxpayer can identify the third party subset, the portion of research expenditures allocable to a third party subset of the dual function computer software may be eligible for the research credit, provided all the other applicable requirements are met.

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.

Additionally, the proposed regulations incorporate a safe harbor for dual function computer software if a third party subset cannot be identified or for the remaining subset of dual function computer software after the third party subset has been identified (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.

Computer software and hardware developed as a single product

The proposed regulations retain the exception for computer software and hardware developed as a single product and provides that internal use software does not include a new or improved package of computer software and hardware developed together by the taxpayer as a single product that is used directly by the taxpayer in providing services in the taxpayer's trade or business.

High Threshold of Innovation Test

Software is determined to be internal use software may still qualify for the research credit, but only if it passes a three-part "high threshold of innovation" test.

The test is derived from the legislative history of Code Sec. 41(d)(4)(E). Congress intended that regulations would make the costs of new or improved internal use software eligible for the credit only if the taxpayer could establish, in addition to satisfying the general requirements for credit eligibility, that the software is (1) innovative; (2) involves significant economic risk to develop; and (3) is not commercially available for use by the taxpayer. The high threshold of innovation test is intended to limit credit eligibility of software developed primarily for internal use to software development that meets a higher standard than other business components. The proposed regulations provide rules of application with respect to the high threshold of innovation test reflect this purpose.

Innovation. The proposed regulations provide a measurable and objective approach to defining innovation. Software is innovative if 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. The innovativeness test does not require that the software development actually be successful, but assuming the software development would have been successful, the test requires that it would have resulted in such an improvement.

Significant Economic Risk. The proposed regulations require the software development to involve significant economic risk, which exists if the taxpayer commits substantial resources to the development and there is "substantial uncertainty," because of technical risk, that such resources would be recovered within a reasonable period. In a departure from prior guidance, the proposed regulations apply the significant economic risk test to the level of uncertainty involved at the outset of the development, rather than the degree of innovation represented by the end result. For purposes of defining "substantial uncertainty" to determine if there is significant economic risk with respect to the high threshold of innovation test, the use of the word "substantial" indicates a higher threshold of uncertainty than that required for business components that are not internal use software.

The proposed regulations provide that 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. Internal use software research activities that involve only uncertainty related to appropriate design, and not capability or methodology, do not qualify as having substantial uncertainty for purposes of the high threshold of innovation test.

Commercially Available For Use. The proposed regulations provide that internal use software may only satisfy the high threshold of innovation standard if the software is not commercially available for use by the taxpayer 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.

Effective Date

Although the proposed regulations are not effective until finalized, the IRS will not challenge return positions consistent with these proposed regulations for taxable years ending on or after January 20, 2015.

According to the IRS, the rules in the proposed regulations are not, and should not be viewed as, an interpretation of prior regulatory guidance or of the 1986 legislative history. For example, software not developed for internal use under these proposed regulations, such as software developed to enable a taxpayer to interact with third parties, may or may not have been internal use software under prior law. (Staff Editor Parker Tax Publishing)

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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