The IRS proposed regulations on Jan. 16 that will offer many taxpayers new opportunities to claim research and development (R&D) tax credits for software that previously would have been excluded under the internal use software rules.
These IRS rules for determining when software is developed for internal use and therefore not eligible for a credit have been highly anticipated for more than 10 years. The new rules are generally taxpayer-favorable, and some of the most important changes propose to do the following:
- Narrow the definition of internal use software to include only specific administrative functions
- Create an exception for software that enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system
- Provide a safe harbor carving out non-internal use portions of dual use software
- Clarify the exception for software that meets a high standard of innovation
The regulations are proposed to be effective for tax years ending on or after the date the regulations are made final, but the IRS will not challenge positions consistent with the proposed regulations for tax years ending on or after Jan. 20. This means many taxpayers can already begin relying on the rules for the 2015 tax year. The R&D credit expired at the end of 2014 but is expected to be retroactively reinstated for 2015.
Generally, Section 41 bars any R&D tax credit for software developed primarily for internal use. However, neither the code nor current final regulations define software that is developed “primarily for internal use” or clarify when internal use software can still qualify for the credit.
The IRS originally issued final regulations in 2001 that defined internal use software as any software that is not developed to be sold, leased, licensed or otherwise marketed to third parties, with an exception for “innovative” software. But the IRS immediately reconsidered the 2001 regulations and later that year proposed a new version with a more stringent “innovative” test. When these R&D regulations were finalized in 2003, the IRS did not include the rules on internal use software, confusing taxpayers and leading to controversy in FedEx Corp. et al. v. United States, (No. 08-2423).
Defining internal use
The new proposed regulations narrow the definition of internal use software to software “developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.”
The regulations further limit the term “general and administrative functions” to the following:
Software used by third parties
- Financial management functions — Involve the financial management of the taxpayer and the supporting recordkeeping
- Human resource management functions — Manage the taxpayer’s workforce
- Support services functions — Support the day-to-day operations of the taxpayer
The regulations retain the rule providing that software is not considered 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. However, the definition of “third party” is restricted, excluding certain related parties and parties that use the software to support the general and administrative functions of the taxpayer.
This rule eliminates the “computer services” and “noncomputer services” provisions in prior regulations and is helpful to taxpayers that develop software that is not sold but that allows customers or other third parties to interact with the taxpayer’s software, such as the following:
- Executing banking transactions
- Tracking the progress of a delivery
- Searching a taxpayer’s inventory
- Storing and retrieving a third party’s digital files
- Purchasing tickets for transportation or entertainment
- Receiving services over the Internet
Importantly, if software is not developed to be commercially sold, leased, licensed or otherwise marketed for separately stated consideration, it is not automatically presumed to be internal use software.
Dual function software
The new regulations do presume that software is developed “primarily” for internal use if a taxpayer develops software that serves both general and administrative and non-general and administrative functions.
However, a taxpayer can segregate a portion of its dual use software by identifying a subset of elements that only enables the taxpayer to interact with third parties or to allow third parties to initiate functions or review data. If a taxpayer cannot identify the third-party function subset, a safe harbor provision allows for 25% of the dual function software to qualify if at least 10% of the dual function software is for third-party use.
High threshold of innovation
The IRS retained a rule, based on legislative history, that provides that internal use software can still qualify for the R&D credit if it meets a higher standard of innovation than is required for other business components.
The standard for this higher threshold for innovation generally follows guidance from prior regulations and provides that development activities are qualified if they meet the following three tests:
- Innovative — This rule is less stringent than the 2001 proposed rules and now requires the intent of the software to be to reduce cost, improve speed, or make another improvement that is substantial and economically significant (i.e., the “unique or novel” standard does not apply).
- Significant economic risk — The regulations retain the language from prior guidance requiring a taxpayer to commit substantial resources to development that would be recovered within a reasonable period if substantial uncertainty and technical risk are overcome. The proposed rules clarify that the type of technical uncertainty required to meet this test must relate to either capability or methodology issues (not appropriateness of design uncertainty).
- Not commercially available — The regulations retain the provision that the software must not be commercially available for its intended purpose without modifications.
The proposed regulations clarify that meeting the high threshold of innovation doesn’t require a revolutionary discovery or the creation of new technologies. The regulations stipulate that the “use of existing technologies in new ways could be evidence of a high threshold of innovation.”
The proposed regulations retain additional exceptions found in prior guidance that allow taxpayers to potentially include certain types of software development in their R&D tax credit claims. Specifically, the rules stipulate that the following types of software are not excluded:
- Software developed for use in an activity that constitutes qualified research
- Software developed for use in a production process
- Computer software and hardware developed as a single product
The proposed regulations include 23 new examples to help taxpayers apply the new guidance to their specific fact patterns. The examples extend beyond how to apply the internal use software rules, and also provide guidance on how to apply software development activities to the process-of-experimentation requirement that applies to all R&D activities.
Several examples in the regulations pertain to development related to enterprise resource planning (ERP) software. The regulations include fact patterns related to ERP projects that would not qualify and circumstance when certain parts of an ERP project (e.g., developing an interface to the ERP system) may qualify.
The IRS said it will not challenge taxpayers who rely on the proposed regulations for tax years ending on or after Jan. 20. Calendar-year taxpayers can begin relying on them for the 2015 tax year. Although the credit is currently expired for costs incurred after 2014, it is expected to be reinstated, and taxpayers should begin identifying opportunities to use the favorable rules. Fiscal year taxpayers with tax years ending after Jan. 20 may have costs from 2014 that are immediately eligible and should explore these opportunities before filing their returns.
The proposed regulations are particularly significant to taxpayers who incur significant software development expenses for software that is not sold, leased or licensed to third parties. Taxpayers that operate in a “software as a service” model or other taxpayers that interact with customers through software functions may have significant opportunities.
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