The U.S. Department of the Treasury and the IRS held a public hearing on April 17 regarding the proposed internal use software (IUS) regulations under Internal Revenue Code Section 41(d)(4)(E). The regulations provide guidance on the R&D tax credit for computer software development activities by or for the benefit of the taxpayer. The following is adapted from my testimony at the hearing.
A significant issue for midsize taxpayers is the effective date of these proposed IUS regulations. They are proposed to apply to tax years ending on or after the date the regulations are finalized, but the IRS is allowing taxpayers to rely on the proposed version for tax years ending on or after the day the proposed regulations were published (Jan. 20, 2015). The timing creates a curious situation: The regulations don’t apply to calendar year-end taxpayers for 2014, and won’t apply to them at all unless the research credit is extended for 2015 or beyond. But the regulations could apply to fiscal year-end taxpayers whose tax years ended after Jan. 20, 2015, and who conducted software research before Dec. 31, 2014. This confusing situation becomes even more complex because of the way the IUS rules interact with the general research credit tests.
Because the IUS regulations are part of Section 41(d) — which includes the IUS rules, the four-part test and other tests defining qualified research — complying with them would require applying multiple versions of the four-part test and the examples from different regulatory regimes. As a result, taxpayers are required to perform significant technical gymnastics.
Consider the example of taxpayers who are preparing 2014 tax returns and have both software development and non-software development (i.e., product or process development). They’ll have to consider, understand and analyze the three following versions of the Section 41(d) regulations:
- The 2004 version for all of the nonsoftware activities
- The 2001 Treasury Decision 8930, the final regulations, which include the discovery test, and all the language related to the discovery test
- The 2001 proposed regulations, whose language differs from the language in the final regulations
Taxpayers will have to administer two versions of the four-part test, two versions of the examples and two versions of all these regulations in order to choose which of the 2001 regulations will apply. This is complicated by the fact that the 2001 regulations retain the discovery test that was removed from the 2004 regulations.
Although we’ve focused on 2014, this is a multiyear issue because returns are open for three years. So there’s a significant amount of related complexity because the proposed regulations would be effective only prospectively.
Based on recent information released by the IRS, 51% of taxpayers claiming an R&D credit in 2012 had gross receipts of less than $10 million. This means the majority of the taxpayers affected are in small and midsize companies, and may have fewer tax resources than larger companies.
The Tax Court recently stated that the R&D credit is one of the most complex sections of the code. That statement was made even before these regulations were proposed and before the prospective effective date of the regulations.
If we look at the guiding principles in the preamble to the regulations, two key questions emerge: Are the regulations readily applied by taxpayers, and can they be readily administered by the IRS?
Treasury and the IRS say they’re concerned about rules that add complexity without providing clarity. They suggest that the IUS part of the Section 41 regs should apply to the same time period as the 2001 version of those regulations.
The advance notice suggests the regulations be applied retroactively to 1986 but says that period of time might be too long. To achieve the outlined guiding principles and enable the regulations to be administered, applying the regulations as far back as 1986 might be too much. There’s really no practical reason to do that, because most of those years are closed.
The most logical timing is for the regulations to apply retroactively to 2004, for a couple of reasons. The regulations are part and parcel of the 2004 final regulations. If they apply retroactively to 2004, the IUS rules, which are part of the exceptions, can match with the four-part test, which taxpayers, Treasury and the IRS have all agreed on. We could do away with the discovery test and have one set of coordinated rules for the R&D credit.
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