IRS issues research tax credit regulations for internal use software
Long-awaited guidance is mostly favorable for taxpayers
TAX ALERT |
The Jan. 20, 2015, issuance of new proposed regulations (REG-153656-03) concerning application of the research tax credit to computer software could be viewed as significant by businesses that invest in software development. These regulations aim to bring to a close more than a decade of substantial tax controversy resulting from attempts to apply previous proposed regulations viewed by many as out of sync with rapidly changing business technology. Furthermore, the proposed regulations’ narrowed definition of internal use software and modifications to the high threshold of innovation test should significantly increase the number of software research projects qualifying for the research tax credit.
Software has been one of the most controversial areas when claiming the section 41 research tax credit. Section 41 provides only a high-level framework for applying the research tax credit to software, stating in section 41(d)(4)(E) that except to the extent provided by regulations, research with respect to computer software developed primarily for a taxpayer’s internal use is excluded from the definition of qualified research. Previous IRS attempts to define internal use software and exceptions resulted in several sets of proposed regulations that were met with public criticism and open to conflicting interpretations. The table below summarizes previous regulations and other IRS guidance:
|Date published||Description||Referred to as:|
|Jan. 2, 1997||Notice of proposed rulemaking (REG-209494-90)||1997 proposed regulations|
|Included innovation test based on legislative history|
|Jan. 3, 2001||Final section 41 regulations including internal use software (TD 8930)||2001 final regulations|
|Included discovery test* and innovation test based on legislative history; new exceptions added for computer services and noncomputer services with features not offered by competitors|
|Jan. 31, 2001||Notice that Treasury and IRS would review final regulations and reconsider comments||Notice 2001-19|
|Indicated final regulations would be changed via new proposed regulations|
|Dec. 26, 2001||New proposed regulations (REG-112991-01)||2001 proposed regulations|
|Excluded discovery test; included presumption that software is internal use if not developed to be sold, leased or licensed, or marketed for separately stated consideration; introduced unique and novel innovation test; eliminated noncomputer services exception|
|Jan. 2, 2004||Final section 41 regulations (TD 9104)||2004 final regulations|
|Excluded discovery test; did not address internal use software|
|Jan. 2, 2004||Advanced Notice of Proposed Rulemaking||2004 ANPRM|
|Requested comments on 2001 proposed regulations relating to internal use software; indicated that until further guidance was published, taxpayers could rely on all provisions in 2001 proposed regulations or all provisions in 2001 final regulations|
|Jan. 20, 2015||Notice of proposed rulemaking (REG-153656-03)||2015 proposed regulations|
|2004 ANPRM is withdrawn|
*The discovery test stated that research must be intended to “exceed, expand or refine the common knowledge of skilled professionals in the field of science or engineering.”
Definition of internal use software and non-internal use software
As part of the Tax Reform Act of 1986, Congress amended the research tax credit to add a statutory definition of “qualified research activities.” The definition, set out in section 41(d), is referred to as the four-part test and excludes certain activities (e.g., market research and research conducted outside the United States). In addition, any research with respect to computer software that is developed by the taxpayer primarily for internal use is specifically excluded from the definition of qualified research. Deciphering the meaning of internal use software has been an area of contention since the 1986 amendments.
The IRS later issued the 1997 proposed regulations, which provided an exception under which internal use software could meet the definition of qualified research by meeting a three-prong high threshold of innovation test. Under these regulations, taxpayers had to establish that 1) the internal use software was innovative, 2) the software development involved significant economic risk, and 3) the software was not commercially available. Later IRS attempts to define innovation made the high threshold of innovation test very restrictive by either pairing it with the “discovery test” (2001 final regulations) or defining innovation as “unique or novel and differing in significant and inventive ways from other software implementations and methods” (2001 proposed regulations).
The 2001 proposed regulations reflected a restrictive interpretation of internal use software. Under a bright-line presumption, software was presumed to be internal use software unless the software was developed to be commercially sold, licensed or otherwise marketed for separately stated consideration to unrelated parties. The 2001 proposed regulations left unresolved the treatment of research activities for software designed to interact with a customer or deliver online services. Further, the IRS began conducting aggressive and time-consuming audits of research credits based on activities related to internal use software, which made taxpayers reluctant to claim internal use software as part of the research credit.
The fast pace of technological advancement hampered the capacity of the Treasury to provide effective guidance. In 2004, the IRS proposed rulemaking on the definition of internal use software and the high threshold of innovation test, but it took another ten years for new proposed regulations to be issued. The 2015 proposed regulations account for the rapid increase in the types of software technology being developed and are generally more taxpayer-friendly. Importantly, the definition of internal use software under the proposed regulations has a more limited scope, which should result in many more software research projects qualifying for the research tax credit.
Internal use software is defined in the 2015 proposed regulations as 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. General and administrative functions are limited to financial management, human resource management and support services. For example, software developed to manage employee health benefits and not developed for sale is internal use software that must meet the definition of a qualified research activity and also meet the high threshold of innovation test in order to qualify for the research tax credit.
The 2015 proposed regulations also limit the definition of internal use software by more clearly stating what is not internal use software. The 2015 proposed regulations define the following as non-internal use software:
- Software developed by a taxpayer to be commercially sold, leased or licensed, or otherwise marketed to third parties (the requirement from the 2001 proposed regulations that it be for separately stated consideration is excluded from the new definition)
- Software 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
This new definition of non-internal use software better aligns with how taxpayers use technology to conduct business and eliminates the controversy that existed under prior guidance with respect to defining computer services and noncomputer services. The preamble to the regulations offers several examples of this new definition of non-internal use software, including 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 third-party digital files, purchase tickets for transportation or entertainment, and receive services over the internet. Accordingly, the development of software that allows customers to place orders online and track the status of their orders is not internal use software and need only meet the general standard of qualified research to be eligible for the research tax credit.
Under the more limited definition of internal use software in the 2015 proposed regulations, many software applications developed by taxpayers in their business operations will not be classified as internal use software. Software development activities unrelated to internal use software have to meet the general definition of qualified research but not the high threshold of innovation test.
Dual function computer software
To solve the problem of how to treat software developed for both internal use and interaction with third parties, the IRS created a new category of dual function computer software. The 2015 proposed regulations contain a general presumption that such software is developed primarily for internal use. However, this presumption may be overcome by identifying the subset of software elements that exist only to enable third parties to interact with the taxpayer, initiate functions or review data. This subset of elements may be treated as non-internal use software. To the extent a subset of elements of dual function computer software remains, a safe harbor allows the taxpayer to include 25 percent of the otherwise qualified research expenditures for the dual function subset in computing the research tax credit as long as the third-party functions account for at least 10 percent of the software’s use. The regulations also contain four examples that address dual function computer software.
Exceptions to disqualification of internal use software
Although the general rule of section 41(d)(4)(E) states that the development of internal use software does not meet the definition of qualified research, the Code provides two exceptions related to the following, which are further defined in the 2015 proposed regulations:
- Software developed for use in conducting qualified research
- Software developed for use in a production process
Furthermore, internal use software used in management and support services functions may still be eligible for the research credit, provided the software meets the additional three-prong high threshold of innovation test. The 2015 proposed regulations take a more mechanical and quantitative approach to the high threshold of innovation test. Under the first prong of the test, software is considered innovative if the software would result in a reduction in cost, improvement in speed, or other measurable improvement that is substantial and economically significant, if the development is or would have been successful. Under the proposed regulations, the improvement represented by the software is measurable and objective, and the software development does not have to be successful.
With respect to the second prong of the test, the 2015 proposed regulations indicate that significant economic risk is demonstrated if the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, as to whether such resources will be recovered within a reasonable time. Technical risk does not mean risk that the final result can ever be achieved, but rather whether the final result can be achieved within a time frame that will allow the substantial resources committed to the development to be recovered within a reasonable period. Substantial uncertainty exists if, at the outset, the taxpayer has not established the capability or the methodology for developing the software; however, uncertainty over design appropriateness is not a substantial uncertainty under this test.
Finally, under the third prong of the high threshold of innovation test, the software cannot be commercially available. Under this test, software is not commercially available if the software cannot be purchased, leased or licensed and used for its intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.
Taxpayers that develop internal use software for internal financial management or support services must meet the three tests set out in the high threshold of innovation test in addition to the four-part test of section 41(d) in order to qualify. The 2015 proposed regulations provide practical guidance to taxpayers on precisely how to meet the three-prong test. This much-needed guidance should increase the availability of the research tax credit to taxpayers engaged in software development.
Process of experimentation
The 2015 proposed regulations contain six examples of how to apply the process of experimentation test contained in the general qualified research requirements to both internal use and non-internal use software. These examples address several commonly encountered technology projects, such as developing load balancing software algorithms and developing interfaces between legacy software and an ERP system.
Effective date and transition
The proposed regulations dealing with internal use software are effective prospectively for tax years ending on or after the date of publication of final regulations in the Federal Register. Before final regulations can be published, there is a period through March 21, 2015, during which comments may be submitted, followed by a public hearing on April 17, 2015. After that, the IRS may modify these proposed regulations based on the written comments and oral testimony received. In the meantime, the IRS will not challenge tax return positions consistent with the 2015 proposed regulations for tax years ending on or after the publication date of Jan. 20, 2015. Since the research tax credit is currently expired for research activities conducted after Dec. 31, 2014, taxpayers cannot rely on these proposed regulations for calendar year 2015 returns unless and until the research tax credit is again extended by Congress. These proposed regulations may, however, be relied upon by fiscal-year taxpayers for the 2014 portion of any tax year ending on or after Jan. 20, 2015.
For tax years ending before Jan. 20, 2015, taxpayers may choose to follow either all of the internal use software provisions in the January 2001 final regulations or all of the internal use software provisions in the December 2001 proposed regulations.
Because they affect the 2004 final regulations, the examples in the 2015 proposed regulations that deal with a taxpayer’s process of experimentation are effective retroactively to tax years ending on or after Dec. 31, 2003.
For years, taxpayers shied away from claiming a research tax credit for internal use software due to definitional uncertainty and the expense of defending software claims in an IRS examination. The new regulations provide favorable guidance with a broader and more realistic definition of software eligible for the credit. In addition, internal use software used in management and support services functions may still be eligible for the research credit, provided the software meets the additional three-prong high threshold of innovation test. The Treasury and the IRS have provided useful guidance on the test that will help taxpayers determine whether internal use software is eligible for the research credit. However, dual purpose software–software that interacts with customers and performs internal functions–is still a gray area under the proposed regulations. Additional guidance in the form of final regulations may provide additional clarification in response to public comments.