United States

Chief Counsel Advice disregards court opinion on research credit

IRS advice on internal use software conflicts with district court


The IRS recently issued a Chief Counsel Advice memorandum (CCA 201650012) addressing when and which rules taxpayers should rely on for purposes of determining whether research conducted on computer software primarily for the taxpayer’s internal use qualifies for the section 41 research tax credit. The memo was decided August 22, 2016, prior to the release of the final internal use software regulations and aims to provide guidance on which of the previous rules should be applicable for tax years that end prior to the release of the 2015 proposed regulations. (See our article on the release of the final regulations.)

The memo responds to the request for advice on three specific issues: Whether the section 41(d)(4)(E) internal use software exception to qualified research is self-executing for determining when internal use software is qualified research; What guidance a taxpayer may rely on to determine the three-part high threshold of innovation test in the absence of a self-executing statute; and If a taxpayer relies on the finalized regulations that contain the rules on how to treat internal use software, must it also apply the “common knowledge of skilled professionals” standard included in those regulations but subsequently eliminated from all future iterations of the regulations as being inconsistent with congressional intent. The intent of this article is to explore the last two issues enumerated in the memo in conjunction with a district court case that decided the same issue in 2009. The first issue will be addressed minimally as it is mostly irrelevant to the larger issue.


Under section 41, taxpayers are allowed a credit for increasing qualified research expenses. In order for expenses to qualify for the credit they must meet the qualified research definition provided under section 41(d). Further, expenses will not qualify for the credit if they are for activities specifically excluded under section 41(d)(4). One such excluded activity is research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer’s internal use. The internal use software exception applies to computer software research except to the extent provided in the regulations and other than for use in otherwise qualified activities or production processes of qualified activities. Therefore, a plain reading of the code provides that research relating to internal use software is generally not eligible for the research credit unless it satisfies the exception requirements to be provided in regulations.

A tax code provision is self-executing if it is operative in the absence of regulations. Determining whether the code section is self-executing requires a distinction between provisions that require the promulgation of regulations to determine how or whether the statute applies. If the statute requires regulations to determine how it applies, then the statute is considered self-executing. However, statutes that require the promulgation of regulations to determine whether the statute applies are not self-executing.

The memo provides an analysis concluding that the language “except to the extent provided in regulations” in section 41(d)(4)(E) which serves to exclude most internal use software research is not self-executing because it determines whether the research qualifies, not how it qualifies. Despite this fact, this article concludes that whether the language of the statute is self-executing is mostly irrelevant as several iterations of regulations have been promulgated and can be relied on by taxpayers.

Internal use software guidance and “common knowledge of skilled professional” standard

The second and third issues addressed in the memo relate to what rules a taxpayer should follow to determine if its internal use software qualifies for the research credit and whether it must follow all provisions found in those rules. Many iterations of regulations have been published addressing or changing the internal use software rules, a brief description and timeline is helpful to understand how they affect each other:

Date published


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 internal use software rules including high threshold of innovation test

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; retained high threshold of innovation test but eliminated all reference to “common knowledge of skilled professionals”

Jan. 2, 2004

Final section 41 regulations (TD 9104)

2004 final regulations

Excluded discovery test; did not include rules for internal use software but reserved section 1.41-4(c)(6)

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

Oct. 3, 2016

Final section 41 regulations (TD 9786)

2016 final regulations

Includes rules for internal use software; added exceptions for software commercial sold, leased, licensed or developed for third-party interactions; retained high threshold of innovation test

*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.”

The memo’s advice is based on a taxpayer who claimed research credits in prior years that include expenses related to research with respect to internal use software. It is the taxpayer’s position that it may choose to apply the internal use software provisions of the 2001 final regulations but without the “common knowledge of skilled professionals” standard contained therein. In the alternative the taxpayer argues that it can apply the legislative history’s high threshold of innovation test which does not reference the “common knowledge of skilled professionals” standard. The IRS, relying on the 2004 ANPRM, asserts that a taxpayer must either apply the 2001 final regulations in their entirety, or the 2001 proposed regulations in their entirety. The memo concludes that should the taxpayer choose to rely on the 2001 final regulations, it must apply the “common knowledge of skilled professionals” standard.


Although the memo does not address it, a similar fact pattern was presented to the Western District of Tennessee District Court in FedEx Corp. v. United States. (103 AFTR 2d 2009-2722, 2009-1 USTC para. 50,435 (W.D. Tenn. 2009)) In FedEx, the taxpayer claimed research credits on research activities relating to internal use software. FedEx argued that the 2004 final regulations’ elimination of the “common knowledge of skilled professionals” standard from the “discovery” test should govern but also argued that the 2001 final regulations’ internal use software test should control due to the absence of internal use software rules in the 2004 final regulations.

The IRS denied the research tax credits reasoning that a taxpayer cannot “cut and paste” portions of the regulations to craft the correct legal standard to be applied. The IRS stated that the 2001 final regulations should apply to the taxpayer in their entirety (for tax years at issue 1997 through 2000) or that the 2001 proposed regulations should apply in their entirety. In making this argument, the IRS relied on the 2004 ANPRM which provided that for taxable years beginning after Dec. 31, 1985, and until further guidance is published, taxpayers can rely either on all the provisions of the 2001 final regulations or all the provisions of the 2001 proposed regulations.

The court agreed with FedEx that it may rely on the 2004 final regulations, stating that the 2004 final regulations and the proposed regulations support that position. Further, the court rejected the IRS’s argument that a taxpayer could rely on the provisions of the 2001 final regulations, stating that the 2004 ANPRM is the IRS’s attempt to impermissibly amend the 2004 final regulations with a mere announcement. The court further reasoned that it would be improper to rely on the 2001 final regulations, citing the preamble to the 2001 proposed regulations which stated that the Treasury and IRS eliminated the “common knowledge of skilled professionals” standard because they believed that the requirement did not “fully address Congress’ concerns regarding the importance of research activities to the U.S. economy.” The court said the IRS, after clearly stating that the 2001 final regulations do not accurately reflect Congressional intent regarding the discovery test, is now seeking to require the taxpayer to “satisfy that test in its former, inadequate incarnation.” Id. In light of determining that the taxpayer can rely upon the 2004 final regulations, the court determined that the issue is how to construe the absence of the internal use software provision from those regulations.

The court held that the only regulations pertaining to internal use software issued by the Treasury pursuant to the specific grant of rulemaking authority in section 41(d)(4)(E) are those contained in the 2001 final regulations. Therefore, the court determined that FedEx may rely on the modified discovery test from the 2004 final regulations (omitting the “common knowledge of skilled professionals” standard) but can rely on the internal use software rules from the 2001 final regulations until Treasury amends or provides new internal use software rules. The IRS filed a motion to reconsider but the court, in an unpublished order, denied the motion and reaffirmed the decision.

2014 Chief Counsel Advice

The current memo also ignores a 2014 Chief Counsel Advice Request “2014 CCA” (CCA 201423023) which requests advice as to which legal standard is applicable for the internal use software exception. The 2014 CCA restates the IRS’s positions that the 2004 ANPRM, which allows for taxpayers to rely upon all provisions of either the 2001 final regulations or the 2001 proposed regulations, is the only published guidance on the applicable standard for internal use software. However, the 2014 memo recognizes the FedEx decision and concludes that the IRS should not challenge taxpayers that choose to follow only the internal use software provisions of either the 2001 final regulations or the 2001 proposed regulations and follow the 2004 final regulations for all other general eligibility rules for qualified research.

Conclusions and potential impact

The current memo is a departure from previous chief counsel advice as well as the decision in FedEx. Despite the IRS’s seemingly about face, several factors limit the impact that the memo’s conclusion might otherwise have. First, CCAs cannot be used or cited as precedent. Although they are generally understood to be indicators of how the IRS might rule on a particular issue, two CCAs of differing opinions are not likely to provide much credible insight.

Secondly, the memo states that the advice is specifically for taxable years ending prior to the issuance of the 2015 proposed regulations, limiting its applicability window. Furthermore, since the date of the memo, the 2016 final regulations were issued and the internal use software provisions contained therein are effective for taxable years beginning on or after Oct. 4, 2016. Also, the 2016 final regulations state that for taxable years that end before Jan. 20, 2015 but begin before Oct. 4, 2016, the IRS will not challenge return positions consistent with the internal use software rules provided under the 2016 final regulations or the 2015 proposed regulations. For taxable years ending before Jan. 20, 2015, section 1.41-4(e) (of the 2016 final regulations) provides that taxpayers may choose to follow either all of the internal use software rules provided under the 2001 final regulations or all of the internal use software rules provided under the 2001 proposed regulations. Of note, these applicability rules specify that they apply to all the internal use software provisions under section 1.41-4(c)(6) but say nothing about applying the other provisions in those regulations.      

Finally, although the FedEx decision applies specifically to taxpayers in the Western District of Tennessee, the decision and its rational has generally been accepted for determining which internal use software regulations are applicable to those taxable years that are not addressed under the 2016 final regulations.

Taxpayers with concerns as to how the CCA might affect their research tax credit should consult their tax advisor to determine which legal standards are applicable given the taxpayer’s specific facts.


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