Recent taxpayer friendly Regulations proposed by the IRS on January 16, should encourage those taxpayers who develop software for internal use, to re-visit the accumulated costs for potential creditable treatment. Many favorable rules are included in these proposals that may enable taxpayers who did not previously qualify for the Research and Development Credit, to now become eligible. While these new proposals have been in the works since around 2003, the issuance is deemed to be in direct relation to the recently decided taxpayer friendly FedX Case and that company’s treatment of its self-developed tracking software.
With the recent passage of the Tax Extenders Act, the Research and Development Credit (“R&D”) was extended through 2014. (The R&D Credit expired at the end of 2014 but is expected to be retroactively reinstated to 2015.) This dollar for dollar credit against tax can be equal to a maximum of 20% of qualified research expenditures. However, expenditures for the development of internal use software were not eligible for the credit unless the expenses incurred met higher standards than other types of R&D costs commonly referred to as the “high threshold of innovation”. Up until now, taxpayers had little guidance on the definition of what constituted internal use software as those rules were absent from previous regulations finalized in 2003. The new Proposed Regulations:
- clarify the definition of internal use software,
- provide new exceptions for internal use software that is used to interact with third parties or allows them to initiate functions or review data on the taxpayer’s system,
- creates an exception for non-internal use of dual purpose software,
- clarify the high threshold of innovation exception.
The proposed regulations include 23 examples applying the guidance to specific fact patterns. They also provide guidance on how to meet the process of experimentation requirement that applies to all R&D activities.
Internal Use Software Defined:
The definition has been narrowed to software that 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”
General and administrative functions are limited to the following:
- Financial management – record keeping and financial
- Human resources – manage workforce
- Support services – day to day operations
Unless the expenditures for developing the software relate to its usage in the new narrow definition of general and administrative functions of running the organization, then the expenditures are eligible for the credit.
Third Party Usage of Software:
If software is developed to be sold, leased, licensed, or marketed to third parties it is not considered developed for internal use. An exception now exists for software that enables a taxpayer to interact with third parties or for third parties to initiate a function or review data on their system.
These exceptions from the definition of internal use software and eligible for the credit do not include related parties or others that use the software to support the general and administrative functions of the taxpayer.
This can be a big win for taxpayers such as banks, brokerage firms, ticketing agents, logistics services, cloud and other digital storage services that allow access to their systems by third parties to execute banking and brokerage transactions, purchase tickets for travel or entertainment, track shipments and utilize or retrieve data.
Dual Function Software:
The current regulatory presumption is that software is developed primarily for internal use if it serves both general and administrative functions and non-general and administrative functions as defined. The taxpayer can now segregate the portion of the software that is identifiable as being utilized solely to interact with third parties or allow third parties to initiate functions of review data on the taxpayer’s system. If the taxpayer is unable to segregate the dual function, then a new safe harbor provision is available. That provision allows 25% of the dual function software to remain eligible for the credit if at least 10% of the dual function software is for third party use.
High Threshold of Innovation:
For internal use software that does not meet any other exception to be eligible for the credit, expenses may still qualify if the development activities meet the following three requirements for a high threshold for innovation:
- Innovative – Intended to reduce cost, improve speed, and make substantial and economically significant improvements.
- Significant economic risk – Substantial resources must be committed to the development and those resources must be recovered within a reasonable period if technical risks are overcome. The technical risks must relate to capability or methodology issues.
- Not commercially available – The software cannot be purchased, leased, or licensed and used for the intended purpose without modifications. These modifications would have to satisfy the other two high threshold of innovation tests; innovative and significant economic risk.
The proposed regulations indicate that the “use of existing technologies in new ways could be evidence of a high threshold of innovation.”
Expenditures for the following types of software development retain their eligibility for the credit:
- Software used in qualified research activities
- Software developed for use in a production process
- Software developed as part of an integrated hardware-software product
Effective Date: The IRS has stated that they will not challenge taxpayers who rely on these regulations provided their year ends on or after January 20, 2015.
These new Proposed Regulations provide clarity to many of the issues that have plagued this Code Section as it relates to software. Besides the proper conceptual application of these complicated rules, the proper maintenance of records for all qualified research expenditures must be adhered to in order to support the validity of the credit. Improper record keeping can result in the loss of the credit even though all other requirements may have been satisfied. In many cases, taxpayers believe that they are not eligible for the credit, or that maintaining the records necessary for compliance is too costly and complex. Whatever your individual case may be, Marcum has an entire R&D team dedicated to providing answers and solutions. If you have any questions related to how these preferable changes to R&D and Software may affect you or your business, we suggest contacting a member of the R&D Tax Incentive Team.