Internal Use Software Regulations for the Research Tax Credit

In 2016, the Internal Revenue Service issued final regulations (T.D. 9786) regarding guidance on software that is developed primarily for a taxpayer’s internal use in computing the credit for increased research activities. These final regulations can provide significant opportunities for taxpayers that did not previously include expenses for software developed primarily for their own internal use, in the calculation of the research tax credit.

Background

The general rule is that software developed by (or for the benefit of) the taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business does not qualify for the research tax credit. Under the final regulations (T.D. 9786), taxpayers that develop internal use software will be able to claim a credit for research and development expenses if the software’s development meets a high threshold of innovation test.

Definition of Internal Use Software

Under the regulations, internal use software is software developed by (or for the benefit of) the taxpayer primarily for internal use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. General and administrative functions include functions such as financial management, human resource management, and support services that support the taxpayer’s day-to-day operations.

Definition of Software Not Developed Primarily for Internal Use

The regulations provide that software is not developed primarily for internal use only 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. The determination of whether software is developed for internal use or 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) depends on the intent of the taxpayer and the facts and circumstances at the beginning of the software development.

Dual Function Software

Dual function software – software used both internally by a taxpayer and by third parties – is presumed to be developed primarily for a taxpayer’s internal use. However, this presumption does not apply to the extent that a taxpayer can identify a subset of elements of dual function software that only enables a taxpayer to interact with third parties (or allows third parties to initiate functions or review data on the taxpayer’s system).

A safe harbor for dual function software or a subset of elements of dual function software allows taxpayers to include 25% of the research expenses of the remaining subsets of the dual function software as qualified research expenses in computing the research tax credit, as long as the third party functions are expected to account for at least 10% of the software’s use. An objective, reasonable method must be used to estimate the dual function subset’s use by third parties or by the taxpayer to interact with third parties, and such use must be estimated at the beginning of the computer software development.

High Threshold of Innovation Test

To be eligible for the research tax credit, the internal use software must satisfy a three-part high threshold of innovation test. The high threshold of innovation test only applies to internal use and dual function software. Under the final regulations, the three parts include the following:

1. The software is innovative in that it would result in a reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant, if the development is or would have been successful;
2. The software development involves significant economic risk in that the taxpayer commits substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period;
3. The software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.

These tests are based on whether uncertainty existed at the beginning of the taxpayer’s activities. The final regulations removed all prior references to capability and uncertainty and “softened” the innovation tests so that the tests will not be so restrictive.

Conclusion

The final regulations provide clarity and guidance on whether software that has been developed by taxpayers for their own internal use can qualify for the research tax credit. The internal use software distinction is important since the high threshold of innovation test makes it more difficult for internal use software to qualify for the research tax credit. The effective date for these regulations is on or after October 4, 2016, but the Internal Revenue Service will not challenge return positions consistent with the final regulations for tax years ended on or after January 20, 2015. The final regulations are not effective retroactively to earlier tax years.