Some Clarity For Software Developers: Research Credit Regulations Issued for Internal Use Software

Entities engaged in research activities are entitled to a tax credit set forth in Sec. 41. The credit is a percentage of qualified research expenses that exceed a base amount, and can be carried back one year and carried forward 20 years.

Having been available since 1981, the research credit has provided a significant tax benefit for companies developing new or improving upon existing products and processes. Nevertheless, the ability to claim the research credit for software development has been a controversial topic since the credit's inception. Earlier this year, IRS issued long-anticipated proposed and final regulations that provide guidance on credit eligibility for research and experimentation on computer software that is developed by the taxpayer primarily for its own internal use.

In general, research related to internal use software (IUS) is not considered to be qualified research for purposes of the credit unless the research satisfies an additional high threshold of innovation tests. However, computer software plays a very different role today than it did when IUS was originally excluded from the definition of qualified research in 1986. Because of its evolving function in business activities across a wide array of industries, the Treasury has provided additional guidance on how taxpayers can qualify certain IUS-related development costs as eligible for the research tax credit. The proposed regulations, generally seen to be favorable for most taxpayers, provide the following:

  • Definitions and examples of IUS and non-IUS
  • Eligibility of certain IUS research if it satisfies the high threshold of innovation test
  • Definition of dual function software, which is software developed for both internal and non-internal use
  • Safe harbor for determining whether any research expenditures related to dual function software can be included as QREs

The proposed regulations define IUS as software that is developed for use in the taxpayer’s general and administrative functions (limited to financial management functions, human resource management functions and support services) that support the on-going operations of a taxpayer's trade or business. The functions that constitute general and administrative functions under the proposed regulations are intended to include back-office functions of a taxpayer that most taxpayers would have regardless of their industry. The regulations also clarify that IUS includes products that provide services such as banking, accounting and consulting. In prior regulations, these were respectively identified as computer and non-computer services. The proposed regulations however, remove this distinction. In short, software developed to be used by the taxpayer that is not commercially sold, leased, licensed, or similarly marketed to unrelated third parties is IUS.

Non-IUS is defined as software developed to be commercially sold, leased, licensed, or similarly marketed to unrelated third parties. This definition is expanded in the proposed regulations to include software that allows a taxpayer to interact with third parties, or allows third parties to access data or initiate functions within the taxpayer's system. The regulations also provide examples of software that would be considered non-IUS software. Such examples include software that allows third parties to:

  • Order and track products online
  • Upload and modify photographs
  • Bid for ad placement and set prices for ads on taxpayer's website
  • Execute banking transactions
  • Search a taxpayer's inventory for goods
  • Purchase tickets for transportation or entertainment
  • Receive services over the internet

The regulations also address computer software that supports the delivery of goods and services to a third party, such as tracking inventory to enable the taxpayer to deliver its inventory to third parties. While IRS does not consider this part of a production process, the regulations note that this type of software might not be considered IUS if the taxpayer can show that the software provides the taxpayer the ability to interact with third parties, or conversely, allows third parties to access data or initiate functions within the taxpayer's system. 

The most significant element of the proposed regulations is the inclusion of dual function software, which is considered to be developed for the taxpayer's internal use, serving both general and administrative and non-general and administrative functions. Under the proposed regulations a taxpayer could identify subsets of dual function software that specifically allows the taxpayer to interact with third parties, making that portion of the software development eligible for the credit. To the extent a taxpayer cannot break the dual function software into discrete subsets, a safe harbor allows for 25% of the costs of the dual function software to be included in the credit calculation if the taxpayer can show that at least 10% of the subset's use is anticipated to interact with third parties.

The proposed regulations may be relied upon for tax years ending on or after January 20, 2015. IRS will not challenge return positions consistent with these proposed regulations for tax years ending on or after that date.

If your company is involved in developing new products, processes, or technologies, or improving on existing ones, let Andersen help you maximize your research tax credit claims. We can help you assess whether your research activities qualify under Sec. 41, calculate any unclaimed credits, and amend returns for prior periods to claim these credits.