Just what qualifies for inclusion in the Sec. 41 research and development (R&D) credit has been a source of many disagreements between the IRS and taxpayers since the credit was enacted as part of the Economic Recovery Tax Act of 1981, P.L. 97-34. While the disagreements cover a large area of taxpayer expenditures, costs for internal-use software have been particularly contentious. On Jan. 16, 2015, the IRS issued proposed regulations (REG-153656-03) intended to provide concrete rules regarding the R&D credit and internal use software.
Since its inception, the R&D tax credit has benefited taxpayers that incurred domestic qualifying research expenditures (QREs). While the R&D credit is not a permanent part of the tax law, it was extended through calendar year 2014 as part of the Tax Increase Prevention Act of 2014, P.L. 113-295. Taxpayers eagerly await another extension for 2015 or the possible (but not likely) permanent inclusion of the credit in the Code.
The federal R&D tax credit is governed by Sec. 41 and its regulations. Expenditures must pass each of these four tests to be deemed QREs eligible for the credit:
•Technological in nature;
•New or improved business component; and
•Process of experimentation.
After these tests are met, taxpayers must then analyze a number of other factors around the timing, type, and location of a given expenditure to determine if it belongs in the pool of QREs. For internal-use computer software, additional requirements, as discussed below, apply in determining whether costs related to the development of the software qualify as QREs.
Current treatment of internal-use software
Currently, Sec. 41(d)(4)(E) governs the treatment of computer software from a federal R&D tax credit perspective. Except as provided in regulations, computer software that is developed by (or for the benefit of) the taxpayer primarily for internal use is excluded from the pool of QREs.
While exceptions do exist for software developed for use in qualifying research activities and in the production process, taxpayers generally must exclude these types of costs in calculating their R&D tax credit. Whereas external-use software must meet only the four-part test discussed above, internal-use software must meet that test, as well as the three-part “high threshold of innovation” test:
•The software must be innovative (defined as resulting 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);
•The software development must involve significant risk (meaning the taxpayer has committed substantial resources to develop it and, due to technical risk, there is substantial uncertainty that the costs of development will be recovered in a reasonable time); and
•The software must not be commercially available for the taxpayer to use, which means it is not available without considerable modification (i.e., it cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements in this list).
Proposed treatment of internal-use software
The IRS and taxpayers have been battling for years over how to define computer software that qualifies for the credit and software that does not qualify. As early as 1997, when proposed regulations (REG-209494-90) were first issued on whether internal-use software qualified for the R&D credit, taxpayers have eagerly awaited guidance. Furthermore, despite the issuance of final regulations governing the credit in 2001 (T.D. 8930), in response to many comments, in 2004, the IRS announced in an advance notice of proposed rulemaking (Announcement 2004-9) that it would issue new proposed regulations in this area.
In January 2015, the IRS issued these new proposed regulations. They provide a clear definition of internal-use software that does not qualify for the credit, restricting the definition to software developed for general and administrative purposes. As detailed in the preamble, the proposed regulations stipulate that general and administrative functions are limited to “financial management functions, human resource management functions, and support services functions.” By narrowing the definition of internal-use software, the IRS is seeking to expand federal R&D credit eligibility for software development that truly does implement, improve, or expand upon the research and experimentation process.
In addition to supplying a clear definition of internal-use software and rules of application for the high-threshold-of-innovation test, the proposed regulations provide guidance in a number of areas, including, but not limited to:
•Dual-function software: Dual-function software is deemed to be primarily for internal use, which means it serves both functions that are general and administrative and those that are not. This software must overcome a presumption in the proposed rules that it is developed for nonqualifying internal use. The presumption will not apply if the taxpayer can “identify a subset of elements of dual function software that only enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data (the third party subset).” If the taxpayer can identify the third-party subset, the portion of research expenditures allocable to a third-party subset of the dual-function computer software may be eligible for the research credit, provided all the other applicable requirements are met. If a third-party subset cannot be identified, the safe harbor discussed below is available.
•Dual-function software safe harbor: If a third-party subset cannot be identified, under the safe harbor, 25% of the taxpayer’s QREs of the dual-function subset is included in computing the amount of the credit if the taxpayer’s research activities for the dual-function subset are qualified research and the use of the dual-function subset by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10% of the dual-function subset’s use.
•Process-of-experimentation examples: The proposed regulations contain examples to aid taxpayers in determining if the process-of-experimentation test has been met for computer software.
These rules are still in proposed form and therefore are not final until they are published in the Federal Register. While we await the final regulations (the public hearing for comments was in April), taxpayers and certain legislators hope that the rules will be applied retroactively, thus allowing taxpayers to amend returns to increase the scope of the benefit. While retroactive application was not introduced in the current form of the proposed regulations, the IRS has indicated that it will not challenge return positions consistent with the proposed regulations for tax years ending on or after Jan. 20, 2015, the date they were published in the Federal Register.