New Regulations Clarify the Term “Internal Use Software” for Purposes of the R&D Tax CreditOctober 2016
On October 4, 2016, the Internal Revenue Service (IRS) released final regulations clarifying what constitutes "internal use software" for purposes of the research and development (R&D) credit (the "Research Credit") under Section 41 of the Internal Revenue Code. The issue addressed by the final regulations is a significant one for many businesses because research expenditures for internal use software do not generally qualify for the Research Credit. The final regulations should help eliminate a large number of disputes over this issue. The final regulations, which generally follow the proposed regulations released on January 20, 2015, with some clarifications, are generally effective for taxable years beginning after October 4, 2016, and address the following issues:
- The definition of "internal use software" for purposes of the Research Credit;
- How dual function software (software that functions in part as internal use software) is treated; and
- What types of internal use software can still qualify for the Research Credit.
What Software Qualifies for the Research Credit under the Final Regulations
Software qualifies for the Research Credit if it is not primarily for the taxpayer's internal use, that is, if it is developed (i) to be commercially sold, leased, licensed, or otherwise marketed to third parties, or (ii) 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. Thus, software developed primarily for one of these purposes is not considered internal use software. For example, if a manufacturer develops software for a website intended to allow customers to order products online and track these orders, this would not be internal use software since it was developed to allow third parties to initiate functions and access data on the manufacturer's system.
What Software Does Not Qualify for the Research Credit under the Final Regulations
Software does not qualify for the Research Credit if it constitutes internal use software, that is, if it is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. General and administrative functions encompass (1) financial management functions, (2) human resource management functions, and (3) support services functions.
Whether software is developed primarily for internal use and therefore constitutes internal use software depends on the intent of the taxpayer and the facts and circumstances as of the beginning of the software's development. Thus, taxpayers who wish to claim the Research Credit for software development need to develop and maintain records documenting this intent from the beginning of the development process.
Dual Function Software
Software developed by (or for the benefit of) the taxpayer that meets some of the criteria for internal use software and some of the criteria for the Research Credit is classified as dual function software, presumed to be developed primarily for a taxpayer's internal use, and therefore considered internal use software.
The final regulations provide taxpayers with some relief from this presumption. 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 (a "third party subset"), the third party subset is not presumed to be internal use software.
In addition, if after identification of such a third party subset, there remains dual function software or a subset of elements of dual function software (a "dual function subset"), a taxpayer may rely on a safe harbor to include 25% of the "qualified research expenditures" for such dual function software or dual function subset in computing the amount of the taxpayer's credit. The safe harbor applies, however, only if (i) the taxpayer's research activities related to the development or improvement of the dual function software or dual function subset constitute "qualified research," and (ii) the dual function software or dual function subset's use by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10 percent of the dual function software or the dual function subset's use.
Internal Use Software Qualifying for the Research Credit
The final regulations provide that certain internal use software may still be eligible for the Research Credit if the software satisfies a high "threshold of innovation" test and satisfies certain other requirements.
The final regulations are prospective and apply to taxable years beginning on or after October 4, 2016. They do not apply retroactively and are not an interpretation of prior regulatory guidance. The final regulations do provide taxpayers with various options for rules relating to internal use software for tax years ending before January 20, 2015.