IRS Finalizes Rules for Internal Use Software and R&D Credit

The Internal Revenue Service has issued final regulations on whether software that has been developed by companies for their own internal use can qualify for the research and development tax credit.

The final regulations also include some examples to illustrate the application of the experimentation requirement to software under Section 41 of the Tax Code. The IRS and the Treasury Department issued proposed regulations on this matter in January 2015 (see IRS and Treasury Propose Rules on Research Tax Credit for Internal Software and R&D Tax Credits Clarified for Internal Use Software). The final regulations were issued Monday with only a few changes.

“The proposed regulations provided that software is developed by or for the benefit of the taxpayer primarily for internal use if the software 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,” said the IRS. “General and administrative functions, as defined in the proposed regulations, are limited to (1) financial management functions, (2) human resource management functions, and (3) support services functions.”

The proposed regulations provided that software is not developed primarily for internal use 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 proposed regulations allow a taxpayer to satisfy a high threshold of innovation test to allow otherwise excluded internal use software development to be considered qualified research. The software needed to pass an innovation test, be unavailable commercially, and involve significant economic risk.

Kendall Fox, technical leader of national R&D tax credit consulting at PricewaterhouseCoopers and a partner in PwC’s New York office, believes the tax community will welcome the final regulations and definition of internal use software. “By and large the final regulations adopted the proposed regulations with very few changes,” he said. “Even though lots of comments were submitted, it doesn’t appear that they resulted in any significant change to the proposed regulations.”

There was one significant change, however. “The proposed regulations would have eliminated appropriateness of design only for purposes of the process of experimentation for internal use software,” said Fox. “There were a lot of comments that this would be difficult to administer, and that appropriateness of design uncertainty can be a very significant risk with respect to software and that it’s often difficult to distinguish between method capability and design uncertainty since they’re inextricably linked together. The way that you may be trying to resolve a method uncertainty is also through a design activity, so they restored appropriateness of design as an uncertainty for internal use software. That’s by and large the most significant change from the proposed regulations to the final regulations.”

Companies that develop software for use by other companies can still qualify for the research credit. The final regulations allow software developers to take into account the impact of the internet, as the original rules date back to the early years of personal computing.

“If you’re developing software for sale, lease, license or to be marketed to third parties, including for online use to transact business, that’s only subject to the regular four-part test,” said Fox. “So a company that develops software for sale, lease, or license, assuming they meet the general definition under Section 41(d) of research, has always been entitled to the research credit. But what happened since 1986, when this law went into effect, is the internet came into being. There’s a lot of software that didn’t appear to fall under sale, lease or license, but also really is not general administrative software. The earlier guidance that was issued didn’t really address these situations so there was always an unknown of what is third-party-facing software that a customer accesses via the internet to transact business with a company, such as to initiate functions or to review data or records, so these regulations make clear that this is not to be considered internal use software.”

In setting an effective date for the new regulations, the IRS provided some leeway for taxpayers who relied on the regulations proposed last year. “The regulations are prospective only, but they do allow taxpayers to go back to taxable years ending on or after January ’15 and to choose to apply either the proposed regulations that were issued back in January ’15, or these final regulations back to that date,” said Fox. “The final regulations will be effective for all taxpayers on a prospective basis, but taxpayers have the option of using the proposed regulations until these final regulations take effect.”