IRS and Treasury Propose Rules on Research Tax Credit for Internal Software

The Treasury Department and the IRS have released proposed regulations on the application of the research tax credit for internal use at companies in an effort to provide better clarity to businesses and tax professionals on the proper rules.

The proposed regulations, which were released Friday, provide guidance on credit eligibility for research and experimentation, or R&E, on computer software that is developed by the taxpayer primarily for its own internal use, known as internal use software. 

The Tax Code generally excludes computer software research from the definition of qualified research if the computer software is developed by, or for the benefit of, the taxpayer primarily for internal use, the Treasury noted. However, neither the Tax Code nor prior administrative guidance specifically defined software that is developed “primarily for internal use.” 

The proposed regulations define internal use software and provide rules for exceptions to the general rule that would exclude certain software development from credit eligibility. They also include examples illustrating the application of R&E credit rules to software development activities.

“Through these proposed regulations, we are providing taxpayers with the clarity that they need to invest in software innovation,” said Assistant Secretary for Tax Policy Mark J. Mazur in a statement. “Computer software plays a vital role in 21st century business activities, and today’s tax guidance will help encourage U.S. firms to make these important investments.”

The proposed regulations that were released Friday define internal use software as software that is developed for use in general and administrative functions (limited to financial management functions, human resource management functions, and support services functions) that facilitate or support the conduct of the taxpayer’s trade or business. The proposed regulations provide 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 Treasury and the IRS said that taxpayers can rely on the proposed regulations pending finalization.