On January 16, the IRS and the Treasury Department released proposed regulations that provide a definition of software developed primarily for internal use and describe software not developed primarily for internal use. The proposed regulations, once finalized, will be effective for tax years ending on or after the date the final regulations are published in the Federal Register.  However, the IRS will not challenge return positions consistent with the proposed regulations for tax years ending on or after January 20, 2015.

Rules Help SaaS Companies and Others

Although computer software developed primarily for internal use doesn't qualify for the Sec. 41 research credit, except to the extent provided by regulations, previous guidance did not clearly define what internal use software is. The new guidance does so.  

According to the proposed regulations, internal use software is software developed for use in general and administrative functions that facilitate or support a company's trade or business―specifically financial management functions, human resource management functions and support services functions. Software would not be considered internal use software if it is developed to be commercially sold, leased, licensed or marketed to third parties, or developed to enable the taxpaying company to interact with third parties or to allow third parties to initiate functions or review data on the company's system. 

High-Threshold-of-Innovation Test

The proposed regulations also allow internal use software to qualify for the research credit if it meets an additional three-part, high-threshold-of-innovation test:

  • The software is innovative and creates a significant reduction in cost or improvement in speed.
  • Development of the software involves significant economic risk and requires substantial resources, which might not be recoverable in a reasonable amount of time because of technical risk.
  • The software is not commercially available for use without modifications that meet the first two requirements.

Under the proposed rules, companies may also be able to qualify for a tax credit for some of their research expenditures if the internal use software is "dual-function software," which serves both general and administrative and non-general and administrative functions. 

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