The IRS released final R&D tax credit regulations on Oct. 3 (T.D. 9786) that reject many of the suggestions for easing restrictions on internal use software, but still provide significant opportunities.
The final rules come nearly two years after the highly anticipated proposed regulations (REG-153656-03) were issued in January 2015. They should finally settle much of the uncertainty for determining when software is developed for internal use and therefore subject to the high-threshold of innovation test for eligibility for the R&D credit. Although the final regulations did not incorporate many taxpayer suggestions, they do retain the bulk of the taxpayer-favorable rules in the proposed regulations. Taxpayers will still benefit from a narrower definition of internal use software, and a safe harbor for carving out eligible portions of dual use software.
The changes in the final version were largely technical, including changes that:
- Adjust the definition of software that is not primarily developed for internal use
- Slightly broaden the concept of "uncertainty" in the test for significant economic risk for meeting the high innovation threshold
- Clarify when the dual use safe harbor is applied
Generally, Section 41 bars any R&D tax credit for software developed primarily for internal use. The IRS originally issued final regulations in 2001 that defined internal use software as any software that is not developed to be sold, leased, licensed or otherwise marketed to third parties, with an exception for "innovative" software. But the IRS immediately reconsidered the 2001 regulations and later that year proposed a new version with a more stringent "innovative" test. When these R&D regulations were finalized in 2003, the IRS omitted all the rules on internal use software, confusing taxpayers and leading to controversy in FedEx Corp. et al. v. United States (No. 08-2423). The final regulations finally define software that is developed "primarily for internal use" and clarify when internal use software can still qualify for the credit.
Defining internal use
The final regulations retain the narrower taxpayer-favorable definition of internal use software to software "developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business." The regulations further limit the term "general and administrative functions" to the following:
- Financial management functions — Involve the financial management of the taxpayer and the supporting recordkeeping
- HR management functions — Manage the taxpayer's workforce
- Support services functions — Support the day-to-day operations of the taxpayer
Many commentators had suggested that the definition of general and administrative functions was too broad because it included functions such as inventory management, marketing, legal services and government compliance that are not necessarily "back office" and provide benefits to third parties. The IRS declined to change its definition, arguing that the third-party benefits are corollary and that the new dual use rules can accommodate any bifurcation.
Software used by third parties
The IRS did slightly broaden the definition of software that is not considered developed primarily for internal use. The proposed regulations provided that software is not developed primarily for internal use only if it 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.
In the final version, this standard is used merely as an example of software that is not developed primarily for internal use, and the actual definition of software not developed primarily for internal use is any software that does not meet the basic internal use definition (developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business).
The final regulations also retain the proposed rule that the determination of whether software is developed primarily for internal use is made at the beginning of the project. Several commentators argued that the intent of software development can change mid-process, but the IRS maintained that any improvements in software that shift the intent must be considered separate from the original software.
Dual function software
The final regulations retain the presumption that software developed to serve both internal and third-party functions is presumed to be developed for internal use. However, the final regulations also retain the rule allowing taxpayers with this dual use software to segregate a subset of elements that enable the taxpayer to interact with third parties or to allow third parties to initiate functions or review data.
In cases of software subsets where the third-party portion and internal use portion of the software is interwoven such that the third-party portion cannot be segregated, a safe harbor provision allows for 25% of the dual function software to qualify if at least 10% of the dual function software is for third-party use. The final regulations clarify that this safe harbor applies only after the determination of whether the software is presumed developed for internal use.
High threshold of innovation
The final regulations provide that internal use software can still qualify for the R&D credit if it meets a higher standard of innovation than is required for other business components. The three-part test for meeting this higher threshold for innovation generally follows the proposed regulations, with a minor change in the significant economic risk test:
- Innovative — Intent of the software must be to reduce cost, improve speed or make another improvement that is substantial and economically significant (i.e., the "unique or novel" standard does not apply).
- Significant economic risk — Taxpayer must commit substantial resources to development that would be recovered within a reasonable period if substantial uncertainty and technical risk are overcome. The final rules remove language that required the uncertainty to be specifically related to capability or methodology issues.
- Not commercially available — Software must not be commercially available for its intended purpose without modifications.
The final regulations are effective for tax years beginning on or after Oct. 4, 2016, but taxpayers can generally rely on either the proposed or final versions of the rules for tax years that end after Jan. 20, 2015 (if they begin before Oct. 4, 2016). The R&D credit is now permanent, and taxpayers should begin identifying opportunities to use the new favorable rules.
The final regulations are particularly significant to taxpayers who incur significant software development expenses for software that is not sold, leased or licensed to third parties. Taxpayers that operate in a "software as a service" model or other taxpayers that interact with customers through software functions may have significant opportunities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.