The IRS has issued final regulations largely adopting provisions in the January 2015 proposed regs on internal use software. These final R&D regulations on internal use software are effective prospectively for tax years ending after October 4, 2016. The new final regs are largely taxpayer favorable and should provide a better way to administer software R&D and distinguish between internal use software and non-internal use software projects based on these rules. Some of the key parts of the new final internal use software R&D regulations are summarized below:
Back Office Software – is Internal Use
The new regulations define internal use software as software that performs back office functions, such as inventory management, marketing, legal services, and government compliance services which provide support to day-to-day operations of a taxpayer. These types of software applications would be considered internal use software under the new R&D regs.
Third parties who Interact with the Software – Not Internal Use
Software is not considered internal use software if the software is either sold, leased or licensed to third parties, or allow third parties (customers) to interact with the taxpayer or where the third party is initiating functions or reviewing data. However, the examples in the final R&D credit regs clarify that if the third party (customer) is only reviewing information on a web site, this is not sufficient interaction with the taxpayer and this activity is considered marketing and thus supporting the taxpayer’s back office functions and will still be considered internal use.
However, if the customer can interact to perform a function with the web application or review non-marketing data (perhaps actual customer data where a customer logs in and reviews their data), this would likely not be considered internal use since it’s not supporting a marketing function or back office function. It’s supporting the customer accessing their records or performing some functionality.
Intent at the outset
The determination of whether the software project is internal use software depends upon the taxpayer’s intent at the outset of the project to determine whether or not it is internal use. If this intent/actions change over time, the taxpayer can bifurcate out the new functionality that may be intended to be licensed/sold or used by third parties from the internal use portion. So the original release or functions may be considered internal use, but later releases/new functionality could be treated differently by the taxpayer in claiming the R&D credit.
Dual Function Software
These rules are retained in the final R&D regulations allowing a taxpayer to break out ‘dual function’ software into the internal use functions and non-internal elements and treat those differently. The final regs also retain the safe harbor rule allowing taxpayers to claim 25% of software costs as QREs if at least 10% of the functionality would be customer facing.
Significant Economic Risk Test – Revised
As in the proposed internal use software regulations, the final IUS R&D regs imply a higher threshold of uncertainty vs. the technical uncertainty standard of the 4 part test. The modifier ‘substantial’ uncertainty according to the IRS should denote uncertainty about the capability or methodology. However commentators expressed concern that design uncertainty should also be part of the test since it is inextricably linked to the other 2 types of uncertainty and software developers may have a hard time distinguishing the exact category of uncertainty. So the IRS has removed the ‘types’ of uncertainty from the significant economic risk test, and thus design uncertainty can be considered in showing the sufficient uncertainty. However the final regs do comment that a project having only design uncertainty would rarely satisfy that substantial uncertainty existed. So taxpayers should be aware that the IRS may be tougher on ensuring that the taxpayer has established all sources of uncertainty to show it was ‘substantial’. Of course, the word ‘substantial’ will still be the subject of dispute and the IRS has never attempted to define what substantial means, which can vary by taxpayer and by project. There is no bright line test for how much uncertainty is considered substantial.
As in the proposed regs, the IRS has eliminated the prior test for innovation which required a taxpayer to show that the software was unique or novel and differed in a significant and inventive way from prior software implementations. Instead, the IRS has gone back to the Congressional history and the current test under these final R&D regs is:
Software is innovative if the software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful. So going forward, this test should be easier to administer and closely aligns with Congressional intent in that it is the standard adopted in the Congressional history.
Process of Experimentation for Software Projects
Although these new R&D tax credit regulations were intended to cover the internal use software additional three part test, the IRS and Treasury, as in the proposed regs, provides some examples of both internal use and non-internal use software activities and whether the taxpayer in those examples met the process of experimentation test. Most examples illustrate ‘routine’ activities not involving evaluating alternatives or doing any new development and thus most examples don’t meet the experimentation test. But the last example (10), illustrates an example of a taxpayer developing a new interface involving an in-house data caching algorithm that does meet the experimentation test under the R&D four-part test. The IRS considered comments to provide more examples of qualifying software R&D projects but declined to expand the examples due to the variance in facts from software project to software project.
Regs are Prospective Only
The final regulations on internal use software are intended to be prospective only, after the date the regs were published in the Federal Register. The IRS considered comments on making these regs retroactive to either 1986 or 2004 but decided in part due to the changing nature of software development and methods, that prospective application would be an easier administrative burden and incentivize prospective R&D vs. prior tax years.
If you have any questions about these final internal use regulations or how the R&D tax credit may be applicable to your facts, please contact us via our contact page or at (800) 792-4861.