These important new proposed regulations issued last week on the R&D tax credit affect what is known as internal use software or IUS which has been debated since Congress distinguished internal use software from other software back in 1986. Over many years, there have been versions of the IRS regulations trying to develop a consistent approach to defining what types of software are internal use for the R&D credit vs. other software, as well as what tests should apply to internal use software to qualify as R&D in light of the higher threshold of innovation set out by Congress in 1986.

In these new R&D credit regs, the IRS recognized in the comments that software plays a vital role in the U.S. economy, providing competitive advantages by continuing to expand the U.S. role in software development; even more so than when the internal use software rules were discussed by Congress in 1986.

The new proposed regulations (REG-153656-03)  eliminate distinguishing between computer and non-computer services in which early version of these regs did. For example, one iteration of the regs (1997) provided that non-computer services that provided new features/functions in which the competition didn’t possess would meet the criteria. Another later version of the regs (2001) eliminated the non-computer services exception but retained the computer services exception where software providing a computer service to customers who come to the taxpayer for such service, would not be considered IUS. This was a difficult and subjective rule to attempt to apply so we’re not surprised that Treasury has done away with this type of test.

Instead, the new R&D credit regs go back to the Congressional language in 1986 and define internal use software for the R&D credit as software providing ‘back-office’ functions, where the software would not directly benefit its customers. On the contrary, if the software is used by customers (i.e., commercial software) and not for the taxpayer’s own internal use in providing back office functions such as HR, payroll, financial, then such software would benefit a taxpayer’s customer base and/or other third parties and should not be considered IUS.

The regs also looks to the purpose of the software – was the purpose to be used internally by the taxpayer or does the customer base/clients/third parties benefit from the software?  This correctly applies what Congress had in mind in the legislative history – determining the intent or purpose in developing the software (and whether it may benefit the U.S. economy in some way by having customers benefit from using the software).

Also, software that allows the taxpayer to communicate with other software systems (at third party companies) or vice-versa is not internal use software. This is very helpful in development such as APIs, gateways, data sharing/data exchange where the purpose is not just back office but the software is communicating with other external systems.

Uncertainty required for internal use software – in considering that there is a higher threshold for internal use software to qualify, the IRS has also modified the significant economic risk test which relates to technical risk on the project. The IRS distinguished this risk or uncertainty from non-IUS or other R&D where the taxpayer could either have capability uncertainty, methodology uncertainty, or uncertainty about the appropriate design. Now for IUS under these regulations, the taxpayer must show uncertainty as to the capability of developing the software or features, or methodology uncertainty, thus eliminating uncertainty relating to the appropriate design of the software. This provision however remains for commercial and other non-IUS software projects where design uncertainty is a legitimate technical uncertainty for purposes of the 4 part test.

Innovation test – 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 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.

This again is a welcome change and easier standard to apply than the subjective standard of whether software is unique or novel or trying to compare to other software on the market.

There are a number of other provisions and examples in the new proposed regulations that you should review if you believe one of the exceptions applies or even if the software is still IUS, the differences in the new proposed regs may impact the outcome. Contact Warner Robinson if you want us to consult on your specific facts and there is no fee for our initial review.