Final R&D tax credit regulations published by the Treasury on October 4, 2016 regarding internal use software introduce a new term, dual function software, as well as a safe harbor provision. Dual function software is “software developed for both internal use and to enable interaction with third parties.” Classifying dual function software allows taxpayers claiming the R&D credit to break out internal and non-internal elements of software R&D development, avoiding the additional scrutiny applied to internal use software for portions of the software developed for use by or interaction with third parties.  However, the internal use software regulations provide that dual function software is presumed to be development primarily for internal use.

To overcome the presumption, the taxpayer must first identify the subset of elements of the software R&D work that are for non-internal use. Non-internal use functions include those that enable a taxpayer to interact with third parties or allow third parties to initiate functions or review data. Each of these functions is known as a “third party subset.” Third party subsets are excluded from the definition of internal use software and avoid the additional scrutiny of the high threshold of innovation test. However, the definition of third party specifically excludes any persons that use the software to support general and administrative functions. This concept is illustrated by Example 6 wherein a vendor accesses the taxpayer’s software for inventory management purposes; therefore, the vendor does not meet the definition of a third party for this section, and the software is considered internal use software under the R&D tax credit rules.

The safe harbor is applied after the third party subsets have been identified. If dual function software remains and at least 10% is used by or to interact with third parties, then the taxpayer can include 25% of the qualified costs (qualifying R&D expenses called QREs). This percentage is only applied to the remaining portion of the dual function software, excluding any identified third party subsets. The regulations provide that an objective, reasonable method within the taxpayer’s industry must be used to make the determination of third party interaction. Processing time, amount of data transferred, and number of user interface screens are proposed as reasonable methods by the regulations, but this is not an exhaustive list.

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