Internal Use Software Regs
Software development projects can qualify for R&D tax credits just as other product development efforts can qualify (same criteria). In addition, software considered to be ‘internal use software’ can also qualify but some additional criteria apply.
Thus, the first step is making the determination as to whether the software project involves creating internal-use software or non-internal use software.
The IRS released new internal use software R&D regulations in January 2015 which have now been finalized as of 2016. These final regs define what types of projects are internal use as well as providing us new definitions for the innovation and significant economic risk tests for the R&D credit.
Under these new internal use software R&D regs, internal use software is software that is developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. This is akin to the Congressional History definition of internal use software and applies mainly to back office software not meant to be customer or third party facing.
Specifically, a software R&D project is NOT internal use if it is:
Software 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. The following examples would meet this exception to internal use software (non-IUS) if the software can:
- Execute banking transactions
- Track the progress of a delivery of goods
- Search a taxpayer’s inventory for goods
- Store and retrieve a third party’s digital files (cloud computing)
- Purchase tickets for transportation or entertainment
- Receive services over the Internet
- Software developed for sale, lease or license
- Software used in R&D
- Software used in a production process that qualifies as R&D
- Software developed as part of a hardware/software product (embedded software)
1. Technical Uncertainty Test
The activity must be intended to eliminate technical uncertainty about the development or improvement of the product or process. This uncertainty exists if the information available to the company does not establish the capability or method for developing or improving the product or process, or the appropriate design of the product or process that would achieve the desired result.
2. Process of Experimentation Test
A process of experimentation (POE) is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.
3. Technological in Nature
The activity must be undertaken must be technological in nature. Whether this test is met depends on whether the process of experimentation utilized in the research fundamentally relies on principles of the hard sciences. The hard sciences are defined as the physical or biological sciences, engineering or computer science.
4. New or Improved Business Component
The activity must be intended to be useful in the development of a new or improved business component of the taxpayer (which means a new or improved product, process, formula, technique, invention or software component).
In addition to the Four-Part Test, if the software is internal-use software (developed primarily for the taxpayer’s internal use), then the following additional three tests must be met per the new 2015 internal use software R&D regulations:
- 1. The software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant;
- 2. The software development involves significant economic risk, in that the project involved a significant commitment of resources, and because of technical risk, the taxpayer is uncertain as to recovery of project dollars within a reasonable period;
- 3. The software as modified/developed/enhanced by the taxpayer is not commercially available.
Contact us today to learn more about how we can assist in securing you R&D Tax Credits and in reviewing software R&D projects under the new internal use software regulations and current software R&D tax credit cases.
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