IRS Issues Final R&D Tax Credit Regulations for Internal Use Software

New regulations may help companies take advantage of this credit where they were previously unable to.

By Carli McDonald, director and Denisse Beldin, associate

Many technology companies develop software to help streamline business processes and improve operations. Designing and developing this software could mean tax savings in the form of Research and Development (R&D) Tax Credits, which provide companies with a dollar-for-dollar offset of their tax liability. New regulations may help companies take advantage of this credit where they were previously unable to.

On Oct. 3, 2016, the IRS published final regulations which provide guidance on the application of internal use software (IUS) as it relates to the credit for increasing research activities. These final regulations largely adopt the proposed regulations, with some amendments, that were issued in January 2015. [1] Qualification of internal use software has been controversial in the past, so the release of the final regulations clarifies the types of activities classified as R&D.

NEW AND IMPROVED DEFINITION OF INTERNAL USE SOFTWARE

The final regulations define IUS as software developed by (or for the benefit of) the taxpayer, if developed for use in general and administrative functions that facilitate or support the taxpayer’s trade or business. General and administrative functions include the following “back-office” functions:

Financial management and supporting recordkeeping functions; [2]
Human resource management functions; or
Support service functions that support the taxpayer’s day-to-day operations. [3]
Under the final regulations, software is considered external use software if it is developed for functions other than general and administrative. This would apply even if the software is not developed to be sold, leased, licensed or otherwise marketed to third parties, is not intended to enable interaction with third parties or does not allow third parties to initiate functions or review data.

HIGH-THRESHOLD-OF-INNOVATION TEST

Generally, research related to IUS is excluded from the R&D Tax Credit, with some exceptions. The final regulations now provide an exception for software development that meets both the regular four-part test for R&D and the new high-threshold-of-innovation test:

The software is innovative; [4]
The development of such software involves significant economic risk; and
The software is not commercially available for use by the taxpayer. [5]
The final regulations remove prior references to capability and uncertainty of method. IUS research activities which involve uncertainty related to appropriate design would rarely qualify as having substantial uncertainty for purposes of meeting the high-threshold-of-innovation test. However, uncertainty related to design can still be factored into the economic risk analysis.

DUAL-FUNCTION SOFTWARE

For software that serves both general and administrative functions and additional functions (i.e. dual-function software), the final regulations presume such software is developed primarily for a taxpayer’s internal use. This presumption is inapplicable if the taxpayer can identify a subset of elements that allows them to interact with third parties or allows third parties to initiate functions or review data on the taxpayer’s system. If the taxpayer can identify a subset of the software relating to third parties, that subset will not be considered to have been developed for internal use.

For the rest of the dual-function software, the final regulations provide a safe harbor that allows a taxpayer to include 25 percent of the qualified research expenditures in computing the amount of the credit, so long as the taxpayer’s research activities are qualified research and the use of the dual-function software by third parties could constitute at least 10 percent of its use.

DETERMINING IUS STATUS

The final regulations also clarify that the taxpayer must determine whether software is developed primarily for internal use at the beginning of the software development process. The same timing rule also applies to dual-function software. However, the regulations do not provide guidance as to when the development actually begins.

Overall, these changes are positive and will open up the door for even more companies to take advantage of the R&D Credit. Taxpayers should consult with R&D Tax Credit experts to evaluate whether they could qualify for R&D Tax Credits for their software development activities.

[1] These final regulations are prospective only and will apply to taxable years beginning on or after Oct. 4, 2016.

[2] Examples of financial management functions include: accounts payable, inventory management and budgeting functions.

[3] An example of support service functions would be data processing.

[4] Per the IRS regulations, “innovative” is defined as software that would result in a measurable improvement that is substantial and economically significant if the development is or would have been successful.

[5] Per the IRS regulations, “commercially available for use” is defined as software that cannot be purchased, leased or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.

Does your company qualify for an R&D Tax Credit? Contact Carli McDonald, director of R&D Tax Credit services, at 770-353-2772 or carli.mcdonald@aprio.com to find out.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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