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IRS Issues Proposed Regulations that Clearly Define Internal Use Software for the Application of Research Credit


2/6/15

Synopsis

On January 16, 2015, the Internal Revenue Service (IRS) issued proposed regulations regarding the application of the Research and Development (R&D) tax credit to computer software that is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer.

Issue

Prior to the issuance of these regulations, the definition of what was considered Internal-Use-Software (IUS) was somewhat cloudy. The significance is IUS is subject to a high threshold of innovation test for purposes of the R & D credit, which makes research costs related to IUS more difficult to qualify for the credit.

Proposed Regulations
The proposed regulations provide a definition of software developed for internal use and also describe software that is not developed primarily for internal use. In addition, the proposed regulations also explain that certain IUS is eligible for the R&D tax credit if the software satisfies the high threshold of innovation test. Under the proposed regulations, IUS is defined as software developed by (or for the benefit of) the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business, and this includes software the taxpayer develops primarily for a related party’s internal use.

Further, the regulations provide IUS does not include: (1) software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or (2) 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.

Examples of software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data include software developed for third parties to:

  • 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;
  • Purchase tickets for transportation or entertainment; and
  • Receive services over the internet.
     

The regulations provide rules for dual function software (internal and non-internal use), including a safe harbor for determining which expenditures incurred in the development of the dual function software qualify for the R&D credit.

The proposed regulations, once finalized, would be prospective only. The rules are proposed to apply to tax years ending on or after the date of publication of the Treasury decision adopting them as final regulations in the Federal Register. Notwithstanding the prospective effective date, the IRS will not challenge return positions consistent with the proposed regs for tax years ending on or after January 20, 2015.

What Does CohnReznick Think?
By providing specific definitions for software developed primarily for internal use, and software primarily developed that is not IUS, the R&D credit should be expanded to more taxpayers. Many taxpayers believed the costs that were incurred to develop software, previous to the issuance of these regulations, had to meet the requirements of the high innovative threshold test to claim the R&D credit.

Contact

For more information, please contact Doug Finkle, a CohnReznick senior manager at doug.finkle@cohnreznick.com or 973-364-7832, or visit the following CohnReznick webpages to learn more about our:

Tax Specialty Services
Manufacturing and Wholesale Distribution Industry Practice
Technology and Life Sciences Industry Practice


Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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