Country / Language

IRS Releases Final Research Credit Regulations Regarding Internal Use Software


10/17/16
 
On October 4, 2016, the IRS issued final regulations (TD 9786) concerning the research credit under section 41 and its application to internal use software (“IUS”). The regulations adopt and finalize, with minor modifications, proposed regulations that were issued on January 20, 2015.
 
Internal Use Software
 
Internal Use Software is software developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. The final regulations define “general and administrative functions” as involving: (1) financial and management functions; (2) human resource management functions; and (3) support services functions. Financial management functions are functions that involve the financial management of the taxpayer and the supporting recordkeeping. Human resource management functions are functions that manage the taxpayer’s workforce. Support services functions are functions that support the day-to-day operations of the taxpayer, such as data processing or facilities services.
 
Generally, IUS does not qualify towards the research credit. However, the final regulations provide an exception to the general rule if the internal use software meets the ‘high threshold of innovation’ test. The final regulations clarify that software is not developed primarily for a taxpayer’s internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.
 
Determining whether a software project is internal use depends on the taxpayer’s intent and the facts and circumstances at the beginning of the software development activities. Changes in a taxpayer’s intent or purpose of the software can trigger different tax treatment with respect to the research credit. Oftentimes, a taxpayer initiates a software development project with one purpose in mind and later discovers that other purposes should be considered and pursued. Certain aspects of the software could be deemed internal use while other functionality may not. The final regulations continue to provide a special rule for improvements to software that can be separately identified.
 
Dual-Function Software 
 
The final regulations provide that software developed by the taxpayer both for general and administrative functions and third party interactions (dual-function software) is presumed to be developed primarily for internal use. Dual-function software must overcome a presumption that it was developed for internal use and, therefore, does not qualify for the research credit. However, a taxpayer does not have to overcome the presumption if the taxpayer can identify a subset of elements of dual function software that enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data on the taxpayer’s system (third party subset). If a third party subset is identified, the dual function software will be eligible for the research credit provided all other requirements are met.
 
High-Threshold of Innovation Test 
 
In order to qualify for the research credit, software that is deemed IUS must satisfy the high threshold of innovation test. Pursuant to this test, the software must: (1) be innovative; (2) involve significant economic risk; and (3) not be commercially available for use by the taxpayer.
 
The final regulations state that software is innovative if it would result in a reduction in cost or improvement in speed or other measurable improvement, which is substantial and economically significant, if the development is or would have been successful.
 
The economic risk test is satisfied if the taxpayer commits substantial resources to the development and there is substantial uncertainly, because of technical risk, where such resources are expected to be recovered within a reasonable period.
 
For the economic risk test, the proposed regulations provided that substantial uncertainty existed if information available could not establish the capability or methodology for developing or improving the software. The final regulations reinstate design uncertainty, as commentators requested, providing a broader definition of uncertainty.
 
The commercially available test is met if the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.
 
The final regulations clarify that the high threshold of innovation test only applies to internal use and dual-function software.
 
Effective Date 
 
The regulations are effective for tax years beginning on or after October 4, 2016. It should be noted that the IRS will not challenge return positions consistent with the proposed regulations for tax years ending on or after January 20, 2015 (proposed regulations publication date).
 
For tax years ending before January 20, 2015, taxpayers may choose to follow either all of IUS provisions of Treas. Reg. Sec. 1.41-4(c)(6) in the final regulations published on January 3, 2001 (TD 8930) or all of the IUS provisions of Treas. Reg. Sec. 1.41-4(c)(6) contained in the proposed regulations published on December 26, 2001 (REG-112991-01).
 
What Does CohnReznick Think? 
 
While commentators requested a myriad of changes to the proposed rules, the IRS made very few modifications. The final regulations provide clarity and guidance to taxpayers seeking to claim the research credit for their software development. Taxpayers can now more easily claim the R&D credit for developing software that interacts with their clients and the final regulations make clear that these taxpayers are not subject to the heightened qualification standards of internal use software.
 
Contact 
 
For more information, please contact Scott Hamilton, Partner, at scott.hamilton@cohnreznick.com or 310-843-8226.
 
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. 
 
Search Our People

Search Our People

Look ahead. Gain insight. Imagine more. Is your business ready to break through?

View our new TV commercial..

Industry Outlooks

Industry Outlooks

Gain insight into what is ahead for the Commercial Real Estate, Technology and Middle Market Private Equity industries.

READ MORE

Learn about our upcoming events.

READ MORE

Working With Us

Working With Us

What makes CohnReznick different from others in our profession? And what should our clients come to expect when working with us? The answer is The CohnReznick Advantage. Contact us to learn how we can out the CohnReznick Advantage to work for your business.


People

The value of an organization is determined by the skills and qualities of its leaders. With more than 280 partners serving clients nationwide, CohnReznick is renowned for the diverse experiences, knowledge and backgrounds of its leadership.

Learn More

Services

We align our services in three segments: Accounting and Assurance, Tax, and Advisory. This approach allows us to provide holistic solutions to complex business problems and to seize upon opportunities requiring an integrated approach.

Learn More

Industries

Accounting and tax issues different significantly based on an organization's industry. We provide clients with expertise in nearly two dozen industries – we know the opportunities, the obstacles, the competitive landscape.

Learn more

Insights

CohnReznick professionals are thought leaders in their industries. Clients benefit from relevant and timely economic, legislative and industry insights that can keep them a step ahead of competition.

Learn More

Global Reach

Our involvement in the Nexia International network of firms enables us assist our clients wherever they do business-providing local expertise and connections wherever they needed. Nexia is comprised of 20,000 professionals operating in over 100 countries.

Learn More