New Definition of Internal Use Software May Expand Opportunity for R&D Credit
The R&D credit is available to certain persons that conduct “qualified research.” Internal use software is excluded from “qualified research activities,” but there has been confusion as to what is considered “internal use”.
To address this confusion, the Proposed Regulation would provide that software is for “internal use software” if the software is developed by the taxpayer for use in general and administrative functions that solely facilitate or support the conduct of the taxpayer’s trade or business. General and administrative functions would be limited to financial management functions, human resource management functions, and support services functions.
The distinction is that software WOULD NOT be for internal use (thus making the R&D credit available) if either: (a) it is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or (b) it is 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 developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data would 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.
Software that serves the dual-function of providing both general and administrative functions, as well as third party interactions, will qualify to the extent the software is used for third party interactions. If the taxpayer is unable to allocate research expenses to the portion of the software that deals with third party interactions, then it may still take 25% of qualified research costs as long as it can prove that third parties will account for 10% of the software’s use.
The Proposed Regulation would also incorporate a “high threshold of innovation” test, which provides that internal use software can nevertheless be qualified research if: (1) it is innovative; (2) the software development involves significant economic risk; and (3) the software is not commercially available for use by the taxpayer (see the regulation for expanded definitions).
Where appropriate, discuss the potential expanded use of the R&D credit with your clients, and reach out to Withum’s National Tax Services Group at [email protected] with any further questions you may have.
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CJ Stroh, Esq. 609.520.1188 [email protected]
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