On October 3, 2016, the IRS released final regulations (TD 9786) clarifying the rules regarding the treatment of research related to internal-use software (IUS) for purposes of the research credit under Section 41. The final regulations offer guidance to resolve controversy between the IRS and taxpayers related to internal-use software. The final regulations related to computer software for purposes of the research credit represent a more taxpayer-favorable interpretation than was set forth in previous regulations.
Under the final regulations, software is developed by (or for the benefit of) the taxpayer primarily for internal use if the software 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. “General and administrative functions” is limited for this purpose to financial management functions (including supporting recordkeeping), human resource management functions and support services functions (e.g. data processing or facilities services).
The change in the definition of software not developed primarily for internal use means that taxpayers do not have to affirmatively prove that the software is either “developed to be commercially sold, leased, licensed, otherwise marketed to third parties, or 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 taxpayer must only show that the software is not developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. If the software is not developed by the taxpayer for use in general and administrative functions, it is not internal-use software.
The final regulations provide rules of application implementing the three-part “high threshold of innovation” test. While Part I (innovation) and Part III (commercially available for use) remain unchanged, Part II (significant economic risk) has been clarified. Part II is now more taxpayer-favorable than what was described previously in the proposed regulations. In short, the technical uncertainties that must be shown to satisfy the significant economic risk under the final regulations now include design uncertainty. This important aspect was excluded under the proposed regulations.
Among other areas where guidance was provided:
- Dual-function computer software – Provides rules including a safe harbor
- IUS development is still eligible if the “high threshold of innovation” test is met
- Certain third-party facing software is not subject to the higher threshold (only four-part test is required)
- In addition, several examples to illustrate the application of the regulations for IUS are provided
The final regulations are effective for tax years beginning on or after October 4, 2016. The IRS will not challenge return positions consistent with either the final or proposed regulations for tax years ended on or after January 20, 2015 (publication date of proposed regulations).
