Taxpayers that develop software for their own internal use will be able to claim a credit for research and development expenditures in some cases under final regulations issued by the IRS on Oct. 3 (T.D. 9786). The rules finalize, with some changes, regulations that were proposed in January 2015 (REG-153656-03).
The general rule is that internal-use software—software developed by (or for the benefit of) the taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business—does not qualify for the Sec. 41 research credit. The regulations provide an exception if the software's development meets a high-threshold-of-innovation test.
General and Administrative Functions
The regulations' definition of "general and administrative functions" remains unchanged from the proposed regulations despite some commenters' concerns that the list was overly broad and would encompass some functions that are not "back office" functions. The IRS, however, stuck with its original definition, which encompasses (1) financial management functions (i.e., functions that involve the financial management of the taxpayer and supporting recordkeeping); (2) human resource management functions (i.e., functions that manage the taxpayer's workforce); and (3) support service functions that support the taxpayer's day-to-day operations (such as data processing).
The preamble to the regulations notes that software that is not developed to be used for general administrative functions is not considered to be developed for internal use, even if the software is not developed to be sold, leased, licensed, or otherwise marketed to third parties and is not developed to enable the taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
Software that serves both general and administrative functions and other functions (called dual-function software) must overcome a presumption that it is developed for internal use and thus does not qualify for the credit. The presumption will not apply if the taxpayer "can identify a subset of elements of dual function software that only enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data (third party subset)" (Regs. Sec. 1.41-4(c)(6)(vi)(B)). That third-party subset will not be considered to have been developed primarily for internal use.
The rules provide a safe harbor that applies to dual-function software, if a third-party subset cannot be identified, or to the remaining subset of dual-function computer software after the third-party subset has been identified (dual-function subset). Under the safe harbor, 25% of the taxpayer's qualified research expenditures of the dual-function subset is included in computing the amount of the credit, if the taxpayer's research activities for the dual-function subset are qualified research and the use of the dual-function subset by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10% of the dual-function subset's use. In the final regulations, the safe harbor has been modified to clarify that it can be applied to dual-function software after the application of Regs. Sec. 1.41-4(c)(6)(vi)(B).
To be eligible for the research credit, the internal software's development must meet a three-part high-threshold-of-innovation test. Under this test, the software must (1) be innovative (as defined in the regulations), (2) involve significant economic risk, and (3) not be commercially available for the taxpayer's use. The final regulations clarify that it is not necessary to have a "revolutionary discovery" to qualify for the innovation portion of the test. The IRS also revised the regulations to clarify that the high-threshold-of-innovation test applies only to internal-use and dual-function software.
The final regulations are effective Oct. 4, 2016 (the date they were published in the Federal Register) and apply to tax years beginning on or after that date.