IRS Weighs In on the Tax Treatment of Computer Costs

Recently, the Office of the Chief Counsel issued Chief Counsel Advice (CCA) 201549024, which reaffirms the principles and conclusions of Letter Ruling 200236028. Letter Ruling 200236028 addresses the income tax consequences of the purchase, development, and implementation of a customized computer software database.

According to the Chief Counsel’s statement in the CCA, some taxpayers have been under the misconception that Letter Ruling 200236028 no longer applied to the treatment of computer software costs after the IRS promulgated Regs. Sec. 1.263(a)-4 in 2004. Regs. Sec. 1.263(a)-4 governs the tax treatment of amounts paid to acquire or create intangible assets.

Since the IRS issued the regulation in proposed form in December 2002 and finalized it in January 2004 after issuing Letter Ruling 200236028 in June 2002, taxpayers apparently have been under the impression that the tax treatment of computer software costs was changed. The Chief Counsel clears up this misconception, stating, “Section 1.263(a)-4 did not render PLR 200236028 obsolete.” CCA 201549024 distinguishes between the regulation and the letter ruling.

Letter Ruling 200236028

In Letter Ruling 200236028, the IRS addressed the tax effects of a taxpayer’s purchase, development, and implementation of enterprise resource planning (ERP) computer software and the purchase of computer hardware from a vendor. ERP software integrates the different business functions, including financial accounting, sales and distribution, materials management, and production planning into one system. The taxpayer also entered into a contract with the vendor in which the vendor would provide consulting services for further software development and employee training. Finally, the taxpayer entered into a contract with another vendor to act as a project manager to implement and design any additional modifications to the software. All these contracts provided no guarantees or warranties. Also, the taxpayer was required to pay the consultants regardless of the success or failure of the implementation of the software, and the taxpayer was responsible for all costs.

Implementation of this software involved various costs: (1) costs to acquire the software, (2) costs to train employees to use the software, (3) costs of the computer hardware, (4) software development costs, as well as costs to install and configure the software to the taxpayer’s needs, and (5) consulting costs for further modifications to the software.

The IRS came to the following conclusions on the tax treatment of the computer costs: (1) the cost of the purchased software (including sales tax) should be capitalized under Sec. 263(a) and depreciated over 36 months under Sec. 167(f); (2) the employee training and other associated costs were currently deductible under Sec. 162; (3) the computer hardware should be capitalized under Sec. 263(a) and depreciated under Sec. 168 over a five-year period; (4) the software development costs were currently deductible under Sec. 162 in accordance with the rules similar to those that apply under Sec. 174 as research and experimentation costs; and (5) the consulting costs associated with additional modifications and implementation of the software should be capitalized with the cost of purchasing the software depreciated over 36 months.

Rev. Proc. 2000-50

The IRS issued Rev. Proc. 2000-50 almost two years before Letter Ruling 200236028. Rev. Proc. 2000-50 defines computer software as any program or routine that causes a computer to perform a desired function or set of functions. For the costs of developing computer software, Rev. Proc. 2000-50 provides that a taxpayer can treat software development costs as a current expense and deduct them in full in accordance with the rules under Sec. 174(a), which permit current deductions of research and experimental expenditures paid or incurred during the tax year in a trade or business. Otherwise, the taxpayer can elect under Sec. 174(b) to capitalize the costs and amortize them over 36 months beginning with the month the software was placed in service (Rev. Proc. 2000-50, §5.01).

However, Rev. Proc. 2000-50 provides that under Sec. 168 a taxpayer must capitalize and depreciate over five years the cost of acquired software, if the cost is not separately stated from the cost of the computer hardware. If it is separately stated from the cost of the computer hardware, it should be capitalized as an intangible asset and amortized over 36 months under Sec. 167(f) (Rev. Proc. 2000-50, §6.01).

Regulations

Shortly after Letter Ruling 200236028 was released, the IRS issued proposed regulations on the application of Sec. 263(a) to amounts paid to acquire, create, or enhance intangible assets (REG-125638-01). However, these proposed regulations did not specifically address the acquisition, development, modification, or implementation of ERP software. In other words, the proposed regulations did not address the issues for which the taxpayer requested rulings in Letter Ruling 200236028. Instead, the preamble to the proposed regulations suggested that the final regulations would address these computer software costs.

At the end of December 2003, the IRS issued the final regulations on the treatment of intangible assets; however, despite the indication to the contrary in the preamble to the proposed regulations, these final regulations also did not contain guidance on the specific treatment for the costs associated with the development and implementation of the ERP software. To explain the absence, Treasury stated in the preamble to the final regulations that the issues of the tax treatment of the development and implementation of ERP software could best be addressed in separate guidance and not in the final regulations (T.D. 9107).

The preamble further provided that, while the final intangible regulations require a taxpayer to capitalize an amount paid to another party to acquire computer software from that party in a purchase or similar transaction, nothing in the final regulations was intended to determine whether computer software is in fact acquired from another party in a purchase or similar transaction or whether the computer software is developed or otherwise self-created (including amounts paid to implement ERP software).The preamble finally stipulates that until separate guidance is provided, taxpayers may continue to rely of Rev. Proc. 2000-50.

CCA 201549024

Because of the IRS’s reliance on Rev. Proc.2000-50 to determine the tax treatment of computer software and its failure to mention the letter ruling in either preamble, the Chief Counsel stated in CCA 201549024, “Some taxpayers are taking the position that Rev. Proc. 2000-50 allows the deduction of all software costs. We disagree.” If all software costs are currently deductible, then Letter Ruling 200236028 would be obsolete.

However, the Chief Counsel still takes the position that the costs associated with the acquisition or purchase of computer software (whether or not separately stated from computer hardware) or any modifications to computer software must still be capitalized under Sec. 263(a) and are not currently deductible under Sec. 162. In other words, the Chief Counsel is reaffirming the principles and conclusions provided in Letter Ruling 200236028.

Richard Ray is an assistant professor in the College of Business at California State University in Chico, Calif.