On Friday, January 16, 2015, the Department of Treasury issued proposed regulations regarding the applicability and inclusion of Internal-Use Software as part of the IRC Section 41 'Credit for Increasing Research Activities,' providing increased availability of the research and development tax credit for a greater number of entities, particularly small to mid-sized taxpayers.

These proposed regulations provide taxpayers guidance regarding software development and its applicability as a qualifying research expenditure. Per the regulations, “The objective of these proposed regulations is to provide a narrower exclusion of software from qualified research than provided in prior regulatory guidance.”

The regulations provide a definition of software developed primarily for internal use and describe software not developed primarily for internal use. Internal use 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.” The proposed regulations define general and administrative functions as “…limited to financial management functions, human resource management functions, and support services functions.”

KBKG Insight: The 1986 legislative history limited the definition of internal use software to software developed for general and administrative and back office support software. The 2001 proposed regulations defined internal use software as anything that was not developed to be commercially sold, leased, licensed, or otherwise marketed to third parties. These newest proposed regulations revert back to the original 1986 legislative intent. However, the characterization of a back office function will be dependent on the business a taxpayer is in. For example, if a taxpayer’s business is providing payroll services, the creation of that software is not used as back office support and, therefore, would not be defined as internal use software.

Additionally software that is marketed to unrelated third parties and enables a taxpayer to interact with third parties (or allows third parties to initiate function or review data on the taxpayer’s system) would not meet the definition of internal use software. Examples of software that allows communication with third parties would be software that allows the tracking of the delivery of goods, purchasing tickets for transportation and entertainment and cloud based internet services.

KBKG Observation: The proposed regulations provide two instances where software would not meet the definition of internal use software: 1) the software is or intended to be sold, leased, licensed, or otherwise marketed to third parties, or, 2) the software is developed to enable a taxpayer to interact with third parties or allow third parties to initiate functions or review data on a taxpayer’s system (for example reviewing bank balances or stocks online).

If the development of computer software is internal use software, it is not necessarily eliminated from qualifying for the research credit. However, the software must meet the traditional “Four-Part Test” AND the “high threshold of innovation” test, requiring the internal use software to 1) be innovative, 2) represent significant economic risk to the taxpayer, and 3) not be commercially available.

Author: Kevin Zolriasatain | Contributors: Lou Guerrero, MBT, Lacey J.S. Robb, J.D., LL.M. & Michael Maroney

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