On October 4, 2016, the Internal Revenue Service issued final regulations which provide guidance on the qualification of internal use software (“IUS”) for purposes of the Section 41 Credit for Increasing Research Activities. The final regulations (TD 9786) address many of the comments received regarding the proposed regulations that were released in January of 2015. The following is a summary of the final regulations:

  • Definition of Internal Use Software: Software that is developed by or for the taxpayer primarily for use in general and administrative (G&A) functions that facilitate or support the conduct of the taxpayer’s trade or business. G&A functions are limited to financial management functions, human resource management functions and support services.

KBKG Insight: The final regulations provide a narrower definition of internal use software when compared to previous guidance.


  • Whether software is deemed IUS or non-IUS depends on the intent of the taxpayer and the facts and circumstances at the beginning of the development.
  • The definition of software that is not for internal use is software that is developed to be commercially sold, leased, licensed or otherwise marketed to third parties. Software that is developed with the intention of allowing taxpayers to interact with third parties or that allow third parties to initiate functions or review data on a taxpayer’s systems is also not considered developed for internal use.
  • Connectivity software (also referred to as bridging software, integration software, or middleware) allows multiple processes running on one or more machines to interact across a network. This software should be specifically identified or categorized differently from other types of software. Whether it is considered IUS depends on the function the software provides rather than on the type of software.
  • Dual function software is G&A software that also allows interaction with third parties. This designation allows the taxpayer to identify a subset of the software development that allows interaction with a third party, even though it was intended for use in G&A functions.
    • SAFE HARBOR – A taxpayer may include 25% of the qualified research expenses of the dual function software in computing the amount of the taxpayer’s credit IF the activities constitute qualified research AND the use of the dual function software by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10% of the dual function software’s use.
    • “Third party” means any corporation, trade or business, or other person that is not treated as a single taxpayer with the taxpayer pursuant to section 41(f). Third parties do not include persons that use the software to support the taxpayer’s G&A functions (e.g., the taxpayer’s own vendors).
  • IUS still qualifies for the research credit if, in addition to the 4-Part Test, it meets the following High Threshold of Innovation test:
    • Software is innovative. If the development is or would have been successful, the result would have been a substantial and economically significant reduction in cost or improvement in other performance metrics.
    • Involved significant economic risk. If the taxpayer commits substantial resources to the development and, due to the technical risk, there is substantial uncertainty whether resources would be recovered within a reasonable period. Note that “substantial uncertainty relates to the capability or methodology of achieving the intended result.
    • Software is not commercially available. Taxpayer cannot purchase, lease or license purchased software without substantial modification and expense.
  • The final regulations are prospective and apply to taxable years beginning on or after 10/04/2016. The IRS will not challenge return positions that are consistent with the final regulations for any taxable year that ends on or after January 20, 2015 (the date on which the proposed regulations were issued).

Author: Michael Maroney | Contributing Author: Kevin Zolriasatain

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