For more than 30 years, the federal research and experimentation tax credit has provided a significant benefit to many U.S. companies that have invested in domestic research and development. Through 2013, manufacturers saw the most benefit, with their annual research credit claims totaling more than 60 percent of all such claims filed. Financial services and insurance companies also benefit from the research credit, but their total claims represent less than 2 percent of all research credit claims.1
This discrepancy might have made sense historically, but in recent years most financial services companies have made significant investments in internet-based and mobile technology. Although such investments might have produced creditable research, a lack of clear IRS guidance on the qualification of software development costs led many financial services companies to forego research credit claims.
The IRS finalized the internal use software regulations on Oct. 4, 2016, providing taxpayers with a clearer view of which software development costs qualify for the federal research tax credit. The final internal use software regulations are taxpayer-favorable and provide an excellent opportunity for financial services companies to take a fresh look at their software development activities for credit eligibility.
Definitions and Requirements
The federal research and experimentation tax credit can be taken dollar-for-dollar against a taxpayer’s federal income tax.2 Currently, two methods for computing the credit exist: the regular method and the alternative simplified credit (ASC). The regular method provides a cash benefit of up to 13 percent of a business’s qualifying research expenses (QREs) that exceed a base amount (most often dated back to the 1984-1988 tax years). The ASC is equal to approximately 9 percent of a taxpayer’s QREs that exceed one-half of the average of the prior three years’ QREs.
The most time-consuming and contested aspect of calculating the research credit generally is identifying current-year QREs. QREs can include wage and supplies expenses, as well as 65 percent of contract research expenses provided the taxpayer retains the risks and rights to the research. The law requires QREs to meet all the criteria of a four-part test. QREs must:
- Be undertaken to eliminate a technological uncertainty, including the capability, method, or best design for developing a product or process
- Rely on principles of physical or biological science, engineering, or computer science
- Involve a process of experimentation designed to overcome or resolve a technical challenge
- Result in a new or improved business component
The research credit cannot be claimed for certain excluded activities, including:
- Research conducted after the beginning of commercial production
- Research conducted to adapt existing business components to a particular customer need
- Reverse engineering
- Routine management activities, including marketing studies and studies related to the social sciences
- Ordinary testing for quality control
- Foreign research
- Funded research
- The development of internal use software, except as permitted by regulations
Of these excluded categories, the internal use software exclusion historically has been the source of the most controversy for financial services companies.
Internal and Noninternal Use Software
For purposes of the research credit, software is divided into two types: internal use and noninternal use. The internal use distinction is very important for research credit purposes because internal use software is held to a higher-threshold-of-innovation standard than noninternal use software. In addition to meeting the general four-part test, internal use software must: 1) result in a cost reduction or measurable improvements, 2) be developed at a significant economic risk to the taxpayer, and 3) not be commercially available. These additional tests for internal use software often limit the number of software development projects that qualify for the federal research and experimentation tax credit.
Under prior guidance, software was considered noninternal use if it was developed for commercial sale, lease, or license to third parties; developed for use in a qualified research activity; developed for use in a qualified production process; developed for use in providing computer services to customers; or developed as part of a new or improved package of computer software and hardware. Unfortunately, relatively few software development projects in the field of financial services fell into one of these categories, which meant that most of those projects had to meet the high-threshold-of-innovation standard to qualify for the credit.
The final regulations limit the internal use distinction to software developed for a taxpayer’s general and administrative functions. Therefore, only software developed primarily for use in a taxpayer’s financial management, human resource management, or support service functions is considered internal use. The regulations also clarify that software is not considered internal use if it 1) is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties or 2) enables a taxpayer to interact with third parties or allow third parties to initiate functions or review data on a taxpayer’s systems.
The new taxpayer-favorable definition of internal use software will make it easier for the software development activities of financial services companies to qualify for the research credit. Examples of potentially credit-eligible software development activities include a financial services company developing a smartphone or web application for customers to initiate banking transactions or an insurance company developing an online system for customers to initiate and track claims.
In light of the new regulations, financial services companies should assess whether their software development activities meet the qualified research criteria so they may benefit from the research and experimentation tax credit.
2 Eligible small businesses may be entitled to a credit against payroll taxes or alternative minimum tax.