On Oct. 4, 2016, the IRS released final regulations that provide guidance on claiming a federal research tax credit for software that is developed by a taxpayer primarily for its own internal use (internal use software).
Research and development costs for new or improved internal use software can qualify for the federal research tax credit. However, to qualify for the research credit, internal use software not developed for use in an activity or production process that constitutes qualified research must meet a high threshold of innovation test established within IRS regulations. Therefore, the internal use software distinction is an important classification since the high threshold of innovation test makes it more difficult for internal use software to qualify for the research credit as compared to noninternal use software.
Before issuing the new regulations, the IRS tended to view internal use software broadly, leading to controversies between taxpayers and the IRS about whether a specific software development project should be subject to the high threshold of innovation test. For example, assume a bank develops new software to internally track customer accounts. As part of the development effort, the bank also develops a subset of the software allowing customers additional options to access and transact with the bank through a mobile phone application. Prior to the new regulations, the IRS would have argued that the entire software development project was internal use subject to the high threshold of innovation test, minimizing or eliminating any possible research tax credit. Under the new regulations, the mobile phone application is not considered internal use.
The final regulations narrow the definition of internal use to software developed for use in general and administrative functions that facilitate or support the conduct of a taxpayer’s trade or business. This limits the internal use distinction to software used for financial management, human resource management, and support services functions. Software developed to support functions outside of these areas is not considered internal use. The regulations clarify that software is not considered internal use if it is developed to be commercially sold, leased or licensed, or otherwise marketed to third parties, or is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on a taxpayer’s system. Software is determined to be internal use based on the taxpayer’s intent and the facts and circumstances at the beginning of software development.
The final regulations also provide guidance for applying the research credit to dual-function software (software developed both for internal use and to enable third-party interaction). Dual-function software is presumed to be internal use software under the final regulations.
- If a taxpayer can identify a subset of the dual-function software that enables only third-party interaction, any development costs related to the third-party subset will be considered noninternal use software.
- If dual-function elements of the software still exist after the third-party subset rules are applied and at least 10 percent of the remaining dual-function software will be used for third-party interaction, the taxpayer may elect to treat 25 percent of the qualified research expenses associated with the dual-function software as noninternal use. This election is useful when there is third-party functionality developed as part of an internal use software project, but it may be difficult to clearly split out costs supporting a specific activity.
The regulations also clarify that the high threshold of innovation test applies only to internal use and dual-function software. Furthermore, the high threshold of innovation test is modified such that qualifying software must do all of the following:
- Be innovative in that the new or improved software would result in a reduction in cost, improvement in speed, or other measurable improvement that is substantial and economically significant
- Involve significant economic risk, have substantial resources committed to its development, and present substantial uncertainty that the resources will be recovered within a reasonable period because of technical risk
- Not currently be available commercially for use by the taxpayer
The final regulations are effective for tax years beginning on or after Oct. 4, 2016, but the IRS will not challenge return positions consistent with the final regulations for tax years ending on or after Jan. 20, 2015, and beginning before the effective date of the final regulations. The IRS has made it clear that the final regulations are not effective retroactively to earlier tax years. Therefore, software considered internal use under the final regulations may or may not have been considered internal use under prior law.