IRS Proposed Regulations for Software R&D Tax Credit

Posted by Jeffrey M. Feingold on 02.06.15

The IRS proposed regulations on Jan. 16, 2015 that will offer many taxpayers new opportunities to claim research and development (R&D) tax credits for software that previously would have been excluded under the internal use software rules. The new rules are generally taxpayer-favorable, and some of the most important changes propose to do the following:

  • Narrow the definition of internal use software to include only specific administrative functions
  • Create an exception for software that enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system
  • Provide a safe harbor carving out non-internal use portions of dual use software
  • Clarify the exception for software that meets a high standard of innovation

The regulations are proposed to be effective for tax years ending on or after the date the regulations are made final, but the IRS will not challenge positions consistent with the proposed regulations for tax years ending on or after Jan. 20. This means many taxpayers can already begin relying on the rules for the 2015 tax year. The R&D credit expired at the end of 2014 but is expected to be retroactively reinstated for 2015.

Background

Generally, Section 41 bars any R&D tax credit for software developed primarily for internal use. However, neither the code nor current final regulations define software that is developed “primarily for internal use” or clarify when internal use software can still qualify for the credit.

Defining internal use

The new proposed regulations narrow the definition of internal use software to software “developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.”

Software used by third parties

The regulations retain the rule providing that software is not considered developed primarily for internal use if it is developed to be commercially sold, leased, licensed or otherwise marketed to third parties, or if it is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. However, the definition of “third party” is restricted, excluding certain related parties and parties that use the software to support the general and administrative functions of the taxpayer. This rule eliminates the “computer services” and “noncomputer services” provisions in prior regulations and is helpful to taxpayers that develop software that is not sold but that allows customers or other third parties to interact with the taxpayer’s software, such as the following:

  • Executing banking transactions
  • Tracking the progress of a delivery
  • Searching a taxpayer’s inventory
  • Storing and retrieving a third party’s digital files
  • Purchasing tickets for transportation or entertainment
  • Receiving services over the Internet

Importantly, if software is not developed to be commercially sold, leased, licensed or otherwise marketed for separately stated consideration, it is not automatically presumed to be internal use software.

Dual function software

The new regulations do presume that software is developed “primarily” for internal use if a taxpayer develops software that serves both general and administrative and non-general and administrative functions. However, a taxpayer can segregate a portion of its dual use software by identifying a subset of elements that only enables the taxpayer to interact with third parties or to allow third parties to initiate functions or review data. If a taxpayer cannot identify the third-party function subset, a safe harbor provision allows for 25% of the dual function software to qualify if at least 10% of the dual function software is for third-party use. Additional exceptions The proposed regulations retain additional exceptions found in prior guidance that allow taxpayers to potentially include certain types of software development in their R&D tax credit claims. Specifically, the rules stipulate that the following types of software are not excluded:

  • Software developed for use in an activity that constitutes qualified research
  • Software developed for use in a production process
  • Computer software and hardware developed as a single product

Next steps

The IRS said it will not challenge taxpayers who rely on the proposed regulations for tax years ending on or after Jan. 20. Calendar-year taxpayers can begin relying on them for the 2015 tax year. Although the credit is currently expired for costs incurred after 2014, it is expected to be reinstated, and taxpayers should begin identifying opportunities to use the favorable rules. Fiscal year taxpayers with tax years ending after Jan. 20 may have costs from 2014 that are immediately eligible and should explore these opportunities before filing their returns.


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