Treasury and IRS Issue Final Regulations for Internal Use Software

On October 3, 2016, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final regulations providing guidance on internal use software (IUS) for purposes of claiming the section 41 research credit (T.D. 9786). These regulations are substantially the same as the proposed regulations issued almost two years ago. Because the regulations are largely similar, this alert focuses on what changed from the proposed regulations to the final regulations and highlights some of the key components of the new rules.

Background

Section 41 of the Internal Revenue Code of 1986 allows a credit for certain qualified research expenditures. Section 41(d)(4)(E) generally excludes research related to IUS except (i) when the IUS is for use in an activity that itself constitutes qualified research, (ii) when it is for an otherwise qualifying production process or (iii) to the extent provided by regulation.

After proposing and then withdrawing several sets of regulations to implement section 41(d)(4)(E), Treasury and the IRS issued proposed regulations (REG-153656-03) in January, 2015. The proposed regulations were aimed at providing a narrow, workable definition of IUS and offering guidance for when that software satisfies the high threshold of innovation required in order for IUS to qualify for the credit.

Overall, the proposed regulations were lauded by tax practitioners as a common-sense approach to IUS and section 41. It is, therefore, not surprising that the regulations were finalized in substantially similar form.

The Highlights of the Regulations

Definition of Internal Use Software. The final regulations adopt the proposed regulations’ definition of IUS as software primarily “developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.”¹ “General and administrative functions” include: (1) financial management and supporting recordkeeping, such as accounts payable and receivable, inventory management and budgeting; (2) human resource management; and (3) support services that support the taxpayer’s day-to-day operations.² These are often colloquially referred to as “back-office” functions. 

The final regulations also adopt, with some clarifications, the proposed regulations’ definition of software not developed primarily for internal use as software that is “not developed for use in general and administrative functions that support the conduct of the taxpayer’s trade or business.” Examples of this software include software that is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties, and software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data.³ 

High Threshold of Innovation Test. Certain IUS may nevertheless be eligible for the credit if, among other things, the software satisfies the three elements of the high threshold of innovation test: (1) the software is innovative in that would result in a measurable improvement that is substantial and economically significant if the development is or would have been successful; (2) the development involves significant economic risk and there is substantial uncertainty due to technical risk; and (3) the software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.⁴ As to the economic risk element, a taxpayer does not have to delineate the specific technical uncertainty it faced. The final regulations also no longer require that the uncertainty relate to uncertainty about capability or methodology; design uncertainty now may factor into the analysis.⁵ Treasury and the IRS cautioned, however, that design uncertainty alone, without any capability or methodology uncertainty, will “rarely” be sufficient.⁶ 

Dual Function Software. For software that serves both internal and external uses, so-called dual function software, the final regulations presume that such software is developed primarily for a taxpayer’s internal use.⁷ This presumption does not apply with respect to the portion of the software for which the taxpayer can identify a subset of elements that enable the taxpayer to interact with third parties or allow third parties to initiate functions or review data on the taxpayer’s system.⁸ With respect to the rest of the dual function software, the regulations provide a safe harbor that allows a taxpayer to include 25 percent of the qualified research expenditures of the dual function software (or dual function subset) in computing the amount of the taxpayer’s credit so long as the research constitutes qualified research and the use of the dual function software (or subset) by third parties is reasonably anticipated to constitute at least 10 percent of its use.⁹ Any objective, reasonable method within the taxpayer’s industry may be used to determine what constitutes reasonably anticipated use.¹⁰ 

Eligibility for the Credit Is Determined at the Beginning of the Development Process

The final regulations make clear that whether software is developed primarily for internal use depends on the intent of the taxpayer and the facts and circumstances as they exist at the beginning of the software development process.¹¹ In finalizing this rule, Treasury and the IRS rejected commentators’ arguments that pushed for a different timing rule, either to take into account a change in the software’s intended use or to ease the taxpayer’s burden of demonstrating the software’s intended use early in the development process. Treasury and the IRS reasoned that the timing rule comports with the purpose of the section 41 credit by encouraging private research and is easy to administer.¹² 

The same timing rule applies to the application of the dual function safe harbor.¹³ In order for a taxpayer to take advantage of the safe harbor, it must estimate the percentage of third party use at the beginning of the software development process.14 Relying again on the purpose of the section 41 credit as an incentive to conduct future qualifying research and not as “an unanticipated reward for doing so,” Treasury and the IRS rejected a number of comments that argued that the safe harbor’s timing rule was unworkable, should be removed altogether and imposed an undue burden on the taxpayers.¹⁵ 

With the timing rules now in final form, it is more important than ever that a taxpayer consider and document the anticipated uses of the software at the beginning of the software development project. This is particularly so for any software that may be dual function software, because the presumption that it is primarily for internal use will apply unless a taxpayer can demonstrate otherwise. If one begins a software development project only later to realize that it may either be dual function or the project transitions to software that is not primarily for internal use, the research credit may no longer be available.

The regulations leave open the question of what constitutes the beginning of development, creating an ambiguity and potential pitfalls for taxpayers. There is nothing in the Preamble or the regulations that sheds light on what the IRS views as the development process, or what constitutes the beginning of it. Hopefully, further guidance will illuminate this, but it is important that taxpayers recognize that, absent such guidance, there is some risk that the IRS could take the position that the taxpayer did not have the necessary intent at the proper time. This is particularly so if the purpose of the project changes over time.

The New Rules Do Not Apply Retroactively

Finally, the final regulations are prospective only.¹⁶ The final regulations will apply to taxable years beginning on or after October 4, 2016.¹⁷ For tax years ending on or after January 20, 2015, and beginning before October 4, 2016, the IRS will not challenge any return that is consistent with the proposed regulations or these final regulations.¹⁸ For taxable years ending prior to January 20, 2015, the IRS will allow taxpayers to choose to follow either the final regulations published on January 3, 2001 (T.D. 8930) or the proposed regulations published on December 26, 2001 (REG-112991-01).¹⁹ 

¹ Treas. Reg. § 1.41-4(c)(6)(iii)(A).
² Treas. Reg. § 1.41-4(c)(6)(iii)(B).
³ Treas. Reg. § 1.41-4(c)(6)(iv).
⁴ Treas. Reg. §§ 1.41-4(c)(6)(i)(C); (c)(6)(vii).
⁵ See Treas. Reg. § 1.41-4(c)(6)(vii)(C); Preamble to Final Regulations, 4830-01-P, at *22-23 (Oct. 3, 2016) (“Preamble”).
⁶ Preamble, at *22-23.
⁷ Treas. Reg. § 1.41-4(c)(6)(vi)(A).
⁸ Treas. Reg. § 1.41-4(c)(6)(vi)(B).
⁹ Treas. Reg. § 1.41-4(c)(6)(vi)(C).
¹⁰ Id.
¹¹ Treas. Reg. § 1.41-4(c)(6)(v).
¹² Preamble, at *11–12. 
¹³ Treas. Reg. § 1.41-4(c)(6)(vi)(D).
¹⁴ Id.
¹⁵ Preamble, at *18-19.
¹⁶ Treas. Reg. § 1.41-4(e).
¹⁷ Id.
¹⁸ Id.
¹⁹ Id.