On January 20, 2015, the Treasury Department and the IRS published long- awaited proposed regulations under Code Section 41 (the “2015 Proposed Regulations”) addressing internal use software (“IUS”) as it relates to the credit for increasing research activities (the “research credit”). The 2015 Proposed Regulations follow an advance notice of proposed rulemaking that the Treasury Department and the IRS issued on January 2, 2004, seeking public comments to the proposed regulations on IUS that they published on December 26, 2001 (the “2001 Proposed Regulations”). Taxpayers are eligible for research credit in connection with expenditures for IUS only if taxpayers can establish that, in addition to meeting the general requirements for research credit eligibility, the IUS also meets certain additional requirements. The changes introduced by the 2015 Proposed Regulations are for the most part favorable for taxpayers because they narrow the circumstances in which software will be considered IUS and, in some cases, make it easier for taxpayers to meet the additional research credit eligibility requirements for IUS.
Section 41 provides that the amount of research credit available to a taxpayer is determined in part by the expenses incurred in connection with “qualified research.” Under the 2001 Proposed Regulations, any research with respect to computer software that is developed by (or for the benefit of) a taxpayer primarily for internal use by the taxpayer (i.e., IUS) is excluded from the scope of “qualified research” unless: (i) the IUS meets the general qualified research eligibility requirements under section 41(d)(1); (ii) the IUS is not otherwise excluded under section 41(d)(4) (other than section 41(d)(4)(E)); and (iii) the software meets one of the conditions set forth under Treasury Regulation section 1.41-4(c)(6). These conditions (as set out in the 2001 Proposed Regulations) require that: (i) the IUS be developed for use in an activity which constitutes qualified research; (ii) the IUS be developed for a production process with respect to which the general qualified research eligibility requirements are met; (iii) the software meet a “high threshold of innovation test”; or (iv) the software be developed together with hardware as a single product. The “high threshold of innovation test” of the 2001 Proposed Regulations requires taxpayers to establish that the software is innovative, that the development of the software involves significant economic risk, and that the software is not commercially available for use by the taxpayer.
As noted above, the 2015 Proposed Regulations narrow the definition of IUS. Under the 2001 Proposed Regulations, unless software was developed to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties, software was presumed to be IUS. However, whether software is held for sale may not be indicative of whether software is developed solely for “internal use”. Accordingly, the 2015 Proposed Regulations state that even if software is not developed to be commercially sold,
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21 Tax News and Developments February 2015
leased, licensed, or otherwise marketed to third parties, software is still not IUS 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. Examples of software that is not IUS would therefore now include software developed for third parties to execute banking transactions, track the progress of a delivery of goods, search a taxpayer’s inventory for goods, store and retrieve a third party’s digital files, purchase tickets for transportation or entertainment, or receive services over the Internet. Under the 2015 Proposed Regulations, software would be IUS if the software is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.
The 2015 Proposed Regulations also provide that IUS that enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data (“dual function computer software”) is presumed to be IUS except to the extent that a taxpayer can identify a subset of elements of the dual-function computer software that cannot properly be characterized as IUS (“third-party subset”). There is also a safe harbor under which a taxpayer may include 25 percent of the qualified research expenditures of the remaining subset of dual- function software in computing the amount of the taxpayer’s credit after excluding any third-party subset. The safe harbor is available only if use of the remaining subset by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10 percent of this remaining subset’s use.
The 2015 Proposed Regulations also modify the high threshold of innovation test. Unlike the 2001 Proposed Regulations, the 2015 Proposed Regulations no longer require that the taxpayer intend software to be unique or novel in order to be considered innovative. Instead, software is innovative if the software would result in a reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant. Also in contrast to the 2001 Proposed Regulations, the 2015 Proposed Regulations provide that the development of the software involves significant economic risk only if there is uncertainty related to the capability or methodology for developing or improving the software. Therefore, IUS research activities that involve only uncertainty related to appropriate design, and not capability or methodology, are not considered to involve significant economic risk. These changes to the high threshold of innovation test may make it easier for taxpayers to demonstrate that their IUS is innovative while at the same time make it more difficult for taxpayers to show that the development of their IUS involves significant economic risk.
The 2015 Proposed Regulations state that the IRS will not challenge return positions consistent with these regulations for taxable years ending on or after January 20, 2015. Taxpayers may therefore want to reexamine whether any of their ongoing or upcoming software expenditures may be eligible for research credit.