Proposed Regulations Present Tax Credit Opportunities for Companies Investing in Software Development

Since the 1980s, the Federal Research and Development tax credit has generated significant savings for companies investing in developing new and improved products and processes. To date, pursuing credits for software developed primarily for internal use was considered highly contentious. The role that computer software plays in business activities is very different today than it was when the exclusion for internal use software was enacted in 1986. Today, computer software is used in all aspects of business activity, especially in interacting with customers, vendors, and third parties. Development of such software has played a vital role in increasing the productivity of the U.S. economy and in making the U.S. more competitive globally. In response to the rapid advancement of technology and software in business, Treasury recognized the need for updated research credit regulations related to software development.

Research Tax Credit Background

Internal Revenue Code Section 41 provides for a credit referred to as the Credit for Increasing Research Activities, better known as the R&D Tax Credit.[2] The R&D credit is a general business tax credit that offsets the income tax liability for corporations and individuals that incur R&D expenses in the United States.[3] Relevant R&D expenses are wages, supplies, and 65 percent of contract research expenses.[4]  To be eligible for the credit, a taxpayer’s R&D efforts must pass qualification criteria described in the four tests below[5]:

  1. The permitted purpose: – the purpose of the effort must be to develop a new or improved product or process; 
  2. Undertaken to eliminate technical uncertainty:  – at the outset of the effort the taxpayer must have technical uncertainties related to the capability, method, or design of the product or process; 
  3. Be a process of experimentation: – specifically, the taxpayer must undergo a systematic process designed to evaluate multiple alternatives in order to eliminate technical uncertainties; and 
  4. Rely on the hard sciences:  – meaning the process of experimentation must rely on principles of physical or biological science, engineering, or computer science.

In addition to the criteria mentioned above, the following items are specifically excluded from qualification:[6]

  • Research performed after commercial production; 
  • Research performed to adapt existing business components to meet a specific customers needs or to duplicate existing business components; 
  • Market research or similar studies, including studies related to the social sciences; 
  • Research conducted outside of the U.S. and its possessions; 
  • Funded research (except if financial risk and substantial rights can be established); 
  • Reverse engineering; or 
  • Software development conducted primarily for internal use (high threshold of innovation test and exceptions discussed below).[7]

Proposed Regulations

The January 20th, 2015 Treasury issued Prop Reg 1.41-4[8] which primarily address the last exclusion item mentioned above: internal use software. The objective of these proposed regulations is to provide a narrower exclusion of software from qualified research than provided in prior regulatory guidance.

For purposes of the R&D tax credit, software development is divided into two categories:

  1. internal use software; and
  2. Commercial software (developed to be sold, leased, licensed, or designed to interact with external parties).

Software development that is focused on creating software to be sold or licensed to a customer is required to meet the requirements of IRC Section 41(d) described above. However, software that is focused on internal systems must pass an additional test called the “high threshold of innovation testthat historically has been extremely difficult to pass. The “high threshold of innovation test” consists of three additional requirements listed below[9]:

  1. The software must be intended to be unique or novel and significantly different from prior software implementations or methods;
  2. The software development effort must present a significant economic risk to the taxpayer; and
  3. The software cannot be commercially available.

Definition of Software Developed Primarily for the Taxpayer’s Internal Use

The proposed regulations significantly limit the “internal use software” classification to a smaller sub-set of software development. These changes open the door for much more software development efforts to qualify for the R&D tax credit. Per the proposed regulations software development activities are considered primarily for the taxpayer’s internal use if:

“…the software is developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. Similarly, software that the taxpayer develops primarily for a related party’s internal use will be considered internal use software.”[10]

The proposed regulations also provide a limitation on what is considered general and administrative functions as it relates to the definition of internal use software above.  Per the proposed regulations general and administrative functions include:

  • Financial Management Functions – Defined as functions that involve the financial management of the taxpayer and the supporting recordkeeping. 
  • Human Resource Management Functions – Defined as functions that manage the taxpayer’s workforce. 
  • Support Services Functions – Defined as functions that support the day-to-day operations of the taxpayer (i.e. data processing and facilities services).

Per the proposed regulations the intention was to target back-office functions of the taxpayer that most taxpayers would have regardless of the taxpayer’s industry. The benefits of software developed by the taxpayer for use in general and administrative functions are likely to be captured only by the taxpayer developing it and therefore exclusion from credit eligibility is more consistent with the purposes for which Congress created the credit.[11]  However, the industry of the taxpayer could also make a difference.  The example provided by the proposed regulations is the development of Tax software by a company that performs tax services.  This development effort would not be considered the development of internal use software, because the software development is considered part of the taxpayer’s product or service.

Identification of Software NOT Developed Primarily for the Taxpayer’s Internal Use

Software development efforts identified in the proposed regulations as not developed primarily for the taxpayer’s internal use and which would not be subject to the “high threshold of innovation test” include:

  • Software developed to be sold, leased, or licensed to third parties[12]; or 
  • Software that enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data on the taxpayer’s system.[13]

The proposed regulations provide the following examples of software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data:

  • Software developed for third parties to execute banking transactions; 
  • Software developed to track the progress of a delivery of goods; 
  • Software developed to search a taxpayer’s inventory for goods; 
  • Software developed to store and retrieve a third party’s digital files; 
  • Software developed to purchase tickets for transportation or entertainment; and
  • Software developed to receive services over the internet[14]

The Intent of the taxpayer and the facts and circumstances at the beginning of the software development could also determine if a software development effort is deemed to be primarily for the taxpayer’s internal use.

Additional Qualification Criteria for Software Developed Primarily for Internal Use

The proposed regulations also provide additional clarification of the “high threshold of innovation test” used to determine if software developed “primarily for internal use” and is therefore qualified for the Sec. 41 Credit for increasing research expense.  Specifically:

For Internal Use Software to qualify under Sec. 41 the development effort must:

  • Be innovative: Per the proposed regulations the development is deemed innovative if,

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, if the development is or would have been successful. This is a measurable objective standard, not a determination of the unique or novel nature of the software or the software development process.”[15]

  • Represent a Significant Economic Risk: Per the proposed regulation this criteria is met if,

“the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period.”[16]

  • Be Commercially Available For Use:  Per the proposed regulations the developed software cannot be,

“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.”[17]

Effective Date

After careful consideration, and in light of the length of time that has passed since 1986, as well as the developments with respect to computer software, the Treasury Department and the IRS have expanded the types of expenditures for internally developed software that will qualify for the R&D credit. Once finalized, these proposed regulations will be prospective only.

Treasury may modify the proposed regulations based on comments received in the April 17, 2015 public hearing. While in temporary form, the proposed regulations cannot be definitively relied upon, the IRS has indicated that it will not challenge tax positions following the proposed regulations for tax years ending after January 20, 2015.[18]

Summary

In summary, the proposed regulations open the door for many more taxpayers to qualify for the R&D tax credit through their software development efforts.  With the clarification of the rules associated with internal use software, taxpayers can now be more confident in their ability to sustain R&D tax credits related to software development. Computer software is used in all aspects of business activity, especially in interacting with customers, vendors, and third parties, and the enhancement of such software has played a vital role in increasing the productivity of the U.S. economy making the U.S. more competitive globally. When taxpayers’ develop and improve software that makes them more competitive in these areas, then significant tax opportunities may be available.

 



[1] Federal Register / Vol. 80, No. 12 / Tuesday, January 20, 2015 / Proposed Rules

[2] Although the IRC refers to these expenditures, and the related credit as “research and experimentation” research and development or R&D how most executives think of these costs.

[3] The general business credit is subject to a limitation based on the taxpayer’s tax liability which is taken into account on the form used to compute the credit. The R&D tax credit does not offset AMT (alternative minimum tax).

[4] IRC Section 41(b)

[5] IRC Section 41(d)

[6] IRC Section 41(d)(4)

[7] IRC Section 41(d)(4)(E)

[8] §1.41–4 also issued under 26 U.S.C. 41(d)(4)(E). * * * Par. 2. Section 1.41–4 is amended by: Adding Example 5 through Example 10 at the end of paragraph (a)(8), and also revising paragraphs (c)(6) and (e).

[9] §1.41-4(c)(6)(vi)

[10] §1.41-4(c)(6)(iii)(A)

[11] Internal Revenue Bulletin:  2015-5 

[12] §1.41-4(c)(6)(iv)(A)(1)

[13] §1.41-4(c)(6)(iv)(A)(2)

[14] Internal Revenue Bulletin:  2015-5

[15] §1.41-4(c)(6)(v)(B)

[16] §1.41-4(c)(6)(v)(C)

[17] §1.41-4(c)(6)(v)(A)(3)

[18] Federal Register / Vol. 80, No. 12 / Tuesday, January 20, 2015 / Proposed Rules