New Regulations for Internal-Use Software and R&D Credit

Due to recently finalized regulations, companies that develop software for their own internal use may now be able to qualify for the Research and Development (R&D) credit. Under T.D. 9786 Section 41, R&D expenditures that were previously excluded under the Internal-Use Software (IUS) rules may now be eligible for valuable tax credits. The final regulations are effective for tax years beginning on or after October 4, 2016.

What is Internal-Use Software?
IUS has now been defined by the IRS as “developed by (or for the benefit of) the taxpayer primarily for 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.”

General and administrative functions refer to software used for financial management, human resource management and support services functions. If the software is outside the scope of those areas of the business, then it is no longer classified as IUS, and therefore allowed as qualifying expenses for purposes of calculating the credit.

Additionally, the software must pass the high threshold of innovation test, which contains three criteria. T.D. 9786 defines these three criteria as:

1. Software is innovative in that 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.
2. Software development involves significant economic risk in that the taxpayer commits substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period.
3. 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.
   It is important to note that software developed with the intention of being commercially sold, leased, licensed or marketed cannot not be treated as IUS software, as it is not primarily developed for internal use.

Third-Party Use
The final regulations do provide further clarification for what is not IUS, which is software that the taxpayer intends to sell or lease or license. Additionally, software that is not sold but facilitates a third-party’s or client’s ability to interact with the taxpayer’s software may qualify for the credit. Some examples of third-party use include software developed for third parties to make bank transactions that tracks the status of a delivery, or if a third party is reviewing a taxpayer’s available inventory prior to purchase.

Dual-Function Software
Another important distinction is that some software may be considered dual function. This distinction was included as the IRS and Treasury recognized that while some software is primarily developed for internal use it could also provide third parties with important information. To be dual-function software, the taxpayer must be able to prove that the portion of the software that a third party is using only allows them to initiate functions or review data and helps to facilitate the taxpayer’s business. The portion that the taxpayer identifies as dual function is then treated as non-IUS and therefore can qualify for the R&D credit. Additionally, an important Safe Harbor was built into the regulation should the taxpayer not be able to identify the specific portions that are dual function. If the taxpayer can reasonably state that at least 10% of the dual-function software is for third-party use, then the safe harbor will allow for the taxpayer to count 25% of the research expenses for the remaining portions of the dual-function software as qualified research expenses.

Effective Dates
As stated previously, the effective date for the final regulations is for tax years beginning on or after October 4, 2016. Additionally, the IRS will not challenge a company’s position if it was consistent with the previously proposed regulations for tax years ending on or after January 20, 2015 and beginning before October 4, 2016.

The finalized regulations offer a valuable opportunity for companies that develop IUS and should be considered, as the benefits of the credit could help reduce the significant cost that is associated with software development. Should you have any questions regarding the final regulations or think your company qualifies for the R&D credit as a result of these changes, please feel free to contact me at (805) 963-7811 or jsheffield@bpw.com.