On Friday, January 16th of 2015, The Treasury Department and Internal Revenue Service (hereinafter the “Service”) released for publication in the Federal Register a notice of proposed rulemaking (REG-153656 -03) concerning the application of the credit for increasing research activities pursuant to I.R.C. § 41 for computer software that is developed by or for the taxpayer, for the taxpayer’s internal use.
These Proposed Treasury Regulations have been long-awaited as the Service previously issued Final Treasury Regulations (T.D. 9104) governing many aspects of the Research Tax Credit (hereinafter “RTC”) back in 2003, but deferred addressing the guidelines dealing with Internal Use Software (hereinafter “IUS”) development. As a reminder, Proposed Treasury Regulations are only binding on the Service and not taxpayers until they become either “Temporary” Treasury Regulations or “Final” Treasury Regulations. It should be duly recalled that the Treasury Regulations provide the official interpretations of the Internal Revenue Code by the Treasury Department and have the force and effect of law. The most common forms of Treasury Regulations include:
• Proposed Treasury Regulations (e.g., binding only on the IRS and not the taxpayers);
• Temporary and Final Treasury Regulations (e.g., binding on both the IRS and the taxpayers); and
• Preambles (e.g., treated just like legislative histories to demonstrate congressional intent and may underlie either type of the aforementioned treasury regulations regardless of status as Proposed, Temporary, or Final).
Pursuant to I.R.C. § 41(d)(4)(E), no RTC claims are permissible for IUS development except as provided by the Treasury Regulations. However, the Service previously issued several regulatory proposals on the subject, and assured taxpayers that a RTC claim is allowed if the IUS development meets three additional testing requirements in additional to the “4-Part Test” under I.R.C. § 41(d) referred to as the “Innovation Test”; “Not Commercially Available Test Without Substantial Modification”; and “The Economic Risk of Loss Test”. Regardless, there has been continuing controversy over the definition of IUS and the precise scope and application of these additional testing requirements. The Service announced at the beginning of 2004 that efforts would continue in connection to issuing Proposed Treasury Regulations for IUS development, and the anticipation of Proposed Treasury Regulations for IUS development has appeared on every Department of Treasury Business Plan since then for over a decade now.
Definition of IUS
Pursuant to the Proposed Treasury Regulations, software is 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. This proposed standard eliminates the distinction between software developed to deliver computer and non-computer services. The new and proposed definition is intended to target software used in the back-office functions (e.g., financial management functions, human resource functions, and support services functions, etc.) of the taxpayer. Moreover, the Proposed Treasury Regulations target software designed by the taxpayer to provide administrative functions to third parties (e.g., vendors).
In contrast, software that is developed to be commercially sold, leased, licensed, or otherwise marketed is treated as software not developed primarily for internal use. The Proposed Treasury Regulations attempt to alleviate confusion prevalent in prior interpretations, that software must have a third-party commercial focus to avoid being characterized as IUS. Select software that benefits third parties by enabling them to interact and/or initiate transactions with the taxpayer may be excluded from the definition of IUS (e.g., software developed for on-line commercial banking purposes enabling customers to pay bills on-line and transfer funds between various accounts; etc.).
Improvements to software, to make IUS commercially available, or to make commercially available software useful for the taxpayer’s general and administrative functions, need to be analyzed separately from the existing software to determine proper treatment under these regulations such as:
• Enhancements to commercially available software specifically designed for the taxpayers administrative use will be considered IUS, and
• Enhancements to IUS that are intended to provide non-administrative functionality to a third party will be considered non-IUS.
It should be duly noted that internal testing of commercial software alone will not make it tantamount to IUS.
Dual function software (i.e., software used both internally by a taxpayer and by third parties whether sold, leased, or licensed) is presumed to be for internal use. However, if the taxpayer can identify subsets of elements that facilitate third-party interaction, or enable third parties to initiate functions or review data, those subsets will not be presumed to be for internal use and may be eligible for the RTC as 3rd party sale, lease or license software without application of the additional three-part test including the high threshold of innovation test. In addition, a safe harbor test is provided that would enable a taxpayer to count 25% of the research expenses of the remaining subsets of the dual use software as qualified research expenses, if it is reasonably anticipated that the 3rd party functions will constitute at least 10% of their use.
Effective Date and Application
The Proposed Treasury Regulations, once finalized, will be prospective only. The rules are proposed to apply to tax years ending on or after the date of publication of the Treasury decision adopting them as Final Treasury Regulations in the Federal Register. Notwithstanding the prospective effective date, the Service will not challenge tax return filing positions consistent with the Proposed Treasury Regulations for tax years ending on or after the date that these Proposed Treasury Regulations are published.
Upcoming IRS Hearing
The Service will hold a hearing on the Proposed Treasury Regulations on April 17, 2015 at 10:00AM EDT. Comments are requested (and are due no later than March 21, 2015), specifically, on
• The appropriate definition and treatment of connectivity software;
• The safe harbor test for dual function software; and
• Other facts and circumstances that could be considered in determining whether IUS development meets the testing parameters of the high threshold of innovation test.
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