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August 10, 2016

Global Marketing sat down with Kathleen King, Managing Director with Alvarez & Marsal Taxand based in Washington, D.C., to discuss her recent comments before the IRS about proposed regulations regarding broadening the research tax credit for internal use software.  Kathleen shares her views why this proposal is an important step forward in clarifying how companies can best assess and leverage internal use software tax credits.

(Global Marketing) We’ve heard about your recent comments to the IRS regarding REG- 153656-03. What exactly is this and why is it important for taxpayers to know about?

(Kathleen King) REG-153656-03 is the latest in a long series of proposed regulations issued for the research and development tax credit.  The research credit is unique in that it has broad application to taxpayers, across multiple industries and organizations. What’s significant and exciting about REG-153656-03 is that this is the first time regulations have been issued for internal use software with the stated intention to provide a narrower exclusion of software from qualified research.  The narrower exclusion is in effect broadening its application to more taxpayers.  

The proposed regulations broaden the tax credit by adding a third-party interaction exception. A third-party might be a customer, a supplier, a regulator, a distributor or other intermediary.   Broadening the tax credit will result in enormous financial benefit and also provide filing clarity for numerous types of internal use software.  This points to an understanding of why broadening the benefits of the tax credit is important and tells me that the system is catching up with the current digital era in which businesses operate.

(G. M.) Can you shed some light on internal use software – what it encompasses and how it’s used?

(K.K.) Internal use software is a legislative designation that was created in 1986. Internal use software solely benefits the taxpayer developing the software.  In order to not be designated as internal use software, the software must provide an external benefit.   Internal use software is defined under the proposed regulations as software that is not:  used in a production process; software used to conduct qualifying research; software that is sold, licensed, leased and otherwise marketed; or software that is intended to benefit third parties.

As you can imagine, defining internal use software in the negative has led to enormous disputes over how and when to consider tax credits, reinforcing the need for greater clarity to better ensure accuracy for evaluating potential tax credits.  The proposed regulations will help to do this with the broadening provided by the third-party exception.

(G. M.) What do the recently proposed tax changes surrounding internal use software look to correct? Why are they significant? What are the implications for corporations?

(K.K.) On a macro-level, the proposed regulations help to formally recognize how much society has changed.  When the concept of internal use software was created in 1986, the Internet was not known or accessible to most consumers, let alone the hyper-connected universe of devices that exist today. How software was viewed nearly three decades ago is very different than how it is perceived and used today.

From a global point of view, the tax credit should encourage firms to develop their software in the U.S. instead of other countries. One of the issues that Congress should address is that the U.S. tax credit isn’t as lucrative as those in other parts of the world.  The changes proposed in REG-153656-03 help address this disparity by broadening the U.S. tax credit.

Beyond the tax savings, the proposed changes will also help provide needed clarity regarding internal use software for many organizations.  Additionally, these proposed tax changes could help spur more U.S.-based research and development in the form of innovative software development.

In our view, taxpayers are already entitled to a broader base of tax credit for internal use software than many IRS examiners believe.  If the regulations are adopted, taxpayers will be better able to claim and sustain the credits that they are entitled to?

(G. M.) What kinds of organizations would benefit most from the changes?

(K. K.) We see great opportunities for taxpayers with E-commerce activities or internet-based service organizations that electronically interface with third-parties such as, but by no means limited to, online retailers, online gaming organizations and online banks.  

(G. M.)  What do taxpayers need to be aware of?

(K.K.)   Taxpayers should remember that the proposed regulations remain a moving target and they are not yet finalized.  They will add more clarity but not certainty.  Additionally, it’s also important to note that at the moment these regulations are not effective retroactively.

(G. M.) How is A&M championing this issue on behalf of clients?

(K.K.)  We are excited to help shape the conversation.  We have submitted written comments regarding the regulations to the Treasury Department and presented oral comments at an IRS public hearing held to gather more information about what these regulations should contain.  Additionally, we will continue to work with the IRS and Treasury Department on an informal basis to ensure that our comments are considered and hopefully implemented once these proposed regulations are finalized.

(G. M.) What should organizations do if they stand to benefit from the proposed changes?

(K.K.)  We encourage all tax departments to take a fresh look at the software development activities within their organizations to determine which of these in particular fall within this third-party interaction exclusion as well as other exceptions.  Now is a good time for corporations to assess which of their software systems are used by third parties and to evaluate how the proposed broadening of the tax credit rules might be leveraged.

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Kathleen King is a Managing Director with Alvarez & Marsal Taxand. She assists clients in claiming, documenting and sustaining tax incentives, including research tax credits, domestic production deductions and fixed asset treatment.

Contact Kathleen King to continue the dialogue about REG-153656-03 and how it may impact your business.