2015-Issue 4—Crosby, Stills and Nash (apologies to Neil Young…maybe next time) could never have imagined the lyrics to their hit single “Long Time Gone” would ever remotely describe an IRS tax pronouncement. Yet, here we are. For nearly two decades, taxpayers, practitioners and the IRS have struggled to make sense of how the available (and often contradictory) guidance on internal use software (IUS) can be applied to a specific set of facts and circumstances as part of a research credit claim. In an attempt to ease this struggle, the Treasury Department recently published proposed IUS regulations (REG-153656-03).
These proposed regulations address a number of topics, ranging from the reinforcement of existing IUS requirements to the introduction of new concepts, such as the notion of “dual function computer software” and an exception from IUS for applications benefiting third parties. This edition of Tax Advisor Weekly focuses on how key aspects of the proposed regulations may affect how taxpayers identify and substantiate IUS-related costs as part of their future R&D credit calculations.
As part of the Tax Reform Act of 1986, Congress amended the research tax credit to add a statutory definition of “qualified research activities.” The definition, set out in Section 41(d), is referred to as the four-part test and excludes certain activities from the definition of qualified research. Section 41(d)(4)(E) generally excludes IUS from the definition of qualified research under Section 41(d). However, the statute gave Treasury the authority to issue regulations under which IUS may qualify for the credit.
The Treasury Department has issued several sets of regulatory guidance in an attempt to define IUS and when it may qualify for the credit. The earlier attempts to define internal use software were generally met with public criticism and open to conflicting interpretations. TAW Issue #30-2014, Internal-Use Software Finally Gets Some Love, provides an expanded analysis of the prior regulatory releases and court decisions over the past decade that contributed to our present-day understanding (or lack thereof) of what constitutes “internal use software.”
The brief outline below summarizes some of the most important IUS-related pronouncements:
- 1997 Proposed Regulations — Affirmation of the “discovery test” standards established in United Stationers. Qualifying research activities must “expand, exceed, or refine” the common knowledge of skilled professionals in a particular field of science.
- T.D. 8930 Final Regulations (early 2001) — Adoption of the discovery test from United Stationers. As part of the “high threshold of innovation” standard, the innovation test requires IUS software development to intend to result in “a reduction in cost, improvement in speed, or other improvement that is substantial and economically significant.” New guidance further expands the list of software development activities excluded from the additional three-part “high threshold of innovation” standard.
- Proposed Regulations (post-T.D. 8930, late 2001) — Eliminates the discovery test requirement of the 1997 proposed regulations/T.D. 8930. Alters the innovation test, requiring IUS software development to “intend to be unique or novel and to differ in a significant and inventive way from prior software.” Adds and refines supplementary exclusions where certain software development activities are excluded from the additional three-part “high threshold of innovation” standard.
- T.D. 9104 Final Regulations (2003) — Further absence of the discovery test requirement as noted in the 2001 proposed regulations. However, the IUS provisions (Reg. Sec. 1.41-4(c)(6)) are marked as “reserved” for future inclusion of IUS regulations when published.
- Announcement 2004-9 — Taxpayers can choose to rely on the IUS rules contained in T.D. 8930 or contained in the 2001 proposed regulations. However, taxpayers who choose to rely on the T.D. 8930 provisions must also satisfy the general definition of qualified research (i.e., the discovery test) of T.D. 8930, a test that was revoked by T.D. 9104. This announcement was overruled by the FedExcase in 2009.
The above (further clarified by certain court decisions) form the foundation of IUS guidance prior to the recent release of the proposed IUS regulations. These earlier attempts to clarify often served to further confuse all parties involved in an IUS research credit claim. It is this complex and confusing history that the new proposed regulations are intended to resolve.
Process of Experimentation — Additional Examples
Before delving into the substance of the latest IUS guidance, the new proposed regulations offer six additional, “generic” examples (Reg. Sec. 1.41-4(a)(8)) that further explain what constitutes a qualifying process of experimentation as it relates to software development. These examples apply to all types of software development — not just IUS.
While the new examples provide further guidance regarding certain fact-specific scenarios (e.g., the taxpayer’s industry, the type of software developed/purchased, etc.), much of the underlying rationale for disqualification in these examples is similar to the high/moderate/low risk software development categories detailed in the IRS’s Audit Guidelines on the Application of the Process of Experimentation for All Software white paper. According to the white paper, areas of “high risk” are activities that “usually fail to constitute qualified research” under IRC Section 41(d). The “high risk” activities are akin to the four non-qualifying examples in the new proposed regulations, while the single qualifying experimentation example parallels activities considered “low risk” activities.
Unlike the provisions related to IUS, these examples are effective for tax years ending on or after December 31, 2003, so they have immediate application.
Modifications to IUS Rules and Definitions
At the heart of the new proposed IUS regulations are clarifying definitions as to what constitutes “internal use” software, the introduction of a new category of software referred to as “dual function computer software,” and modifications to the high threshold of innovation test. It is important to understand that as a starting point, the proposed regulations generally divide software into three categories for purposes of determining whether the associated software development work will qualify:
- Computer software developed primarily for internal use;
- Computer software not developed primarily for internal use; and,
- Dual function computer software.
The preamble provides that the general rule is that software is IUS unless it meets certain exceptions. IUS must satisfy all three prongs of the additional high threshold of innovation requirement to qualify.
Because the standard for qualification is higher for IUS, the proposed regulations attempt to identify and describe areas of development that are typically treated as internal use software (Reg. Sec. 1.41-4(c)(6)(iii)(B)). In general, the proposed regulations define IUS as software developed by the taxpayer for use in “general and administrative functions” that facilitate or support the conduct of the taxpayer’s trade or business.
For the first time, the regulations expand on what types of software fall within “general and administrative” category. “Financial management,” “human resource management” and “support services” (collectively referred to as “general and administrative (G&A) functions”) represent significant new IUS categories. Each category is broad in scope:
- “Financial management” relates to anything involving a taxpayer’s financial management and supporting recordkeeping. Specific examples include “accounts payable, accounts receivable, inventory management…disbursements…finance…tax.”
- “Human resource management” functions include activities “that manage the taxpayer’s workforce.”
- “Support services” include “other functions that support the day-to-day operations of the taxpayer.” Specific examples include “data processing…marketing…government compliance services.”
The preamble to the proposed regulations also explains that this list intended to target the “back-office functions” that most taxpayers would have regardless of the taxpayer’s industry. The IRS explains that “because the benefits from software held for commercial sale, lease, or license are likely to be captured by persons other than the taxpayer developing the software … it should be eligible for the research credit provided the other requirements of section 41 are met.”
Perhaps the most important change is the introduction of a new exception from IUS for certain applications intended for use by third parties. The regulations provide that “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 does not solely benefit the taxpayer developing the software, and therefore…” is not subject to the definition of IUS.
Another noteworthy addition to the proposed regulations stems from the concept of the G&A activities discussed above. The proposed regulations acknowledge that certain instances may occur where a taxpayer develops software to support G&A functionality within its business and the software also enables the taxpayer to interact with third parties (Reg. Sec. 1.41-4(c)(6)(iv)(C)(1)). Referred to as “dual function computer software,” taxpayers may bifurcate these components into IUS and non-IUS buckets. The subset of system elements allowing a taxpayer to interact with third parties is not considered IUS and is subject only to the traditional four-part test for qualifying research. However, the remaining subset of G&A functionality must be evaluated using the additional three-part high threshold of innovation test.
For cases in which it is not possible to isolate the third-party subset, the new dual function software rules also include a safe harbor. Under the safe harbor rules, if, at the outset of development, the taxpayer reasonably anticipates that the subset of functionality to be used to interact with third parties will constitute at least 10 percent of the overall use of that particular subset, the safe harbor allows taxpayers to include 25 percent of the potential qualified research expenses of that third-party subset in its research credit calculation (Reg. Sec. 1.41-4(c)(6)(iv)(C)(3)). The remaining 75 percent would have to meet the high threshold of innovation test discussed below. However, the regulatory definition of a “third party” in Reg. Sec. 1.41-4(c)(6)(iv)(D) does not include “any persons that use the software to support the general and administrative functions of the taxpayer.” This narrow definition of “third parties” may still require many software development activities to satisfy the more stringent high threshold of innovation test.
The regulations include language acknowledging that the nature of a project can evolve over time. A development effort that began as an IUS project can morph into one that could satisfy an exception if the subsequent improvements made by the taxpayer are made with an intention to make the improvements available for sale/lease/license or to interact with third-party systems. The converse is also true — what began as software that was for sale to a taxpayer’s customers may no longer meet the exception if subsequent improvements are made with the intent to use the software internally. Thus, the exclusion is applied only to that subset of improvements made available to a taxpayer’s customers, while the remainder is deemed internal and must satisfy the additional IUS requirements.
As part of the simplification process, the proposed IUS regulations addressed several earlier exclusions that describe when a taxpayer’s qualifying software development activities are not required to satisfy the high threshold of innovation test. The statutory exceptions for software used in research or a production activity still remain. However, the exceptions for computer and non-computer services introduced in T.D. 8930 have been removed. The proposed regulations retain the hardware-software exception contained in prior regulatory guidance, but have broadened its application to include single-product hardware/software used within service industries.
High Threshold of Innovation Test
The proposed regulations also clarify the three-part test for innovative software, also known as the high threshold of innovation test. The regulations are faithful to the legislative history in that they require that the software provide a significant reduction in cost or improvement in speed, that they involve a significant risk that the investment will not be recovered in a reasonable time because of technical risk, and that no existing commercially available software could perform the function. While the third requirement is usually straightforward, the other two requirements can be contentious.
The 2001 proposed regulations introduced a relatively ambiguous “unique or novel” standard to the innovation prong of the three-part test that would be difficult for many taxpayers to satisfy. However, these proposed regulations have reverted to the definition contained in the legislative history. Satisfaction of the innovation test will now require the taxpayer to meet the “cost reductions/speed improvements/other substantial improvements” threshold from the T.D. 8930 regulations. This is broadly viewed as a favorable change.
The proposed regulations reinforce that both technical and economic risk must be present in order to satisfy the significant economic risk portion of the three-part test. The proposed regulations further emphasize that both risk levels must be evaluated at the beginning of the development effort and that economic risk is present when the taxpayer is uncertain “the final result can be achieved within a timeframe that will allow the substantial resources committed to the development to be recovered within a reasonable period” (Reg. Sec. 1.41-4(c)(6)(v)(C)). This differs from the prior economic risk thresholds, which were measured based on the degree of innovation exemplified by the results of the research. In perhaps the most significant shift, “design uncertainty” is deemed to no longer establish acceptable levels of “substantial uncertainty” for meeting the significant economic risk test. Under the proposed regulations, “capability” and “method” uncertainties are the only type of uncertainty that will satisfy this requirement.
The commercial availability test remains relatively unchanged — a taxpayer must demonstrate that the developed internal use software could not be purchased, leased or licensed and used for the intended purpose without modifications that would satisfy the innovative and economic risk requirements under the high threshold of innovation test.
The regulations related to the process of experimentation examples are effective for tax years ending on or after December 31, 2003, so can be applied to any open year. The regulations dealing with internal use software are to be applied prospectively for tax years ending on or after January 20, 2015 (the date of publication in the Federal Register). Ironically, the regulations currently have limited value to calendar-year taxpayers, since the research credit has expired for research expenditures incurred after December 31, 2014. It should be noted that the proposed regulations reflect Treasury’s interpretation of the research credit, so they may impact litigation hazards for all IUS issues currently in Appeals.
Alvarez & Marsal Taxand Says:
The proposed regulations can generally be viewed as favorable for taxpayers hoping to claim software development activities for the research credit. The preamble discussion recognizes that the role that computer software plays in business today is very different from what it was when the general exclusion for IUS was enacted in 1986, and Treasury has expanded the definition of software that can qualify as non-IUS with the introduction of the third-party exception and the dual function software safe harbor.
While there are a number of positive developments, there will likely be many comments on the regulations. In particular, we note that the economic risk standard, the application of the dual function software rules and the narrow focus on the customer as a third party will likely draw comments. However, in an area of tax that has been known for being very contentious, the proposed regulations should be embraced as a starting point for better settlements for IUS.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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