IRS Proposes New R&D Tax Rules for Internal-Use Software
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Does your company use proprietary software to deliver your product or service? If so, newly proposed amendments to IRS regulations may enable your company to qualify for the R&D tax credit in the future.
The IRS and Treasury Department recently released proposed amendments of regulations (REG-153656-3 per Internal Revenue Bulletin: 2015-5) regarding the eligibility of computer software projects for the federal research credit, commonly known as the R&D tax credit. The proposed amendments address the lack of clarity in previous regulations and provide guidance regarding the definition of internal-use software and its eligibility for the credit.
Evolution of technology in the business world
Companies that develop software for use in the service and e-commerce industries historically faced extensive challenges to qualify their software projects for the R&D tax credit.
Prior IRS guidance generally suggested that software developed for purposes other than to be commercially sold, leased, licensed or otherwise marketed to unrelated third parties was classified as internal-use software and therefore was not eligible for the R&D tax credit in most cases. That classification included software used in the delivery of a service (e.g., bank transaction software) or a product (e.g., e-commerce website).
Internal-use software is not eligible for the R&D tax credit unless it can satisfy a particularly challenging test known as the high threshold of innovation. The definition of that test evolved in the early 2000s, generating even more confusion about what software qualified for the credit.
The proposed amendments to the regulations better reflect the role that computer software plays in today’s business world. The changes take into account how central information technology is to the service industry and how companies now interact with customers online on a daily basis.
A changing definition of internal-use software
Under the proposed regulations, internal-use software that would generally be excluded from the R&D tax credit is limited to software developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business, such as financial management, human resources management and support services functions.
Software developed primarily for internal use in general and administrative functions can still qualify for the R&D tax credit, but only if it satisfies the high threshold of innovation test. The proposed regulations clarify the requirements of the three-prong test:
- There is an economically significant reduction in cost or improvement in speed or other measureable improvement that is targeted by the project.
- There is a significant economic and technical risk that makes the recovery of the resources devoted to the project uncertain.
- The software is not commercially available.
Most importantly, the proposed amendments specify the following will not be considered internal-use software:
- Software developed to be commercially sold, leased or licensed
- Software that enables a company to interact with third parties or that allow third parties to initiate functions or review data on the company’s system. For example, software for customers to execute banking transactions, track the progress of deliveries of goods, search inventories, retrieve digital files, purchase tickets, or receive other services over the Internet.
The second bullet point expands the IRS’s previous definition of research credit-eligible software. In prior regulations, if the software itself was not an income-producing activity that was sold or licensed, it was automatically defined as internal-use software. Software developed to interact with third parties is no longer required to satisfy the high innovation threshold test and therefore will be able to qualify for the R&D tax credit as long as the software meets the other requirements of Section 41 of the Internal Revenue Code.
Applicability of new rules
The proposed regulations only apply to tax years ending after the regulations were released (2014 and onward) and would not be retroactive. Still, they indicate that the IRS and the Treasury Department are moving in the right direction when it comes to expanding the R&D credit for internal-use software.
If you have questions about the R&D tax credit and whether your business might be eligible, check out our FAQ guide, “What You Need to Know About the Research Tax Credit” or contact us.
Louis Guay is a Cost Segregation, Tax Credits & Incentives Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.
