New regulations add clarity: Good news for taxpayers with software development activities

The Treasury Department (Treasury) and the Internal Revenue Service (IRS) recently released proposed regulations, which provide a clearer definition of internal use software (IUS) for the research and development (R&D) tax credit. In addition, the proposed regulations provide examples that further clarify what is or is not considered IUS for qualification purposes. Historically, IUS has been subject to a heightened level of scrutiny by the IRS due to the necessity to meet higher threshold requirements to qualify for the tax credit. However, the clarity and broader application of the new regulations will likely have a positive impact on taxpayers seeking to claim the R&D tax credit related to their software development activities.

The proposed regulations clarify that software “sold, leased, licensed, or otherwise marketed to third parties” is not considered IUS. The proposed rules go on to exclude from IUS, software that enables the business “to interact with third parties.” Examples may include software developed for third parties to execute banking transactions, track the progress of a delivery of goods, search a taxpayer’s inventory of goods, receive services over the internet, and purchase tickets for transportation or entertainment.

The proposed rules also specify that software should be classified as IUS if it is developed “for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.” Examples of general and administrative functions include financial management, human resource management, and support services designed to target back-office activities, regardless of business type or industry. It is important to note that IUS may still qualify for the R&D tax credit as long as it is able to meet all the higher threshold requirements.

The clarity and broader application of the newly proposed regulations provided by Treasury may allow taxpayers to more easily determine whether or not software development activities are considered IUS. As a result, more businesses may be able to claim R&D tax credits related to their software development activities.