Taxpayers claiming the research & development (R&D) tax credit for software development activities now have a clearer understanding of what the IRS considers internal use software (IUS). On October 4, 2016, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released final regulations clarifying the definition of IUS for R&D tax credit purposes. The final regulations adopt much of the language from the proposed regulations, which were previously released January 20, 2015.
In addition, the final regulations provide examples that further clarify what is and is not considered IUS when claiming the R&D credit, which helps determine when the additional “high threshold of innovation test” must be applied. The clarity 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 final regulations provide examples that further clarify what is and is not considered IUS when claiming the R&D credit.
What’s not IUS?
One of the most beneficial aspects of the final regulations is clarity on what IUS is not. The taxpayer-favorable language tells us that the following types of software are presumed not to be IUS:
- Software that’s commercially sold, leased, licensed, or otherwise marketed to third parties.
- Software developed to allow interaction with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. This includes software developed for third parties to execute banking transactions, track the progress of a delivery of goods, search a taxpayer’s inventory of goods, or to receive services over the internet.
- Software developed to be used primarily in an activity that constitutes qualified research, such as software that will run test equipment in a laboratory.
- Software developed for use by the taxpayer in a production process that’s otherwise considered qualified research.
- A new or improved package of hardware and software developed as a single product, or the costs to modify an acquired software and hardware package if the software is integral to the services provided by the taxpayer in its trade or business.
What is IUS?
The new regulations also define IUS as software 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’s important to distinguish between IUS and non-IUS because IUS is subject to a heightened level of scrutiny by the IRS and additional criteria called the “high threshold of innovation test,” which requires that:
- The software must be innovative, in that it results in a reduction of cost, improvement of speed, or other measurable improvement.
- The software development must entail significant economic risk, in that the taxpayer commits substantial resources to the development, with substantial uncertainty because of technical risk, that such resources will be recovered in a reasonable period.
- The software is not commercially available for use by the taxpayer, in that it cannot be purchased, leased, or licensed, and used without modifications that would satisfy the first two requirements.
What is dual function software?
The final regulations also provide a framework for the treatment of software that’s developed both for the taxpayer’s internal use and to enable integration with third parties, including a safe harbor provision. Such “dual function software” will be presumed to be primarily for internal use and subject to the high threshold of innovation test, yet to the extent the taxpayer can specifically identify the elements that only enable third-party interaction, such elements will not be subject to the high threshold of innovation criteria. In addition, a safe harbor test is provided for such dual function software (or the dual function subset), allowing the taxpayer to claim 25 percent of development costs if third-party interaction, or third-party use, is expected to constitute at least 10 percent of the total use of the software (or the subset).
The clarity of the final regulations provided by Treasury may allow taxpayers to more easily determine whether or not software development activities are considered IUS and thus, if they’re subject to the high threshold of innovation test. As a result, more businesses may be able to benefit from R&D tax credits related to their software development activities.