Proposed Rules Would Govern Sec. 41 Credit for Software: The IRS Offers a Test and Safe Harbor for Qualifying Dual-Junction Internal-Use Software
The IRS issued long-awaited proposed rules on what type of internal-use software qualifies for the Sec. 41 research credit (REG-153656-03). Although the new rules are proposed, not final, the IRS says it will not challenge taxpayers' return positions that apply these rules currently. Final regulations (T.D. 8930) on internal-use software and the research credit were released in 2001 but caused considerable controversy among practitioners. In response, in 2004, the IRS issued an advance notice of proposed rulemaking (2004 ANPRM), announcing that it would consider the comments it had received and promulgate new proposed regulations. Internal-use software is software developed by (or for the benefit of) the taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. General and administrative functions are limited to financial management, human resources management, and support services functions. Internal-use software generally does not qualify for the credit but can if it meets a high-threshold-of-innovation test with three requirements: 1. The software is innovative (defined as resulting in a reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant, if the development is or would have been successful); 2. The taxpayer incurs significant economic risk in developing the software (has committed substantial resources to develop it and, due to technical risk, there is substantial uncertainty that the costs of development will be recovered in a reasonable time); and 3. The software is not commercially available without considerable modification (i.e., the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements). Dual-function internal-use software, which serves functions that are general and administrative and those that are not, must overcome a presumption in the proposed rules that it is developed for nonqualifying internal use. The presumption will not apply if the taxpayer "can identify a subset of elements of dual function computer software that only enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data (third party subset)" (REG-153656-03, preamble). However, if the taxpayer can identify a third-party subset of the dual-function computer software, the portion of research expenditures allocable to the third-party subset may be eligible for the research credit, provided all the other applicable requirements are met. …