On January 16, 2015, the United States Department of the Treasury issued long awaited proposed regulations on the qualification of internal use software (IUS) development efforts for the federal research and experimentation (R&E) tax credit. The new proposed regulations introduce several taxpayer favorable provisions, including a well-defined limit on the type of software that will be treated as developed for internal use, a new safe harbor for dual function computer software, and a lower threshold of innovation that must be satisfied to meet the requirements of the high threshold of innovation test.
Key Provisions of the Proposed Internal Use Software Regulations
- The updated definition of IUS focuses on support of general and administrative (G&A) functions, including financial management, human resources, and support services.
- IUS will qualify for the R&E tax credit if it meets requirements of Section 41(d) and meets the updated three-part high threshold of innovation test for qualified IUS:
- High Threshold of Innovation – The software must intend to create a measurable improvement in the taxpayer’s business.
- Significant Economic Risk – There must be development dollars at risk because of the technical uncertainty that exists as the outset of the development effort.
- Not Commercially Available – There can be no commercially available software that could be purchased as an alternative to self-development (modification of software can qualify if it otherwise meets the above tests).
- Third-Party Subset Exclusion from IUS – If taxpayers have dual function software (internal and external use), they can carve out the development expense associated with the component of the software that interacts with third parties and claim these expenses under the normal R&E tax credit rules.
- Dual Function Computer Software Safe Harbor – If the third-party subset can’t be isolated, taxpayers can invoke a safe harbor to claim 25% of the IUS development expense if they reasonably anticipate that at least 10% of the software’s use will come from third parties. Taxpayers must use an objective and reasonable method for estimating anticipated use.
- Character of software as IUS can change depending on industry and/or the taxpayer’s development intent (for commercial sale, lease or license, or exclusive in-house use).
- New examples to existing regulations illustrating how and when enterprise resource planning (ERP) software implementation costs are credit eligible (with retroactive application to tax years ending on or after December 31, 2003).
Impact of the Proposed Internal Use Software Regulations
Before the release of the new proposed regulations, many taxpayers decided not to claim internal use software when calculating their annual R&E tax credit. Prior guidance on what qualified for the credit as internal use software was confusing and frequently became the subject of taxpayer controversy.
The new proposed regulations are a welcomed step in the right direction. Taxpayers should consult their Ryan tax advisors regarding any IUS development efforts that are on-going or begin after the effective date of the proposed regulations (January 20, 2015). If development relates to dual function computer software, Ryan can assist taxpayers in implementing cost accounting procedures that will enable companies to carve out expenses associated with development of the third-party subset. In addition, Ryan’s tax experts can help taxpayers evaluate ERP implementation costs that were incurred during any open tax year to determine if taxpayers should consider claiming additional credits.
Consult your Ryan tax advisor today to learn how the new proposed internal use software regulations might impact your business.
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