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On October 4, 2016, the Treasury Department issued final regulations (T.D. 9786) which provide guidance in identifying software research and development activities of internal use software for purposes of the Internal Revenue Code (“IRC”) Section 41 research and development (“R&D”) tax credit.
These new rules provide a narrow definition of internal use software that is limited to software projects that support general and administrative activities of a business. These back office software packages include financial management systems, human resource management systems, and other support service systems. The limited definition of internal use software is important since internal use software projects are subject to a higher standard than other research activities. Specifically, internal use software must meet the general criteria for research activities and also meet an additional requirement that the research be innovative.
The four part test to determine whether activities qualify as qualifying research expenses for federal income tax purposes includes:
1. Elimination of Uncertainty (Sec. 174)
The activity must be intended to discover information that would eliminate uncertainty concerning the capability or the method for developing or improving a product or process, or the appropriateness of the product design.
2. Process of Experimentation
- The project must have identified one or more alternatives intended to eliminate uncertainty.
- The project must have identified and included a process of evaluating the alternatives.
- Evidence of the confirmation of the hypothesis through testing or modeling.
3. Technological in Nature
The activity must rely on principles of:
4. Permitted Purpose
The activity must relate to a new or improved function, performance, reliability, or quality.
The additional innovation test for internal use software requires that the activities not only meet the four part test but also (1) be innovative, (2) represent significant economic risk, and (3) not be commercially available.
Another opportunity for taxpayers to take advantage of the R&D credit exists in the dual function exclusion to back office software. If general and administrative software classified as internal use software also enables the taxpayer to interact with third parties, the software may be classified as dual function and therefore non-internal use software. In such instances, the software project only has to meet the general four part R&D test.
If you would like to discuss the impact of the final regulations for the research credits as it relates to software development, please contact Debora McGraw or any other professional at Zaino Hall & Farrin LLC.