New regulations released on October 4, 2016 by the U.S. Treasury Department and IRS provided additional guidance on the definition of internal use software (IUS) for the R&D tax credit. These new regulations both modify and adopt most of the proposed regulations that were previously issued in January 2015. These regulations help clear up the confusion that has long reigned over what is truly considered internal use software development, as opposed to software developed with the intent to sell, lease or license it.
Thanks to these new regulations, non-traditional software companies that are investing time and efforts into the development of internal use software to build and streamline their business functions can expect to receive a substantial boost in their ability to claim R&D-based tax incentives.
The R&D Tax Credit rewards companies for improving a product, process, formula, invention, software, or technique, offering additional tax savings to companies taking active steps to improve in these areas. Given the high amount of R&D work required in designing and developing software, companies involved in technology and software development are generally some of the better candidates in claiming the credit, with many of their everyday projects tying directly to eligibility.
However, for companies seeking to qualify for the credit on the grounds of IUS software, the hurdle to qualify has traditionally been much higher, with companies needing to pass the high threshold of the innovation test, a three-prong test where the taxpayer must prove that the software is innovative, the software development involves significant economic risk, and the software is not commercially available.
The IUS Innovation test:
1. There must be an economically significant reduction in cost or improvement in speed or other measureable improvement that is targeted by the project.
2. The software must not be commercially available.
3. There must be significant economic and technical risk that makes the recovery of the resources devoted to the project uncertain.
The most significant change in the new regulations relates to the economic risk factor of the three-prong test. The previously proposed regulations would have eliminated the “appropriateness of design uncertainty” for the purposes of satisfying the economic risk factor. Generally, economic risk is present if the taxpayer dedicates substantial resources to the development of the software, and there is a technical risk that poses a substantial uncertainty whether those resources will be recovered within a reasonable period. Substantial uncertainty exists when the information available to the taxpayer does not establish the capability or method for developing or improving the software. The proposed regulations would have made it difficult for taxpayers to distinguish between the appropriateness of design uncertainty, and method or capability uncertainty since these uncertainties may often overlap during the process of experimentation. The final regulations eliminate references to method or capability uncertainty so that the focus can rest on the level of uncertainty that is present rather than the type of uncertainty.
Why is this change so important? The high threshold of innovation test has generated a great deal of confusion and aversion as companies have been unsure whether their internal use software development efforts qualify as R&D given the broad verbiage and outdated considerations regarding process of experimentation. With the inclusion of these companies in mind, the IRS has now reinterpreted both the definition of IUS software and the strict criteria to reflect the ever-evolving way companies use software to manage and interact with their B2B and B2C clientele.
Software development activities that are designed for the purposes of financial management, human resources, and support service functions qualify as activities that are considered internal use software. This is good news for companies that are seeking to consolidate and organize their internal business operations into more integrated and user-friendly systems. As these companies research and test multiple alternatives to meet specific functionality and performance requirements, they may be able to find additional benefits under these updated regulations. The recent change in the IUS regulations will open the door for more companies to claim the credit, but the regulations also give a much clearer view of software that will not be considered internal-use software:
• Software developed to be commercially sold, leased or licensed
• Software that enables a company to interact with third parties or that allow third parties to initiate functions or review data on the company’s system. For example, software for customers to execute banking transactions, track the progress of deliveries of goods, search inventories, retrieve digital files, purchase tickets, or receive other services over the Internet.
The commercially-available test is satisfied if the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.
These final regulations apply to tax years ending on or after October 4, 2016. However, the IRS will not challenge claims consistent with the proposed regulations for tax years ending on or after January 20, 2015.
BGI employs a staff of professionals with industry expertise in software and can help clients identify whether they are conducting qualified activities pertaining to software for internal use. We understand the type of work done by software developers and engineers that rise to the level of qualifying activity for R&D purposes.