The United States Treasury proposed new regulations regarding Internal Use Software (IUS) for purposes of the research and development (R&D) credit under Section 41 of the Internal Revenue Code on January 20, 2015. These proposed regulations were finalized on October 4, 2016, bringing the suspense to an end. The finalized regulations are very similar to those proposed which was not the only positive outcome. The definition of IUS for purposes of the Research Credit was clarified and the non-IUS definition extended, aiding taxpayers in determining eligibility requirements. The IRS also provided clarity on how dual-function software is treated and what type of internal software can still qualify for the Research Credit. The regulations were not introduced retroactively and taxpayers are not able to amend prior returns.
Overview of Clarifications of IUS
The finalized regulations provide a clear definition of IUS as software developed for general administrative functions facilitating or supporting the conduct of the taxpayer’s business. Generally these functions are administrative or general tasks required for the function of the business, and are not designed for client use.
They are defined in three categories:
- Financial Management
- Human Resources Management
- Support Services
Software characteristics not qualified for the Research Credit:
- Software offered for commercial sale, lease or licence, or otherwise marketed to third parties;
- Software to enable a taxpayer to interact with third parties; or
- To allow third parties to initiate functions or review data on the taxpayer’s system.
Any software developed primarily for any purpose described above is not considered to be IUS within the new regulatory definition.
The Consistency Rule
The finalized regulations require taxpayers who have previously claimed the research credit to adjust and recalculate their base calculations in order to claim research expenses under the newly defined, favorable regulations in current and future years’ returns. Taxpayers must perform two calculations;
- One applying the new regulations for tax years after January 20, 2015; and
- One for any returns amended for prior years by choosing between TD 8930 or Regulation 1.41 – 4(c)(6)
Dual Function Software
Dual function software is presumed to be software that has been designed primarily for a taxpayer’s internal use. However where a taxpayer can identify a subset of elements of the software that only enable to the taxpayer to interact with third parties or allows third parties to initiate functions or review data, that presumption does not apply. The portion of expenditure allocated to this subset only needs to qualify for the Research Credit under the less stringent four-part test.
Where this third party subset has been identified and their remains dual function software or a subset of elements of dual function software a safe harbor rule is applicable. This allows for a taxpayer to include 25 percent of the potentially qualified research expenditures associated with the dual function subset through meeting the four-part qualifying test, while the remaining 75 percent would have to meet the higher threshold of the innovation test below.
Safe harbor is applicable where such third party interactions are reasonably anticipated to constitute at least 10% of dual function software use. When changing focus from dual to IUS or the opposite, qualifying expenses are determined on a prospective basis according to the time of change in taxpayer intent.
Three Part Test for IUS
Qualification for IUS requires three core tests can be established:
- Innovation Test – Measurable and objective, and should reduce the potential for controversy. Innovative software must result in cost reduction, measurable improvement such as speed or reliability.
- Significant Economic Risk – reasonability test requiring detailed documentation and circumstantial consideration. Taxpayer must show commitment of substantial resources, uncertainty due to technical risk and degree of uncertainty.
- Commercially Available Test – Analysis of whether similar software may be purchased, leased or licensed and used for the intended purpose without modification, satisfying the innovation and significant economic risk requirements.
In determining the eligibility of your research, speaking with a qualified and experienced professional will be highly beneficial. Many opportunities to claim the research and development incentive are surpassed due to the common mistake of assuming ineligibility.
Whether you are interested in eligibility, adjusting your base calculation or preparing a claim as per the released IUS Regulations, if you would like to discuss the R&D Tax Incentive further, please do not hesitate to contact one of Swanson Reed’s offices today.
