CIP addresses three-part exception for internal-use software development.

• Author: McClelland, Sara
• Position: IRS Coordinated Issue Paper

The IRS recently released a Coordinated Issue Paper (CIP) addressing the three-part exception to the exclusion from the definition of "qualified research" for internal-use software. To focus the scope of the CIP's analysis of the three-part internal-use software exceptions, the Service assumes, solely for purposes of the CIP that the general tests of qualified research under Sec. 41(d)(1)(A), (B) and (C) have been met.

The CIP attempts to apply the exceptions for internal-use software to a taxpayer installing, maintaining and enhancing a pre-packaged software system, rather than internally developing its own system. From the legislative history, it is clear that Congress intended to allow the research credit for internal-use software only in certain exceptional situations. However, in the IRS's attempt to clarify these exceptions, it takes some rather extreme positions that do not seem to be based either on the legislative history or existing law.

Innovativeness Test

The first requirement of the internal-use software exception is that the software be innovative. "Innovative" is described in the legislative history as a reduction in cost or improvement in speed that is substantial and economically significant. In the Service's view, the "substantial" requirement focuses on the quantity of cost savings or magnitude of the improvement in speed attributable to the software. Noting that no bright-line test of substantial cost savings exists, the IRS determined that the taxpayer's 80% reduction in costs would satisfy this requirement.

In determining whether a reduction in cost or improvement in speed is economically significant, the Service takes a position that would require a taxpayer to prove that a software system provides a competitive advantage over software performing similar functions elsewhere in the industry; implementing a software package to reduce a competitive disadvantage resulting from the use of substandard software would not appear to meet this test. The IRS's position is unsupported by the legislative history. Rather, it seems to be loosely based on a statement by the Tax Court in Norwest Corp., 110 TC 454 (1998). In Norwest, the court cited the maximization of certain software capabilities, giving Norwest a clear advantage over its competitors, as evidence that the software's benefits were economically significant. It seems the Service is attempting to make obtaining a competitive advantage the test rather than viewing it as...