Final Regulations on Software Development Qualifying for Research Tax Credit

Date01 March 2017
Published date01 March 2017
© 2017 Wiley Periodicals, Inc.
Published online in Wiley Online Library (
DOI 10.1002/jcaf.22256
Final Regulations on Software
Development Qualifying for
Research Tax Credit
Shirley Dennis-Escoffier
The research tax
credit has resulted
in a tax savings for
many businesses since
it was first enacted in
1981. As part of the
1986 Tax Reform Act,
Congress amended
the Internal Revenue
Code (IRC) to add a
definition of qualified
research activities.
This definition, con-
tained in IRC Section
41(d)(1), is referred to
as the four-part test
and requires:
1. The expenses
qualify as research
and experimental
expenditures under
IRC Section 174
(research intended
to discover information that
would eliminate uncertainly
concerning the development
or improvement of a product).
2. The research is undertaken
to discover information
that is technological in
3. Substantially all of the
research is incurred in a
process of experimenta-
tion relating to a new or
improved function,
performance, reli-
ability, or quality.
4. The taxpayer
intends to use the
information to
develop a new or
improved business
activities that are
associated with
computer software
developed primar-
ily for internal use
by the taxpayer are
specifically excluded
from qualifying for
the research credit
except as permit-
ted by IRC Section
41(d)(4)(E). Before
research activities
related to internal-use
software are eligible
for the research credit, they
must pass an additional onerous
high threshold of innovation
test that includes three more
requirements. Thus, classify-
ing software as not for internal
use is important because the
The research tax credit has served as a financial
incentive to encourage innovative businesses to
increase their spending on research and develop-
ment of new technologies and products; how-
ever, a special provision restricts the ability of
businesses to claim the research tax credit for
expenditures related to development of internal-
use software. Over the past 30 years, the Internal
Revenue Service (IRS) has issued several sets
of proposed regulations in an attempt to clearly
define internal-use software but these attempts
were criticized as not adequately reflecting the
technological advances of the Internet and the
important role of software in all business activities.
Finally, in October 2016, the IRS issued regulations
providing guidance for identifying software devel-
opment activities that are considered internal-use
software and those that are not, expanding the
opportunities for businesses to claim research
credits for software-related expenditures.
© 2017 Wiley Periodicals, Inc.

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