IRS issues reasonable internal-use software regulations for the research tax credit.

• Author: Bertiglia, Rory

On Oct. 3, 2016, the Treasury Department issued much-anticipated final regulations (T.D. 9786) addressing software developed primarily for a taxpayer's internal use under the Sec. 41 credit for increasing research activities. The final regulations adopt many of the provisions included in the proposed regulations (REG-153656-03) issued in 2015 and are considered to be taxpayer-friendly. More importantly, the final regulations could provide significant opportunities for companies and industries that previously did not include expenditures for software developed primarily for their own internal use in the calculation of the Sec. 41 research tax credit due to confusing and sometimes controversial guidance.

Background

Since the incremental research credit under Sec. 41 was introduced with the Economic Recovery Tax Act of 1981, RL. 97-34, there has been much discussion and uncertainty regarding its application to software development. For example, in 1986, Congress amended the research credit statute to add a definition of qualified research activities but specifically excluded certain activities, including computer software developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than software developed for use in qualified research or a production process (Sec. 41(d)(4)(E)).

Several sets of proposed and final regulations were issued over the ensuing years to address internal-use software and to introduce various concepts, including the high-threshold-of-innovation test (see below); a definition of "innovation"; and a temporary imposition of a more stringent discovery test.

Taxpayers were finally afforded some clarity when proposed regulations were issued in January 2015 that provided a more narrow definition for internal-use software, introduced "dual function" software, and established a safe-harbor alternative.

Qualified research activities: The four-part test

Qualified research activities are generally identified by satisfying all four requirements of the "four-part test":

Permitted purpose: The activity relates to a new or improved function, performance, reliability, or quality of a product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, or license or used in the taxpayer's trade or business (Sees. 41(d)(l)(B)(ii) and (d)(2)(B)).

Technological in nature: The activity performed must fundamentally rely on principles of physical science, biological...