Qualifications for use of research tax credit modified.

• Author: Becchi, Rosemary
• Position: Internal use software development

In Norwest, 110 TC No. 34 (1998), the Tax Court has held that costs incurred in internal-use software development require a higher threshold of technological advancement and functional improvement to qualify for the Sec. 41 research tax credit.

Norwest and the IRS agreed that seven tests must be satisfied to obtain the Sec. 41 qualified research credit. The first four tests, found in Sec. 41 (d), require that:

1. The expenditure must qualify as a Sec. 174 expense (the Sec. 174 test);

2. The taxpayer must discover information that is technological in nature (the discovery test);

3. The application must be useful in the development of a new or improved business component (the business component test); and

4. Substantially all the research activities must constitute elements of a process of experimentation (the process-of-experimentation test).

   In the case, the Service conceded the Sec. 174 test.

   The additional three tests for internal-use software, set forth in the Conference Report accompanying the Tax Reform Act of 1986, are:

1. The software must be innovative (the innovativeness test);

2. The software development must involve significant economic risk (the significant economic risk test); and

3. The software must not be commercially available (the commercial availability test).

   The Tax Court agreed with the IRS that the Sec. 41 discovery test is narrower than the discovery test in Sec. 174. To satisfy the discovery test, the court stated, "[T]he fact that the information is new to the taxpayer, but not new to others, is not sufficient for such information to come within the meaning of discovery." To satisfy the discovery test, the court concluded that the taxpayer must go "beyond the preexisting knowledge of the principles of the hard sciences."

   As to the process-of-experimentation test, the Tax Court agreed with the Service that "substantially all" of the experimentation activities means "at least 80 percent of the activities that constitute elements of a process of experimentation," i.e., development, testing and analysis. For the innovativeness test, the court believed that quantification would not be materially helpful; based on House and Senate reports, it concluded that "the extent of the improvements required by Congress with respect to internal use software is much greater than that required in other fields."

   The Tax Court determined that the significant economic risk test also raises a threshold higher than in other...