Proposed regulations under section 41 on the eligibility of internal-use software for the credit for increasing research activities.

• Position: Tax Executive Institute's comments of June 9, 1997

On June 9, 1997, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations relating to the eligibility of internal-use software for the research tax credit. The Institute's comments were developed under the aegis of TEI's IRS Administrative Affairs Committee whose chair is Robert L. Ashby of Northern Telecom Inc. In addition to Mr. Ashby, the following members of the Institute contributed to the development of TEI's comments: David L. Klausman, Westinghouse Electric Corporation (Chair, Federal Tax Committee); Paul Cherecwich, Jr., Thiokol Corporation; Lester D. Ezrati, Hewlett-Packard Company; Sheldon A. Kimel, Brunswick Corporation; Fred Lesser, Lucent Technologies, Inc.; Mark A. Modjeski, Tektronix Inc.; Kelly A. Nall, EDS; Robert H. Proehl, BellSouth; Gary Richards, US West, Inc.; Thomas P. Rogers, Apple Computer, Inc.; James A. Ramsey, General Motors Corporation; Raymond G. Rossi, Intel Corporation; Richard C. Sammut, Whirlpool Corporation; and John P. Shepherd, PacifiCorp.

On December 31, 1996, the Internal Revenue Service issued proposed regulations under section 41 of the Internal Revenue Code describing when computer software that is developed primarily by (or for the benefit of) a taxpayer primarily for the taxpayer's internal use can qualify for the credit for increasing research activities. The proposed regulations, which reflect a change made by the Tax Reform Act of 1986 to section 41(d)(4)(E) of the Internal Revenue Code, were published in the Federal Register on January 2, 1997 (62 Fed. Reg. 81) and in the Internal Revenue Bulletin (1997-8 I.R.B. 24). A public hearing on the proposed regulations was held on May 13, 1997.

Background

Tax Executives Institute is the principal association of business tax executives in North America. The Institute has more than 5,000 members who represent 2,800 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, including companies that engage in all levels of research activities. We are dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--both for taxpayers and tax administrators.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the recordkeeping and other compliance challenges associated with the business tax laws. We believe the diversity and training of our members enable us to bring a unique, balanced, and practical perspective to the issues raised by the IRS's proposed regulations relating to the eligibility of internal-use software for the research tax credit and to the research credit generally.

Enactment and Amendment of the Research Tax Credit

The research tax credit was enacted by Congress in 1981 in order to provide an incentive to taxpayers for increasing their research activities within the United States. Now contained in section 41 of the Internal Revenue Code, the research tax credit is equal to the sum of (i) 20 percent of the excess of the taxpayer's qualified research expenses for the taxable year over a base amount and (ii) 20 percent of the taxpayer's basic research payments. "Qualified research expenses" include in-house expenses for wages paid and supplies used in the conduct of qualified research, and 65 percent of any contract expenses for qualified research.(1)

The definition of "qualified research" was amended by Congress in 1986. Section 41 provides that, to be eligible for the research tax credit, an activity must do more than satisfy the definition of research and experimental expenditures for purposes of section 174; it must also be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in development of a new or improved business component of the taxpayer. In addition, an activity is eligible for the research tax credit only if substantially all of the activities of the research constitute elements of a process of experimentation for a new or improved function, performance, reliability, or quality.

Moreover, the Code imposes additional requirements in respect of computer software developed by (or for the benefit of) the taxpayer primarily for the taxpayer's own use--so-called internal-use software. Specifically, section 41(d)(4) (E) states that, except to the extent provided in regulations, such software is ineligible for the research tax credit unless the software is used in (1) qualified research undertaken by the taxpayer, or (2) a production process that meets the requirements of the credit. Importantly, the legislative history of the 1986 amendment provides detailed instructions on the scope of the regulations to be promulgated under section 41(d)(4)(E) in respect of internal-use software not enumerated in clauses (1) and (2) above:

The conferees intend that

these regulations will make

the costs of new or improved

internal-use software eligible

for the credit only if the taxpayer

can establish, in addition

to satisfying the general

requirements for credit eligibility,

(1) that the software is

innovative (as where the software

results in a reduction

in cost, or improvement in

speed, that is substantial and

economically significant); (2)

that the software development

involves significant

economic risk (as where the

taxpayer commits substantial

resources to the development

and also there is substantial

uncertainty, because

of technical risk, that such

resources would be recovered

within a reasonable period);

and (3) that the software is

not commercially available

for use by the taxpayer (as

where the software cannot be

purchased, leased, or licensed

and used for the intended

purpose without modifications

that would satisfy

the first two requirements

just stated).

H.R. Rep. No. 841, 99th Cong., 2d Sess. II-73 (1986). Thus, Congress clearly intended for certain internal-use software to qualify for the research tax credit as long as it satisfies the three-part test quoted above.(2) In Notice 87-12, 1987 C.B. 432, the IRS confirmed that regulations would be issued under section 41 reflecting the legislative history and that the regulations would be effective for taxable years beginning after December 31, 1985.

The Critical Need for Guidance

Given the menagerie of amorphous concepts and terms in the research tax credit -- for example, "process of experimentation," "technological in nature," "innovative," "significant economic risk," and "commercially available" -- it is not surprising that many disputes have arisen between taxpayers and the IRS concerning the meaning and application of section 41. These disputes have been punctuated by what TEI and its members perceive as a historical aversion of the IRS National Office and field personnel to implement the research credit in a manner fully consistent with the congressional intent to provide an incentive for increasing research activities. Significantly, we believe that the number and extent of disputes -- and, indeed, the enmity that has sometimes marked them -- have been exacerbated by the lack of formal guidance from the IRS. Hence, although the IRS issued final regulations under section 41 in 1989, those regulations do not address themselves to the 1986 changes in the definition of qualified research and basic research, nor to the amended rules for computing the credit in respect of basic research payments. (The regulations similarly do not reflect changes made to section 41 in 1989, 1993, and 1996.) Without meaningful guidance in the decade and a half since the credit was enacted, IRS agents adopted differing (and generally restrictive) views of what constitute qualified research activities and expenditures.(3)

Thus, much of the controversy in this area owes itself to the Treasury Department and the IRS's not fulfilling their mandate under section 7805(a) to prescribe "all needful rules." If guidance is needed anywhere, it is here -- where clarity is essential for section 41 to effect the incentive intended by Congress. (If taxpayers cannot discern the scope of the credit, how can the provision operate to stimulate research activities within the United States?) TEI sincerely believes that the promulgation of comprehensive final regulations on the definition of credit-eligible activities and expenses -- complemented by numerous examples -- is critical to bringing salutary clarity to the area, enhancing the ability of taxpayers to voluntarily comply with the Internal Revenue Code's complicated requirements in respect of the research tax credit, and materially reducing the number and magnitude of disputes between taxpayers and the IRS in respect of the credit. Indeed, given the explosive growth of software development since 1986, the need for guidance is even more pronounced in 1997 than it was 11 years ago when section 41 was amended.

Consequently, although TEI has serious concerns about the content of the proposed regulations, we commend the IRS for seeking to fill the guidance void by promulgating proposed regulations relating to the eligibility of internal-use software for the credit. We urge the IRS and Treasury to proceed with revising the internal-use regulations (along the lines set forth below) and, indeed, with the issuance of more general guidance on the application of section 41.(4)

The Shortcomings of the Proposed Regulations

TEI's desire for guidance notwithstanding, the Institute regrets to say that the proposed regulations substantially fail to bring certainty to this area. They not only provide precious little practical guidance to taxpayers and IRS field agents, but the guidance they do contain...