Proposed regulations: Credit for increasing research activities involving computer software

Credit for increasing research activities

The Treasury Department and IRS today released for publication in the Federal Register a notice of proposed rulemaking (REG-153656 -03) concerning the application of the credit for increasing research activities pursuant to section 41 for computer software that is developed by or for the taxpayer, for the taxpayer’s internal use.

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These regulations have been long-awaited. The IRS issued final regulations (T.D. 9104) on many aspects of the research credit at the end of 2003, but deferred addressing the rules dealing with internal use software.

Under section 41(d)(4)(E), no research credit is allowed for internal use software development except as provided by regulations. The IRS earlier issued several regulatory proposals on the subject, and assured taxpayers that a credit is allowed if the software development meets some additional requirements referred to as the “high threshold of innovation test.”

There has been continuing controversy over the definition of internal use software and the precise application of this test. The IRS announced at the beginning of 2004 that work would continue on proposed regulations on this subject, and the project has appeared on every IRS-Treasury Business Plan since then.

Today’s proposed regulations [PDF 242 KB] would provide a comprehensive set of rules dealing with the requirements for a research credit for internal use software development. The proposed regulations are scheduled to be published in the Federal Register on January 20, 2015.

Definition of internal-use software

Under the proposed regulations, software is developed by (or for the benefit of) the taxpayer primarily for internal use if the software is developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business.

If developed for the internal use of a member of the taxpayer’s controlled group, it will be considered internal-use software. This is relevant based on the rules that must be applied to determine qualification for research credit purposes.

This standard eliminates the distinction between software developed to deliver computer and noncomputer services.

The definition is intended to target software used in the back-office functions of the taxpayer—financial management functions, human resource functions, and support services functions. Additionally, the new regulations target software designed by the taxpayer to provide administrative functions to third parties (e.g., vendors).

Software that is developed to be commercially sold, leased, licensed, or otherwise marketed is treated as software not developed primarily for internal use. The proposed regulations attempt to alleviate confusion prevalent in prior interpretations, that software must have a third-party commercial focus to avoid being characterized as internal use software.

Certain software that benefits third parties by enabling them to interact and/or initiate transactions with the taxpayer may be excluded from the definition of internal use software. Examples include software enabling electronic banking transactions and/or logistical software.

Improvements to software, to make internal-use software commercially available, or to make commercially available software useful for the taxpayer’s general and administrative functions, need to be analyzed separately from the existing software to determine proper treatment under these regulations. More specifically:

  • Enhancements to commercially available software specifically designed for the taxpayers administrative use will be considered internal use software, and
  • Enhancements to internal use software that are intended to provide non-administrative functionality to a third party will be considered non-internal use software.
Internal testing of commercial software will not make it internal-use software.
Dual function software (software used both internally by a taxpayer and by third parties) is presumed to be for internal use. However, if the taxpayer can identify subsets of elements that facilitate third-party interaction, or enable third parties to initiate functions or review data, those subsets will not be presumed to be for internal use and may be eligible for the research credit without application of the three-part high threshold of innovation test.
A safe harbor is provided that would enable the taxpayer to count 25% of the research expenses of the remaining subsets of the dual use software as qualified research expenses, if it is reasonably anticipated that the third-party functions will constitute at least 10% of their use. An objective, reasonable method must be used to estimate the dual function subset’s use by third parties or by the taxpayer to interact with third parties and such use must be estimated at the beginning of the computer software development.
By statute, software that is developed for use in a production process that meets the requirements for qualified research is not considered developed for internal use. The regulations would specify that computer software supporting the delivery of goods or services to third parties is not part of a production process that is excluded from the definition of internal use software.
Also, as in the past, software developed for use in a qualified research activity is not affected, and development costs of a package of software and hardware that are a single product that is used in providing services is evaluated as a single product, not as separate internal use software and another business component.
Similar to prior regulations, internal-use software requires additional tests to be met in order to constitute qualified research under these regulations, as discussed below.

High threshold of innovation test

Internal-use software development will, as under prior standards, be qualified research if it meets a three-part high threshold of innovation test. The preamble states that this is to be a higher standard than for other business components to be qualified research, but the test is not to be so restrictive as to make the test impossible to meet.

The proposed regulations retain the outline and traditional statement about what the three additional requirements are. However, they also provide further nuances of what is required that are likely to provide new challenges to taxpayers seeking to satisfy the high threshold of innovation test.

The traditional innovative test, similar to that in 1986 Committee Reports, is reiterated, requiring an economically significant reduction in cost or improvement in speed or other measurable improvement. The proposed regulations would not require successful development, but would require the hoped-for result to be a measurable and objective improvement.

The traditional significant economic risk requirement has been modified from prior guidance. This test is to be applied to the level of uncertainty involved at the outset of the development, rather than the degree of innovation represented by the end result. A substantial uncertainty would be considered to exist if, at the beginning of the taxpayer’s activities, the information available to the taxpayer does not establish the capability or method for developing or improving the software.

Uncertainty related to appropriate design (which is an eligible uncertainty under section 174 and for purposes of the general four-part test for all R&D projects) is insufficient for purposes of the high threshold of innovation test.

Significant economic risk requires both technical and economic risk that the substantial uncertainty be resolved. To satisfy this requirement, the taxpayer is expected to be uncertain whether the resolution of the technical uncertainties—and achievement of the final result—can be achieved within a timeframe that will allow the resources devoted to be recovered within a reasonable period.

The traditional requirement that the software not be commercially available is retained.

Process of experimentation requirement for all software development

These proposed regulations contain examples of how the IRS will apply to computer software (and not only to internal-use software) the requirement in the general definition of qualified research that the activity qualify as a process of experimentation with respect to technical uncertainty.

The preamble states that the examples are intended to reflect the view that the development of certain types of web design and installation of enterprise resource planning (ERP) software would generally not qualify as a process of experimentation. The examples, however, also show how systematic design, evaluation, and testing of algorithms will satisfy the requirement, and show that shrinking back principles will be applied.

Comments requested

A hearing at the IRS on the proposed regulations has been scheduled for April 17, 2015 at 10:00 a.m. Comments are requested (and are due March 23, 2015), specifically, on

  • The appropriate definition and treatment of connectivity software
  • The safe harbor test for dual function software
  • Other facts and circumstances that could be considered in determining whether internal use software development meets the three prongs of the high threshold of innovation test

Effective dates

The proposed regulations, once finalized, will be prospective only, applicable in tax years ending on or after the date final regulations are published in the Federal Register.

However, the IRS will not challenge return positions consistent with the proposed regulations for tax years ending on or after January 20, 2015.

The advance notice of proposed rulemaking published at the beginning of 2004 is withdrawn. That notice had contained what was viewed as a contentious statement that taxpayers “may rely” on all of the provisions in the 2001 final regulations, including the since-disavowed “discovery test,” or the provisions dealing with internal use software in the 2001 proposed regulations that included a “unique or novel” requirement to satisfy the innovativeness prong of the high threshold of innovation test.

Instead, for tax years ending before January 20, 2015, taxpayers “may choose to follow” all of the internal-use software provisions in either the 2001 final regulations (without application of the “discovery test”) or the 2001 proposed regulations.


For more information, contact a tax professional with KPMG’s research credit practice:

David P. Culp | +1 (202) 533-4104 |

Tyrone Montague | +1 (212) 954-6818 |

Christine Kachinsky | +1 (212) 872-2187 |

Michael Brossmer | + 1 (408) 367-4127 |

Richard G. Blumenreich | + 1 (202) 533-3032 |

Todd Mazzeo | + 1 (212) 872-3846 |

Michael Fishman | + 1 (214) 840-6966|

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