After much anticipation the United States Treasury issued final regulations for Internal Use Software (IUS) regulations. The good news is they are substantially similar to the proposed regulations issued on January 20, 2015. They are taxpayer friendly as they clarify and arguably expand the definition of non-IUS. Citing the intent behind the credit (to incentivize increasing research on a go forward basis) they determined the regulations will not be retroactive (the bad news if we can really call it “bad”). However, the IRS will not challenge returns consistent with the proposed regulations and filed on or after January 20, 2015.
Clarification of IUS
The biggest highlight in the finalized regulations is the clarification of the definition of IUS. First, the finalized regulations clarify that software developed for general and administrative functions that facilitate or support the conduct of the taxpayer’s business is IUS. The regulations define general and administrative functions in three categories:
- Financial management
- Human resources management
- Support services.
Each of these three functions are further defined in the regulations and are essentially “back office” functions that are neither marketed to, or interact with, potential clients. The clarification is applicable to related parties treated as single taxpayer pursuant to section 41(f).
The final regulations then clarify what is not included in IUS as software a taxpayer offers for sale, lease or license or is otherwise marketed to third parties OR developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. The italicized portions of this regulation have the potential for very broad application. Regardless, the entirety of the clarification is an expansion of what most taxpayers have considered qualified research expenses and will necessitate a rework of any process they currently use to calculate their research credit.
Another highlight from the finalized regulations includes the requirement that a taxpayer must continue to apply the Consistency Rule. Therefore, taxpayers who have claimed the research credit on prior returns will be required to recalculate and adjust their base calculation accordingly if they intend to claim research expenses under these new favorable regulations on current and future years’ returns. Note the Consistency Rule will require a base calculation adjustment. However, the nature of the prospective application of the new regulations requires a taxpayer to continue to choose between the application of TD 8930 and regulation 1.41-4(c)(6) to calculate their prior year credit. Therefore, two calculations will be required. One using the new regulations for tax years after January 20, 2015 and one for any returns amended for prior years utilizing the taxpayer’s choice between TD 8930 and regulation 1.41-4(c)(6).
“Dual Function” Software
What about IUS that also interacts with third parties or “dual function” software? There is a Safe Harbor rule that allows the taxpayer to claim 25 percent of the expenses if the third party’s interaction is reasonably anticipated to constitute at least 10 percent of the dual function software.
What if you start out with the intent to develop IUS and then change your mind and decide to license it or otherwise convert it into non-IUS or vice versa? The determination is based on the taxpayer’s intent at the outset of the development considering all the facts and circumstances. However, that determination can be converted if the taxpayer changes their intent. The qualification determination is determined on a prospective basis at time of the change in taxpayer intent.
Three Prong Test for IUS
For IUS the qualification remains a three prong test. The first prong or innovation test remains consistent with the proposed regulations in that it provides a test for what the Service says is “measurable and objective, and should reduce the potential for controversy.” But don’t relax too much because the second prong or significant economic risk test tends to muddy the waters. Instead of sticking with the proposed version and requiring the uncertainty to relate to capability or methodology the Treasury settled on a reasonability test. As we all know, reasonable minds can differ so this test will require documenting the facts and circumstances. The third prong or commercially available test remains the same as the proposed regulations. Recall the commercially available test which simply asks whether similar software may be purchased, leased or licensed and used for the intended purpose without modification that would satisfy the first two tests.
The bottom line is if you are going to take a research credit on your tax returns for software development or in the past you thought or have been told you do not qualify, you need to speak to an experienced, capable professional. Between adjusting the base calculation, weeding through the reasonableness test, along with all the facts and circumstances tests, you need an expert who has experience. ThreeFive Inc. has the experienced, knowledgeable professionals you can trust to help you navigate the new R&D and Internal Use Software landscape.
Submitted By: Joyce Exmundo