A happy day for the software industry with the Treasury Department issuing last week new regulations on when development of software would be eligible for the Research and Development (R&D) tax credit. Treasury notes in the regulations (and we agree) that it expects the regulations will have a positive economic impact on a substantial number of small entities (especially manufacturers, sellers on the web [both retail and business-to-business], banks and financial institutions are all potential beneficiaries).

We view that the proposed regulations not only are a boon for those engaged in software development, but for close readers the proposed regulations also have broad benefits for industries seeking to qualify for the R&D tax credit.

Historically, the grind in software development being eligible for the R&D tax credit has been the definition of “Internal Use Software” (IUS) – i.e. software that is not sold, leased or licensed to a third party. In brief, if the software is considered IUS it is a higher hurdle for companies to have that work eligible for the R&D tax credit. The new Treasury regulations basically put a fence around what is IUS and limit the definition of IUS (a good thing for taxpayers), and at the same time Treasury effectively expands what is not IUS (also good for taxpayers).

New Proposed Regulations

On Friday, the Treasury Department and the IRS went to great lengths to bring some clear lines on IUS – an area of the law that had previously been fairly murky and uncertain. The Treasury and Service recognized that many small businesses develop software to run their business and at the same time interact with customers (think of sales on the web). By narrowing the definition of what constitutes IUS, the Treasury guidance reflects the realities of software development in the economy and will also ensure that the research credit will be available to benefit a greater number of small businesses.

Let’s take a look at how the Treasury and Service actually expanded the research credit for software. In the past, if you developed software that was sold, leased or licensed and was considered not IUS, and the taxpayer simply had to satisfy the traditional four-part test of the R&D tax credit (which is, in short, developing a new or improved product by eliminating uncertainties through a process of experimentation that was technological in nature).

Now, under the new Treasury regulations, software is not considered IUS if the software is “sold, leased, licensed or otherwise marketed to third parties” (and still meeting the four-part test for R&D).

Treasury further clarifies in the proposed regulations that IUS only refers to software that is developed for general and administrative functions that facilitate or support a taxpayer’s trade or business. General and administrative functions are defined for the first time, with respect to IUS, as limited to financial management functions, HR management functions and support services.

The new rules also go a giant step forward when it comes to developing software that allows you to interact with your customers. Specifically, the rules state that software that enables a business to interact with a third party (i.e. customer) is appropriate to exclude from the definition of IUS. (As an example, FedEx, who challenged the government’s definition of IUS in court, developed software that allows customers to track packages. With this new definition, the software would not be considered IUS).

By narrowing the initial definition of what constitutes IUS, Treasury and the IRS have made it much easier for companies to claim the R&D tax credit for software they have developed to provide services to customers.

Clarity on IUS and Qualifying for the R&D Tax Credit

While it is much easier for businesses to have software development qualify for the R&D tax credit, if the software is not IUS, it is still possible for IUS to also qualify for the R&D tax credit – it is just a higher threshold that must be met.

There is a three-part heightened test (along with the normal four-part R&D test) for IUS qualifying for the R&D tax credit (the three tests – driven by the legislative history are: 1) the software is innovative; 2) that the software development involves significant economic risk; and, 3) the software is not commercially available). The heightened “significant economic risk” is now a two-part test:

First, the taxpayer must have “substantial uncertainty” as to whether the taxpayer is capable of doing something or know what the best method is to solve your problem (but note: there is not a heightened requirement for uncertainty for appropriate design). This is an entirely new requirement for IUS, but it also has some additional benefits to industries outside of the software world (where the IRS has in essence tried to apply such a heightened standard for the R&D tax credit in other fields without any legal authority. This new guidance should end such free-lancing by IRS examiners).

Second, the taxpayer must devote “substantial resources” to the development (defined as whether the final result can be achieved within a timeframe that will allow the substantial resources committed to be recovered with a reasonable period – fun).

On the heightened three-part test for software that is “innovative” – the new definition again reflects a real-world understanding. “Software is innovative if the software would result in a reduction in cost or improvement in speed or other measureable improvement, that is substantial and economically significant, if the development is or would have been successful. This is a measureable objective standard, not a determination of the unique or novel nature of the software or the software development process (emphasis added).

This again is an important point broader than just the software industry – time and again we have emphasized with taxpayers that the R&D credit is not just about a unique or novel development process or product, but also encompasses changes that will result in reduction in cost; energy and economic efficiencies; improved speed, etc. It is good to see that the Treasury similarly recognizes that economic growth and development fueled by R&D takes many shapes and forms.

Summary

For many years, determining whether the software you have developed was internal or external use has been difficult at best. If you found yourself dealing with IUS in exam with the IRS, you may have felt like the Service was doing everything possible to make it impossible to qualify. With Friday’s regulations, the Treasury and Service have come forward to recognize that the IUS requirements should not be so restrictive as to make the test impossible to meet. The proposed regulations provide a narrower scope that will allow more companies – especially small and medium companies – to qualify for the Research Credit and make it more straightforward for those developing IUS to apply the High Threshold of Innovation test.

Finally, the regulations also speak to other industries as well that the IRS should not be applying a “substantial uncertainty” outside of IUS and that the IRS should bear in mind that the R&D tax credit applies broadly – encompassing not just products but also improvements that lead to reductions in cost, speed, and other substantial and economically significant improvements for the company.