Software Credit for Increasing Research Activities: New Treasury Regulations concerning the Application of the Software Credit for Increasing Research Activities Went into Effect October 4, 2016

By Shah, Aashna; Rinier, James W. | Strategic Finance, March 2017 | Go to article overview

Software Credit for Increasing Research Activities: New Treasury Regulations concerning the Application of the Software Credit for Increasing Research Activities Went into Effect October 4, 2016


Shah, Aashna, Rinier, James W., Strategic Finance


The credit for increasing research activities under Internal Revenue Code (IRC) [section]41 was enacted in 1981 to help support U.S. businesses incur greater research expenditures and thus stimulate a greater level of innovation. Software technology has evolved significantly since then, leading the Treasury Department and IRS to issue proposed regulations that provide a definition of internal use software. Most businesses today use "cloud" solutions, which make the computer software explanation for claiming the credit more significant.

The Final Regulations (TD 9786) published in the Federal Register, 81 Fed. Reg. 68299 (October 4, 2016) provide a summary of examples and comments made in response to the proposed regulations, adding more details and clarification. The internal use software and the dual-function software provisions appear to be the most useful to review.

INTERNAL USE SOFTWARE

Under IRC [section]41(d)(4)(E), no research credit is allowed for internal use software development, except as provided by regulations. Under the proposed regulations, software was considered to be for internal use if it's developed by (or for the benefit of) the taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business.

The final regulations include further details that clarify when software isn't developed for internal use, such as: (1) software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties or (2) software 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.

For example, a restaurant named Clara develops software for a website that provides information to potential customers, such as the menu, price, location, phone number, and hours of operation. At the beginning of the development, Clara doesn't intend to develop the website software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable Clara to interact with third parties or to allow third parties to initiate functions or review data on Clara's system. Clara intends to use the software for marketing by allowing third parties to review general information on Clara's website. Would this be considered as developed for internal use? With the final regulations, there's a definite answer: Yes. The software is developed for use in a general and administrative function because the software was developed to be used by Clara for marketing, which is a support services function under Regulation [section]1.41-4(c)(6)(iii)(B)(3). Thus, no credit would be allowed in this example.

Consider another hypothetical situation: Tomas is a provider of cloud-based software. Tomas develops enterprise application software (including customer relationship management, sales automation, and accounting software) to be accessed online and used by Tomas's customers. At the beginning of development, Tomas intended to develop the software to collect fees for commercial sale, lease, license, or to be otherwise marketed to third parties. Considering the facts of this situation, the software isn't developed primarily for internal use because it isn't developed for use in a general and administrative function. Tomas developed the software to be commercially sold, leased, licensed, or otherwise marketed to third parties under Regulation [section]1. …

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