On January 16, the Treasury Department issued proposed regulations limiting the definition of internal use software, and thereby broadening the scope of the Research and Development tax credit. Section 41(d)(4)(E) of the Internal Revenue Code excludes internal use software from the definition of “qualified research activities” under § 41(d). Previous guidance under TD 8930 defined internal use software as software that was primarily for a taxpayer’s internal use. Therefore, software developed by a taxpayer to help it interact with third parties would be non-qualified internal use software.
Under the new regulations software that “allows third parties to initiate functions or review data on the taxpayer’s system does not solely benefit the taxpayer developing the software” and is therefore not considered internal use software. Instead, software is held for internal use if it is used for the general administrative functions of financial management, human resources and support services. Software that serves the dual-function of providing both general administrative functions and third party interactions will qualify to the extent software is used for third party interactions. If the taxpayer is unable to allocate research expenses to the portion of the software that deals with third party interactions, then it may still take 25% of qualified research costs as long as it can prove that third parties will account for 10% of the software’s use.
The new regulations also incorporate the old threshold of Innovation Test, which allows internal use software to qualify for the credit if the software 1) is innovative; 2) involved significant economic risk; and 3) is not commercially available to the taxpayer. The new regulations add objective, taxpayer friendly criteria for each of the elements of the test.
The new regulations will allow a greater number of taxpayers to claim the Research and Development tax credit. More specifically, smaller entities that were previously unable to claim the credit will be eligible to claim research and development expenses for software developed for interactions with third parties.