03 October 2016 Treasury issues final research credit regulations On October 3, 2016, the Treasury Department released final regulations (TD 9786) clarifying the rules related to software development for purposes of the research credit under Section 41. Importantly, the final regulations offer guidance to resolve controversy between the IRS and taxpayers related to internal-use software. The final regulations provide guidance on the following topics: The final regulations also include new examples demonstrating the process of experimentation requirement in the context of computer software development, regardless of whether the software is internal-use software. This Alert provides a brief overview of the regulations. A more detailed Alert will be issued shortly. The majority of the January 2015 proposed regulations are made final in TD 9786. Comments were requested on the proposed regulations and several were submitted. After considering the comments, the government rejected most of them. Under the final 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. The final regulations limit "general and administrative functions" for this purpose to financial management functions (including supported recordkeeping), human resource management functions and support services functions (e.g., data processing or facilities services). This definition is consistent with the proposed regulations. The final regulations, however, modify the definition in the proposed regulations of software not developed primarily for internal use to include all software not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. The final regulations use, as examples of software not developed primarily for internal use, the items included in the proposed regulations' definition of software not developed primarily for internal use. Those examples include software "developed to be commercially sold, leased, licensed, or otherwise marketed to third parties," and 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." This subtle but important change results in a new paradigm under the final regulations: if software is not developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business, it is not internal-use software. On examination, the IRS frequently took the position under the proposed regulations that a taxpayer's software was internal-use software unless it was 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, even if the software was not developed for general or administrative functions. Despite many comment letters related to the dual-function software rules, which include a presumption that dual-function software is internal-use software, the final dual-function software rules are unchanged from the proposed rules. The safe harbor, however, has been modified to clarify that the safe harbor can apply to the dual-function software or the dual-function subset of the software. Thus, to the extent the taxpayer can demonstrate that some portion of the software it is developing as part of an integrated system is not internal-use software, that piece of the software will be excluded from internal-use software and the dual-function software rules. The final regulations provide rules of application implementing the three-part "high threshold of innovation test." Part I (innovation) and Part III (commercially available for use) remain unchanged from the proposed regulations. Part II (significant economic risk), however, has been clarified and is more taxpayer-favorable than what was described as significant economic risk in the proposed regulations. The technical uncertainties that must be shown to satisfy the significant economic risk under the final regulations include design uncertainty (which was excluded under the proposed regulations). The final regulations are effective for tax years beginning on or after the date they are published in the Federal Register, which is expected to be October 4, 2016. The final regulations state that the IRS will not challenge return positions consistent with the final or proposed regulations for tax years ended on or after January 20, 2015, the date of publication of the proposed regulations. The final regulations related to computer software for purposes of the research credit represent a more taxpayer-favorable interpretation of Section 41(d)(4)(E) than was set forth in previous regulations. The change in the definition of software not developed primarily for internal use means that taxpayers do not have to affirmatively prove that the software is either "developed to be commercially sold, leased, licensed, 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 taxpayer must only show that the software is not developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. Additionally, the final regulations' change to the proposed regulations' significant economic risk test provides taxpayers with a wider path to prove the existence of technical uncertainties.
Document ID: 2016-1685 | |||||||||
