07 October 2016 Final research credit software regulations affect media and entertainment industry The final research credit software regulations (TD 9786) will significantly affect the treatment of software developed by taxpayers in the media and entertainment industry for research credit purposes. These regulations make clear that, unless software is developed for general and administrative functions, it is not internal-use software. The Treasury Department released these final regulations clarifying the rules related to software development for purposes of the research credit under Section 41 on October 3, 2016. 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: 1. What internal-use software is 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 be commercially sold, leased, licensed, or otherwise marketed to third parties These final regulations clarify that software developed by media and entertainment companies to provide their software-based products and services is not internal-use software and thus not subject to the high threshold of innovation test. Among many other examples, software developed to provide the following types of services is not internal-use software: — Online education Provided below are three in-depth examples prepared by EY to demonstrate the application of these final regulations to the media and entertainment industry. X, an education services company, undertakes a software development project to create a new technology platform that betters services students, educators, and administrators. The platform will be designed to integrate the majority of X's previously disparate systems into a cohesive education platform that will be accessed by customers through an X-hosted environment. X intended to develop the education platform for commercial sale, lease, or license, or to be otherwise marketed to third parties. In particular, students, teachers and school districts pay subscription and license fees to use the technology to manage the student education process and provide courses and diagnostic services. Conclusion — The education platform software is not developed primarily for internal use because it was not developed for use in X's general and administrative functions (the software is not developed for use in X's financial management, human resources management or support services functions). X is a data information company that provides customers with the capability to efficiently search large data sets for topically relevant information. For example, X's customers use X software to search for specific keywords or details to identify relevant and responsive data. During the tax year, X developed software enhancements that provide new features and improved and more accurate search results to improve the search capability. X customers subscribe for the right to use the search software and interact with the software through an X-hosted portal. Conclusion — The software enhancements were not developed primarily for internal use because the software was not developed for use in a general and administrative function (the software is not developed for use in X's financial management, human resources management or support services functions). The software enhancement development was undertaken to provide improved search services to third-party customers. X, a film production studio, undertakes a software development project to develop customized film production software for use in its trade or business. X utilizes third-party software as a platform but must develop significant customizations and enhancements in order to achieve their required proprietary functionality. Conclusion — The customized film production software is not developed primarily for internal use because it was not developed for use in X's general and administrative functions (the software is not developed for use in X's financial management, human resources management or support services functions). X provides industry-specific data analytics based on data feeds from third-party providers. X consolidates this data and then uses software algorithms developed by X to evaluate, process, and analyze the data. X generates industry-specific reports to which X's customers subscribe. Conclusion — The software algorithms developed by X are not developed primarily for internal use because the software was not developed for use in a general and administrative function (the software is not developed for use in X's financial management, human resources management or support services functions). The software provides data analytics reports to third-party customers. The final regulations contain many more examples demonstrating various aspects the regulations' application. 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 dual function safe harbor, which allows a taxpayer to include 25% of these expenses as non-internal use software, 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. In addition, 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 high threshold of innovation rules. This rule will likely have a very limited application for taxpayers in the media and entertainment industry. It only applies when a taxpayer is developing general and administrative software that will also allow third parties to initiate functions. For example, the development and implementation of enterprise software modules related to customer billing or inventory management may include third-party interfaces that meet this dual-function definition. Example 8 of the final regulations provides an important example of software that is not dual-function software. In this example, the taxpayer is developing software that allows its users to upload and modify photographs at no charge. X earns revenue by selling advertisements that are displayed while users enjoy the software that X offers for free. X also developed software that has interfaces through which advertisers can bid for the best position in placing their ads, set prices for the ads, or develop advertisement campaign budgets. At the beginning of the development, X intended to develop the software to enable X to interact with third parties or to allow third parties to initiate functions on X's system. This example concludes that this software is not considered to be internal-use software or dual-function software because it is not developed for general and administrative functions. More specifically, the software that allows for advertisement placement bidding is not considered to be general and administrative support service software, such as marketing software, because the software does not facilitate the advertisement of the taxpayer's goods or services. 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 the proposed regulations. For software that is considered to be internal-use software (e.g., enterprise software, human resource software, billing software, customer management software, etc.) the regulations clarify that technical uncertainties related to the appropriate design of the software can meet the significant uncertainty test. The proposed regulations suggested that only uncertainty related to the taxpayers capability or methods to achieve the required software functionality could meet the significant uncertainty definition. The final regulations are effective for tax years beginning on or after October 4, 2016, the date they were published in the Federal Register. 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, and beginning before October 4, 2016. 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 for taxpayers in the media and entertainment industry. The change in the definition of software not developed primarily for internal use means that Media & Entertainment 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: 2016-1712 | |||||||||
