Understanding how final regs differed from proposed, and the significance of them
Earlier this month, the IRS published final regulations concerning guidance on Internal Use Software (IUS) development and its eligibility for the research and development tax credit under IRC Section 41.
In last week’s blog post, we outlined some of the key taxpayer takeaways stemming from these final regulations. Today, we wanted to provide you with further detail on how final regulations actually compared to proposed regs, and what the significance of the final regs really mean to businesses. Let’s begin by addressing the long awaited, often confusing question – how to define Internal vs. Non-Internal Use software?
DEFINITION OF IUS:
The final regulations contain the general rule found in the proposed regulations – software is developed by (or for the benefit of) the taxpayer primarily for the taxpayer’s internal use if the software is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. The regulations contain a list of general and administrative functions, under the categories of financial management, human resources, and support. Per the final regulation preamble, the listed functions are intended to identify “back-room” functions, which would be applicable regardless of the taxpayer’s industry, but depending upon facts and circumstances of the taxpayer, will vary.
SO WHAT NOW IS NON-IUS?
Final regulations state,
Software not developed primarily for internal use. Software is not developed primarily for the taxpayer’s internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business, such as—(A) Software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or (B) 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.
The regulations provided that the determination of whether the software will be categorized as IUS or non-IUS will be based on the taxpayer’s intent and facts and circumstances at the beginning of the software development.
The final regulations mirror the proposed regulations, in not requiring a “separately stated consideration” for sold/leased/licensed software, and went further to specifically include hosted software (i.e. where no transfer of a copy of the software takes place) as non-IUS software.
Finally, the preamble and applicable example in the final regulations clarify that a web site intended for mere marketing and lacking the ability for third party interaction or data review on the taxpayer’s system, will be considered developed for internal use since it was intended for use in a general and administrative function.
HIGH THRESHOLD OF INNOVATION TEST:
Under final regulations, IUS software development may still be eligible for the research credit, if among other things, the three component requirements of the High Threshold of Innovation Test are met. However, the final regulations include a significant revision to the “significant economic risk” test, modifying the “substantial uncertainty” component of this test to include design uncertainty. The proposed regulations had allowed for only uncertainty in the areas of capability and methodology, to be considered in whether this requirement was met.
The final regulations state, in part,
Significant economic risk. The software development involves significant economic risk if the taxpayer commits substantial resources to the development and if there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period. The term “substantial uncertainty” requires a higher level of uncertainty and technical risk than that required for business components that are not internal use software. This standard does not require technical uncertainty regarding whether the final result can ever be achieved, but rather whether the final result can be achieved within a timeframe that will allow the substantial resources committed to the development to be recovered within a reasonable period.
The final regulation’s focus on the level of uncertainty component of this test is a vast improvement to the proposed regulation’s approach of focusing on the type of uncertainty, to differentiate a substantial versus non-substantial uncertainty.
Finally, specifically stated in the preamble to these regulations and in the regulation drafting, is that a revolutionary discovery is not required to meet the high threshold of innovation test; another huge taxpayer win.
WHAT IT NOW MEANS:
With the explosive growth in the use of computer technology to drive new product development, operational improvement, and customer interaction, more businesses than ever are investing in the development of computer software. Based on these final regulations, regardless of what industry they are in, businesses of all industry sizes and sectors may now have new opportunities to secure tax credits to help offset some of that development expense.
If you have questions about whether or not your client may now eligible for tax savings opportunities under these new IUS regulations, please give us a call today at 440.331.0714 or contact us at http://taxcreditsgroup.com/contact-us.
