Internal-Use Software

Groups that will likely be affected by these proposed regulations include financial institutions, manufacturers and online retailers that develop their own digital platforms to provide services to their customers. Considering the growth and importance of online banking, the proposed regulations should provide more clarity for a banking sector that is becoming increasingly more dependent on developing a strong digital platform for its customers. According to a 2015 North America Consumer Digital Banking Survey by Accenture, 38% of consumers ranked good online banking services as the number-one reason that they stay with their bank, ahead of branch locations and low banking fees. Even more important is the fact that the banking sector's primary target for future customer growth lies with millennials, who as a group are most likely to stay with their current bank if online services are good.

Defining 'Internal Use' Software

Under the proposed regulations, internal use software is defined as that which is developed by the taxpayer (or a related party) for use in general administrative functions that facilitate or support the conduct of the taxpayer's trade or business. The term “general and administrative functions” is separated into three categories of internal operations for a company: financial management, human resource management and support services. Examples of such functions include financial management of the taxpayer and support for record-keeping; management of the taxpayer's hiring, recruitment and training for their workforce; and functions that support the day-to-day operations of the taxpayer's business.

As provided in the preamble of the proposed regulations, the character of the software as internal use can change depending on the nature of the taxpayer's business. If the software is being developed to be commercially sold, leased, licensed or otherwise marketed to third parties, then the primary use of the software is not for internal use. This is especially true in the case where a taxpayer decides to change the course of an internal development effort toward commercialization (or vice versa). Likewise, the initial intent in developing the software will play a considerable role in determining the character of the software for internal use or some other purpose.

Dual-Function Software

Software serving a dual purpose ' supporting the general and administrative functions ' is a scenario directly contemplated by the proposed regulations. Under these proposed regulations, if software serves a dual purpose in supporting the general and administrative functions as well as interacting with third parties, a presumption arises that the software is primarily for internal use. To the extent a taxpayer can identify a third-party subset of the software that is not for internal use, an allocation of a portion of the developmental expenses should be treated as software for commercial use. Where the third-party subset cannot be isolated, the dual-function subset is provided the possibility for safe-harbor treatment, providing the taxpayer with the ability to claim 25% of its qualified research expenditures incurred in developing the dual-function subset.

Although many agree that the new proposed regulations successfully address issues that have concerned taxpayers in the past, some practitioners are still calling for the IRS to simplify some provisions in internal software rules. In particular, these practitioners foresee revenue agents confusing interactive software with dual function software. They provide that the dual-function requirements are too stringent for developing long-term technological projects. To avoid the future confusion on these potential issues, guidance on these matters would allow companies, which would potentially claim the credit, to incorporate their internal use software expenses into their total expenditure data.

Revision of the Three-Part High Threshold of Innovation Test

The prior regulations allowed internal-use software to qualify for the credit if Section 41 of the Internal Revenue Code was met, and if the taxpayer could demonstrate a high threshold of innovation, as provided by a three-part test in the prior regulations. The three-part test required the taxpayer to demonstrate a high threshold of innovation, significant economic risk and lack of a commercially available alternative. When the prior regulations expired, taxpayers were advised that they could rely on the three-part test from the prior regulations if they also applied an onerous discovery test, which was later overruled in FedEx Corp. v. United States. The new proposed regulations do not require the discovery test to be met, but have changed how the three-part test is applied.

If the taxpayer could demonstrate a measurable improvement in its business if the software were to be developed, then the software would meet the high threshold of innovation standard required under the first part of the test. To qualify, the initial objectives in developing the software must aspire to achieve some measurable improvement in the business, regardless if such success is ever achieved. The proposed regulations' innovation standard is a departure from the previously expired regulations' standard, which required that the software be unique or novel in an inventive way that distinguished it from other types of software.

Under the prior regulations, the significant economic risk standard of the second component would be met if the taxpayer demonstrated that the amount of money expended in the development process of the software might not be recovered within a reasonable time period because of a technical risk of failure. In the proposed regulations, the determination of significant economic risk is based on the level of actual uncertainty that is present at the outset of the development effort. Under the proposed regulations, substantial uncertainty exists only where the development effort involves technical uncertainty.

The proposed regulations expand the first two components of the three-part test. The third component of the test remains the same. Therefore, as provided in the prior regulations for internal-use software, a commercially available alternative to the development effort being undertaken by the taxpayer cannot exist.

Conclusion

Other areas of the proposed regulations remain consistent with prior guidance. For example, software developed in conjunction with hardware is not deemed to be internal-use software regardless of the fact that it was developed by the taxpayer with the intent of using the product for providing services in its trade or business. The key takeaways are that the new proposed regulations limit what can be characterized as internal-use software, provide a safe harbor for taxpayers to claim internal use software expenses when dealing with dual function software, and loosen the type of innovation required to qualify for the credit. Although many still call for added guidance to the dual-function rules, the proposed regulations do provide much needed clarity for practitioners that otherwise had not been addressed.

Manuel Garcia-Linares is the managing shareholder and George L. Metcalfe, Jr. is an attorney with the Florida law firm of Richman Greer. Garcia-Linares concentrates his practice in the areas of corporate law and commercial transactions, complex commercial and business litigation, officer and director liability. Metcalfe focuses his practice on taxation, probate administration and litigation, international and domestic estate planning, and corporate law. They can be reached at [email protected] and [email protected].

The tax credit for research and development (R&D) of internal-use software under Section 41 of the Internal Revenue Code has been the subject of many concerns regarding the current tax code. The R&D tax credit has been renewed 16 times since its implementation in 1981. The most recent renewal occurred on Dec. 19, 2014, when President Obama signed into law the Tax Increase Prevention Act, which called for a one-year extension of the tax credit and applied it retroactively from Jan. 1, 2014, until Dec. 31, 2014. Currently, the R&D tax credit has not been extended beyond calendar year 2015.

Many business leaders and commentators have called for this tax credit to become permanent. They argue that the temporary status of the credit has had two main effects. First, companies have faced a tremendous amount of uncertainty in calculating the after-tax cost of their R&D investments, and often have to commit to these investments long before they know whether the credit will be extended. Second, the credit has gotten lumped in with a wide variety of other tax provisions, including an important provision on Medicare reimbursement that expires on a regular basis.

Despite the lack of any guaranty of the R&D credit in the future, the Treasury issued proposed regulations in January regarding the qualification of internal use software for the federal research credit under Section 41 of the Internal Revenue Code. Nearly 11 years in the making, and after the repeal of two sets of internal-use software regulations that were published in 2001, taxpayers finally have a clearer picture on whether the expenditures made to research and develop their software will qualify for the credit.

Groups that will likely be affected by these proposed regulations include financial institutions, manufacturers and online retailers that develop their own digital platforms to provide services to their customers. Considering the growth and importance of online banking, the proposed regulations should provide more clarity for a banking sector that is becoming increasingly more dependent on developing a strong digital platform for its customers. According to a 2015 North America Consumer Digital Banking Survey by Accenture, 38% of consumers ranked good online banking services as the number-one reason that they stay with their bank, ahead of branch locations and low banking fees. Even more important is the fact that the banking sector's primary target for future customer growth lies with millennials, who as a group are most likely to stay with their current bank if online services are good.

Defining 'Internal Use' Software

Under the proposed regulations, internal use software is defined as that which is developed by the taxpayer (or a related party) for use in general administrative functions that facilitate or support the conduct of the taxpayer's trade or business. The term “general and administrative functions” is separated into three categories of internal operations for a company: financial management, human resource management and support services. Examples of such functions include financial management of the taxpayer and support for record-keeping; management of the taxpayer's hiring, recruitment and training for their workforce; and functions that support the day-to-day operations of the taxpayer's business.

As provided in the preamble of the proposed regulations, the character of the software as internal use can change depending on the nature of the taxpayer's business. If the software is being developed to be commercially sold, leased, licensed or otherwise marketed to third parties, then the primary use of the software is not for internal use. This is especially true in the case where a taxpayer decides to change the course of an internal development effort toward commercialization (or vice versa). Likewise, the initial intent in developing the software will play a considerable role in determining the character of the software for internal use or some other purpose.

Dual-Function Software

Software serving a dual purpose ' supporting the general and administrative functions ' is a scenario directly contemplated by the proposed regulations. Under these proposed regulations, if software serves a dual purpose in supporting the general and administrative functions as well as interacting with third parties, a presumption arises that the software is primarily for internal use. To the extent a taxpayer can identify a third-party subset of the software that is not for internal use, an allocation of a portion of the developmental expenses should be treated as software for commercial use. Where the third-party subset cannot be isolated, the dual-function subset is provided the possibility for safe-harbor treatment, providing the taxpayer with the ability to claim 25% of its qualified research expenditures incurred in developing the dual-function subset.

Although many agree that the new proposed regulations successfully address issues that have concerned taxpayers in the past, some practitioners are still calling for the IRS to simplify some provisions in internal software rules. In particular, these practitioners foresee revenue agents confusing interactive software with dual function software. They provide that the dual-function requirements are too stringent for developing long-term technological projects. To avoid the future confusion on these potential issues, guidance on these matters would allow companies, which would potentially claim the credit, to incorporate their internal use software expenses into their total expenditure data.

Revision of the Three-Part High Threshold of Innovation Test

The prior regulations allowed internal-use software to qualify for the credit if Section 41 of the Internal Revenue Code was met, and if the taxpayer could demonstrate a high threshold of innovation, as provided by a three-part test in the prior regulations. The three-part test required the taxpayer to demonstrate a high threshold of innovation, significant economic risk and lack of a commercially available alternative. When the prior regulations expired, taxpayers were advised that they could rely on the three-part test from the prior regulations if they also applied an onerous discovery test, which was later overruled in FedEx Corp. v. United States. The new proposed regulations do not require the discovery test to be met, but have changed how the three-part test is applied.

If the taxpayer could demonstrate a measurable improvement in its business if the software were to be developed, then the software would meet the high threshold of innovation standard required under the first part of the test. To qualify, the initial objectives in developing the software must aspire to achieve some measurable improvement in the business, regardless if such success is ever achieved. The proposed regulations' innovation standard is a departure from the previously expired regulations' standard, which required that the software be unique or novel in an inventive way that distinguished it from other types of software.

Under the prior regulations, the significant economic risk standard of the second component would be met if the taxpayer demonstrated that the amount of money expended in the development process of the software might not be recovered within a reasonable time period because of a technical risk of failure. In the proposed regulations, the determination of significant economic risk is based on the level of actual uncertainty that is present at the outset of the development effort. Under the proposed regulations, substantial uncertainty exists only where the development effort involves technical uncertainty.

The proposed regulations expand the first two components of the three-part test. The third component of the test remains the same. Therefore, as provided in the prior regulations for internal-use software, a commercially available alternative to the development effort being undertaken by the taxpayer cannot exist.

Conclusion

Other areas of the proposed regulations remain consistent with prior guidance. For example, software developed in conjunction with hardware is not deemed to be internal-use software regardless of the fact that it was developed by the taxpayer with the intent of using the product for providing services in its trade or business. The key takeaways are that the new proposed regulations limit what can be characterized as internal-use software, provide a safe harbor for taxpayers to claim internal use software expenses when dealing with dual function software, and loosen the type of innovation required to qualify for the credit. Although many still call for added guidance to the dual-function rules, the proposed regulations do provide much needed clarity for practitioners that otherwise had not been addressed.

Manuel Garcia-Linares is the managing shareholder and George L. Metcalfe, Jr. is an attorney with the Florida law firm of Richman Greer. Garcia-Linares concentrates his practice in the areas of corporate law and commercial transactions, complex commercial and business litigation, officer and director liability. Metcalfe focuses his practice on taxation, probate administration and litigation, international and domestic estate planning, and corporate law. They can be reached at [email protected] and [email protected].