Claiming Research and Development Tax Credit for Software
New regulations allow many businesses who use proprietary software in the delivery of their product or service to claim the Research & Development tax credit on that software for the first time.
The U.S. Treasury Department and the IRS released final regulations regarding the definition and treatment of internal-use software (IUS) with respect to the federal research credit which is also known as the Research and Development tax credit. These modify and adopt the proposed regulations that were issued in January 2015 and opened the door to a less restrictive definition of internal-use software and its eligibility for the credit.
The final regulations will be welcomed by e-commerce businesses as well as companies developing software to be used in their operations. The benefits could span a variety of industries. For example, the new rules may make claiming the credit easier for banks developing transaction software or healthcare organizations developing their own electronic health record system or patient portal.
Previous barriers to claiming the R&D tax credit
Prior to the change, there were extensive challenges associated with substantiating the eligibility of IUS projects for the credit. Internal-use software was not eligible for the R&D tax credit unless it could satisfy a particularly challenging test known as the high threshold of innovation. As a result, businesses developing software for a purpose other than to be commercially sold or licensed often refrained from trying to capture the R&D tax credit for such projects.
Prior IRS guidance also generally suggested that almost any software developed for purposes other than to be commercially sold, leased, licensed or otherwise marketed to unrelated third parties was developed for internal-use purposes and therefore needed to satisfy the high threshold of innovation.
Changes under the new final regulations
Under the new final regulations, any software that is not developed to be used strictly in a “general and administrative function” could potentially qualify for the credit without having to pass the notoriously stringent test. General and administrative functions are defined as financial management functions, human resource management functions and support services functions.
Further, the final regulations provide that software is not considered to be internal-use software (and therefore is not subject to the test) if it is developed to enable a company to interact with third parties or to allow third parties to initiate functions or review data on the company’s system. Examples may include tracking deliveries, purchasing tickets, and receiving services over the internet.
Therefore, software developed to be used in general and administrative functions could potentially avoid the IUS classification if it enables such third-party interaction. However, if the functions initiated by third parties on the software relate to the taxpayer’s general and administrative functions, the software will fall under the IUS definition.
The final regulations better reflect the critical role that software plays in today’s business world and account for how central information technology is to the service industry. Companies that develop their own technology platform and applications to provide services could benefit from these more permissive rules.
Any business owner who was refraining to capture the R&D tax credit because of the IUS exclusions should consult their tax consultant and re-evaluate the eligibility of those projects in light of these final regulations. They might be pleasantly surprised.
