T he U.S. Department of the Treasury Jan. 16 issued

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1 Daily Tax Report Reproduced with permission from Daily Tax Report, 25 DTR J-1, 02/06/2015. Copyright 2015 by The Bureau of National Affairs, Inc. ( ) Stephanie Shell Condon and Jeff Malo of Ryan LLC offer a breakdown of the longawaited new rule proposal on research and experimentation credit claims associated with internal use software. The authors say the new taxpayer-friendly regulations are a big improvement over prior guidance. They examine a new safe harbor for software that both serves internal functions and interacts with third parties, new rules that apply when software is developed in conjunction with other business components and the revised high threshold of innovation test, among other aspects of the regulations. Treasury Releases Internal Use Software Regulations BY STEPHANIE SHELL CONDON AND JEFF MALO T he U.S. Department of the Treasury Jan. 16 issued long-awaited proposed regulations (REG , RIN 1545-BC70) governing the qualification of internal use software (IUS) for the federal research and Stephanie Shell Condon, director, federal income tax, for Ryan LLC, may be reached at or stephanie.shell-condon@ ryan.com. She has more than 10 years of research and experimentation tax credit experience, including tenures with Big Four and boutique R&E practices. She specializes in providing research and experimentation tax credit consulting services to clients in a variety of industries, and has extensive audit and appeals experience, including the emendation and defense of studies performed by other firms. Jeff Malo, director, federal income tax, for Ryan, may be reached at or jeff.malo@ryan.com. He has more than 15 years of experience that includes Big Four public accounting and government service. In Big Four firms, Malo was part of the federal tax practice, where he gained extensive industry experience in technology and manufacturing, computer sciences, medical devices and pharmaceuticals, real estate and financial services. In government, he litigated corporate tax cases for the U.S. Department of Justice Tax Division. experimentation (R&E) tax credit. The regulations were 11 years in the making, following the issuance and repeal of two sets of internal use software regulations that were published in While taxpayers were waiting for further guidance, the different standards for the qualification of internal use software that were advanced by the competing 2001 regulations led to a judicial decision on the eligibility of IUS development efforts for the R&E tax credit in FedEx Corp. v. United States. 1 The new proposed regulations supersede the two sets of 2001 regulations and propose standards that are consistent with the case law that was decided while the Treasury was drafting the new rules. The new proposed regulations are a big improvement over prior guidance. They establish clear limits on the definition of internal use software, create a new safe harbor for the qualification of dual function computer software and lower the bar on the level of innovation required for internal use software to qualify for the R&E tax credit. Background Final regulations (T.D. 8930, RINs 1545-AV14 and 1545-A051) issued in January 2001 contained rules on the qualification of internal use software, including a three-part high threshold of innovation test: s the goal of the development effort had to result in a reduction in cost, improvement in speed or other im AFTR 2d , 2009 BL (W.D. Tenn. 2009). COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

2 2 provement that is substantial and economically significant; s the development had to involve significant economic risk (due to potential failure); and s the software couldn t otherwise be commercially available. 2 These regulations also contained the so-called discovery test, which required that research be undertaken for the purpose of exceeding, expanding or refining the common knowledge of skilled professionals in a particular field of science or engineering in order to qualify for the credit. 3 This test applied to the general definition of qualified research, making it difficult for any research activity to qualify for the R&E tax credit. Objections to the discovery test led to the demise of the 2001 final regulations. Substitute regulations (REG , RIN AY82) were proposed in December These proposed regulations removed the onerous discovery test but also added language to the IUS portion of the previous regulations requiring that internal use software had to be unique or novel and intended to differ in a significant and inventive way from prior software implementations or methods in order to qualify for the R&E tax credit. Again, taxpayers and practitioners objected to the unreasonably high standard for qualification that was now proposed for internal use software. The 2001 proposed regulations were finalized in As a result of the aforementioned controversies, the final 2003 regulations (T.D. 9104, RIN 1545-AY82) eliminated the unreasonable discovery test and withdrew completely the proposed rules for internal use software. Instead, the Treasury issued an announcement in early 2004, requesting public comments on internal use software. 4 The Treasury promised to publish future regulations governing the eligibility of internal use software for the R&E tax credit. In the 2004 announcement, taxpayers were advised that they could rely on the internal use software rules contained in either the January 2001 final regulations with the difficult discovery test or the December 2001 proposed regulations that eliminated the discovery test but imposed the unique or novel high threshold of innovation test. Taxpayers were left with confusion and controversy until the Treasury published the recent proposed internal use software regulations. Internal Use Software Defined Under the new proposed regulations, internal use software is defined as software that 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. General and administrative (G&A) functions include three categories of internal operations 5 : s Financial Management Functions. These functions involve the financial management of the taxpayer New Internal Use Software Rules New taxpayer-friendly proposed regulations (REG , RIN 1545-BC70) on research and experimentation credit qualification for internal use software address issues that have long been a source of taxpayer controversy. The new proposed rules: s limit what is characterized as internal use software; s provide a new safe harbor for taxpayers to claim internal use software expenses; and s lower the bar on the type of innovation required to qualify internal use software. Taxpayers should be mindful of applicable effective dates for the regulatory provisions the majority of the rules changes will only apply for tax years ending on or after Jan. 20, 2015, but enterprise resource planning software implementation can qualify for the R&E tax credit in years ending on or after Dec. 31, and support record keeping. They include, but aren t limited to, accounts payable, accounts receivable, inventory management, budgeting, cash management, cost accounting, disbursements, economic analysis and forecasting, financial reporting, finance, fixed asset accounting, general ledger bookkeeping, internal audit, management accounting, risk management, strategic business planning and tax. s Human Resources Management Functions. These functions involve the management of the taxpayer s workforce. They include, but aren t limited to, recruiting, hiring, training and assigning personnel, and maintaining personnel records, payroll and benefits. s Support Services Functions. These are other functions that support the day-to-day operations of the taxpayer. They include, but aren t limited to, data processing, facility services (groundskeeping, housekeeping, janitorial and logistics), graphic services, marketing, legal services, government compliance services, printing and publication services, and security services. It is noted in the preamble to the proposed regulations that the character of software as internal use can change depending on the nature of the taxpayer s business. For example, payroll software generally supports an internal G&A function unless the taxpayer is in the business of providing payroll services to third parties. The proposed regulations also describe software that isn t primarily for internal use. Software that is developed with the intent of selling, leasing, or licensing the software to third parties isn t developed for internal use. 6 Likewise, software that interacts with third parties or enables third parties to initiate functions or review 2 T.D. 8930, Section (c)(6)(vi). 3 T.D. 8930, Section (a)(3). 4 Announcement , I.R.B Prop. Treas. Reg. Section (c)(6)(iii)(B)(1)-(3). 6 Prop. Treas. Reg. Section (c)(6)(iv)(A)(1) COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. DTR ISSN

3 3 data on the taxpayer s system isn t primarily developed for internal use. 7 The character of the software as internal use is largely dependent on the initial intent of the development effort. 8 Its character can change if the taxpayer later decides to commercialize an internal development effort (or vice versa). Dual Use Software and the Dual Function Computer Software Safe Harbor Where software serves a dual purpose in supporting G&A functions and interacting with third parties, the proposed regulations presume that the software is primarily for internal use. 9 However, to the extent that the taxpayer can identify a third-party subset of the software that isn t for internal use, the taxpayer can allocate a portion of the development expense that should be treated as software developed for commercial sale, lease or license. 10 If the third-party subset can t be isolated, the dual function subset is eligible for safe harbor treatment under the proposed regulations. Taxpayers may claim 25 percent of the qualified research expenditures incurred on the development of the dual function subset. 11 To be eligible for this safe harbor, the taxpayer must reasonably anticipate that at least 10 percent of the dual function subset s use will come from third parties. 12 Taxpayers are instructed to use an objective and reasonable method for establishing this 10 percent threshold. Beyond that, the proposed regulations request commentary on the administration of the dual function computer software safe harbor. Software Embedded In Other Business Components 7 Prop. Treas. Reg. Section (c)(6)(iv)(A)(2). 8 Prop. Treas. Reg. Section (c)(6)(iv)(B). 9 Prop. Treas. Reg. Section (c)(6)(iv)(C)(1). 10 Prop. Treas. Reg. Section (c)(6)(iv)(C)(2). 11 Prop. Treas. Reg. Section (c)(6)(iv)(C)(3). 12 Id. 13 Prop. Treas. Reg. Section (c)(6)(ii). Consistent with prior guidance, the proposed regulations don t treat software developed in conjunction with hardware as internal use software. 13 This rule applies to products that are developed for sale to third parties and to products that are used by the taxpayer for providing services in the taxpayer s trade or business. The critical inquiry in determining whether the software is primarily developed for internal use is whether the software is part of a product or service that is provided to third parties. Where software is developed in conjunction with business components that don t interact with third parties, it will be treated as developed for internal use. This determination doesn t preclude credit eligibility, but it does impose additional requirements to claim the development expense. The proposed regulations provide a general rule that the expense associated with development of internal use software will be credit eligible if the development effort otherwise meets the requirements of Internal Revenue Code Section 41(d)(1), isn t otherwise excluded under Section 41(d)(4) and one of three conditions is met: s the software is developed for use in an activity that constitutes qualified research itself; s the software is developed in conjunction with production processes that constitute qualified research activities under Section 41(d)(1); or s the software otherwise satisfies the high threshold of innovation test. 14 The first two conditions mirror the language of Section 41(d). The third condition is the latest incarnation of the three-part high threshold of innovation test described in prior guidance on internal use software. Revision of the Three-Part High Threshold of Innovation Test For Qualified Internal Use Software The repealed 2001 final regulations provided that internal use software could qualify for the federal R&E tax credit if the development effort satisfied the threepart test in addition to the general requirements of Section 41(d). 15 To qualify, the internal use software had to demonstrate a high threshold of innovation, involve significant economic risk and have no commercially available alternatives. 16 When the 2001 final regulations were repealed, taxpayers were advised that they could rely on the internal use software test in the repealed regulations, as opposed to the higher innovation standard included in the 2001 proposed regulations, if they also applied the discovery test contained in that authority. 17 In 2009, FedEx Corp. v. United States was decided by a Tennessee federal district court, which determined that taxpayers could invoke the internal use software rules in the 2001 final regulations without submitting to the onerous discovery test. 18 The new regulations redefine the high threshold of innovation test to achieve a result that is consistent with the FedEx opinion. High Threshold of Innovation The most significant difference between the new proposed regulations and the final and proposed regulations from 2001 is centered on the high threshold of innovation test. 14 Prop. Treas. Reg. Section (c)(6)(i)(A)-(B). The first two conditions closely track the statutory language in I.R.C. Section 41(d)(4). The proposed regulations revise the third condition also contained in the 2001 regulations regarding the high threshold of innovation test. 15 T.D. 8930, Sections 1-41(c)(6)(vi)(A)-(C). T.D was the culmination of proposed regulations that were issued in 1997, which described the three-part test for qualifying internal use software for the R&E tax credit based on legislative history associated with the Tax Reform Act of See H.R. Conf. Rept. No. 841 at The proposed regulations retain this three-part test for internal use software at Prop. Treas. Reg. Sections (c)(6)(v)(A)(1)-(3). 17 Announcement FedEx Corp. v. United States, 103 AFTR 2d , 2009 BL (W.D. Tenn. 2009). DAILY TAX REPORT ISSN BNA

4 4 The innovation component in the first version of this test required a measurable improvement in conjunction with the onerous discovery test. The innovation component in the second version of this test required that the software be unique or novel in an inventive way that distinguished it from other types of software. 19 Either standard was difficult to meet, and both tests were frequently the subject of taxpayer controversy. The new proposed regulations offer a lower threshold for qualification, which mirrors the innovation component of the high threshold of innovation test in the earlier 2001 final regulations (without adding the difficult discovery test). Software is considered innovative if its successful development would result in a reduction in cost, improvement in speed or other measureable improvement in the taxpayer s business. 20 The development effort doesn t have to succeed to qualify, but the initial objectives must aspire to achieve some measurable improvement. Significant Economic Risk The 2001 regulations required that the development of internal use software involve significant economic risk that the amount expended in the development process might not be recovered within a reasonable period of time because of the technical risk of failure. The new proposed regulations retain this requirement but refine the definition of significant economic risk to make clear that the determination is based on the level of uncertainty that is present at the outset of the development effort. The proposed regulations also provide a bright-line test with respect to the type of uncertainty attempting to be resolved through the development effort to qualify for both the R&E tax credit generally and for IUS. Under existing Treasury regulations, uncertainty related to the capability or method of achieving a stated goal will qualify for the credit (technical uncertainty). In the absence of technical uncertainty, an evaluative effort to select the appropriate design from alternatives that are known to be feasible will also qualify for the credit (design uncertainty). 21 However, under the proposed IUS regulations, substantial uncertainty exists only if the internal use software development effort involves technical uncertainty. 22 Commercial Availability The proposed regulations keep the same requirement as the 2001 regulations that any taxpayer claiming internal use software development expenses for the R&E tax credit can t have commercially available alternatives to the self-development effort. The modification of purchased software can qualify for the credit as an internal use software development effort, but only if the modifications independently satisfy the high threshold of innovation and significant economic risk tests. 23 Enterprise Resource Planning Software 19 T.D. 8930, Section (c)(6)(vii). 20 Prop. Treas. Reg. Section (c)(6)(v)(B). 21 Treas. Reg. Section (a)(3). 22 Prop. Treas. Reg. Section (c)(6)(v)(C). 23 Prop. Treas. Reg. Section (c)(6)(v)(A)(3). The Internal Revenue Service has long taken the position that the costs of implementing enterprise resource planning (ERP) software, such as Oracle or SAP, are generally not qualified research expenses for the purposes of the R&E tax credit. 24 The proposed regulations provide new guidance on this topic, suggesting that some ERP implementation costs are credit eligible. Two examples in the proposed regulations deal with taxpayers who are implementing ERP systems. In the first example, the implementation expense isn t credit eligible because the taxpayer is configuring the software by selecting from a variety of templates, reports and other standard programs to meet its business needs. 25 In the second example, the taxpayer is confronted with technical uncertainty because the ERP software lacks a particular function that the taxpayer must selfdevelop. The example employs the shrinking-back rule to isolate the component of the development expense that satisfies the three-part test for qualification as internal use software and is otherwise credit eligible under Section 41(d), with the result that a portion of the implementation expense is qualified for the R&E tax credit. Effective Dates The majority of the proposed regulations are applicable for tax years ending on or after the date the regulations were published in the Federal Register (Jan. 20, 2015). Some of the examples added to existing regulations are applicable for tax years ending on or after Dec. 31, 2003 (including the examples that discuss ERP implementation expenses). The proposed regulations advise taxpayers that they may follow the internal use software provisions of either the final or proposed regulations that were published in 2001 for tax years ending before the effective date of the new proposed regulations. The Takeaway The new proposed regulations successfully address specific areas that have long been the subject of frequent taxpayer controversy. The new guidance is overwhelmingly taxpayer-friendly in that the proposed regulations limit what is characterized as internal use software, provide a new safe harbor for taxpayers to claim IUS expenses and lower the bar on the type of innovation required to qualify IUS. Taxpayers should be mindful that the effective date for the majority of the taxpayer-favorable changes in the proposed regulations will only apply to tax years ending on or after Jan. 20, If taxpayers are developing dual function computer software, they should review their cost accounting procedures now to ensure that expenses related to third-party subsets can be carved out when they claim the R&E tax credit for tax years ending after the proposed regulations effective date. The examples illustrating how ERP implementation can qualify for the R&E tax credit are applicable to tax years ending on or after Dec. 31, Taxpayers who 24 See Audit Guidelines on the Application of the Process of Experimentation for all Software. 25 Prop. Treas. Reg. Section (a)(8) Examples 9 and COPYRIGHT 2015 BY THE BUREAU OF NATIONAL AFFAIRS, INC. DTR ISSN

5 5 have implemented ERP solutions in any open tax year should revisit their treatment of the associated costs and consider whether they should claim additional R&E tax credits. DAILY TAX REPORT ISSN BNA