New internal-use software regulations may provide additional opportunities for online retailers to claim federal research tax credit

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1 from Retail & Consumer Products New internal-use software regulations may provide additional opportunities for online retailers to claim federal research tax credit March 24, 2015 In brief Many taxpayers, including online retailers and direct-to-consumer manufacturers (collectively, online retailers ), have long awaited additional guidance regarding internal-use software (IUS) for purposes of claiming the Section 41 research credit. The new proposed regulations (REG , 2015 proposed regulations ) reflect thoughtful consideration of numerous complex issues that historically have been the source of significant controversy. In particular, the 2015 proposed regulations highlight that certain third-party-facing software is considered to be non-ius (e.g. software developed to enable third parties to initiate functions, track the progress of a delivery of goods, search a taxpayer s inventory for goods, and receive services over the internet). Under previous guidance, this type of software generally was presumed to be IUS because it was not developed to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties (i.e., there was no explicit exception for third-party-facing software). As a result, the related research activities often did not qualify for the credit because they were subject under Section 41(d)(4)(E) and the applicable regulations to a high threshold of innovation test that outlined three additional requirements for credit eligibility. Given the provisions in the 2015 proposed regulations, online retailers should consider reviewing their current research activities related to software development to determine whether the software may be considered third-party-facing software that could qualify for the research credit as non-ius. Although not final, the IRS will not challenge return positions consistent with the 2015 proposed regulations for tax years ending on or after January 20, 2015, the date these regulations were published. Note: The Tax Increase Prevention Act of 2014 extended retroactively the research credit and other notable business tax provisions through It is expected that Congress will at some point retroactively extend the research credit through 2015, and maybe even make it permanent.

2 In detail Background General research credit requirements The Section 41 research credit is a credit against regular federal income tax. Enacted in 1981 to stimulate research and development in the United States, the credit is available to trades or businesses that increase their spending on activities associated with qualified research. Under the four-part test in Section 41(d)(1), qualified research means: Research related to expenditures that are deductible under Section 174 (i.e., research intended to discover information that would eliminate uncertainty concerning the development or improvement of a product); Research that is intended to discover information that (1) is technological in nature and (2) will result in the development of a new or improved business component of the taxpayer; and Research that involves a process of experimentation related to a new or improved function, performance, or reliability or quality. Certain research-related activities do not qualify for the research credit. Excluded activities generally include research activities associated with computer software that is developed primarily for internal use by the taxpayer. Research activities related to IUS are ineligible for the credit, except to the extent permitted by Section 41(d)(4)(E) and related regulations. Historical IUS rules Before the 2015 proposed regulations were issued, the 2003 final regulations contained the most recent Treasury guidance regarding qualified research expenses. While these regulations clarified certain issues relating to qualified research expenses, they did not include any guidance related to IUS (that paragraph was reserved ). Therefore, the IRS stated in Ann that taxpayers could rely on the regulations proposed in 2001 until further guidance regarding IUS was issued. Alternatively, taxpayers could rely on the older 2001 final regulations, which were replaced by the 2003 final regulations. Under the 2001 proposed regulations, software was presumed to be for internal use unless it was developed to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties. However, under the 2001 proposed regulations, IUS could qualify for the research credit provided the software met the general requirements for the credit outlined in Section 41; the software was not otherwise excludible under Section 41(d)(4) (other than subparagraph (E)); and one of the following conditions was met: for use in an activity that constituted qualified research (other than the development of the IUS itself); for use in a production process which met the general requirements for the credit outlined in Section 41; for use in providing computer services to customers; or The software met the high threshold of innovation test. In certain circumstances it may have been possible to avoid the high threshold of innovation test under the computer services exception. However, that exception generally was only available where customers were conducting business with the taxpayer primarily for the use of the taxpayer's computer or software technology, not where customers were merely interacting with the taxpayer's software. This caveat was problematic for many online retailers because customers generally were interacting with the software as a means to conveniently shop for and purchase tangible products, not for the actual use of the software. The 2015 proposed regulations eliminate the distinction between software developed to deliver computer services and non-computer services, leaving just three main alternatives. The 2001 proposed regulations explained that the high threshold of innovation test was met if: The software was innovative in that it was intended to be unique or novel and to differ in a significant and inventive way from prior software; The software development involved significant economic risk to the taxpayer in that there was substantial uncertainty because of technical risk; and The software was not commercially available for use by the taxpayer in that the software could not be purchased, leased, or licensed and used for the intended purpose without certain modifications. There were several differences between the 2001 final regulations and the 2001 proposed regulations with respect to qualified IUS. Most 2 pwc

3 notably, the 2001 final regulations only required that software result in a reduction in cost, improvement in speed, or other improvement, with respect to the first prong of the high threshold of innovation test. On the other hand, there was also a very specific discovery test (i.e., a requirement to undertake research to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering). For a prior discussion of the FedEx decision in which the US District Court concluded that since the 2003 final regulations effectively renounced the discovery test outlined in the 2001 final regulations, the IRS could not hold the taxpayer to that standard, see WNTS Insight, Stringent research credit test held not to apply to internal-use software, June 11, Distinguishing IUS from non-ius Classifying software as non-ius is important because the associated software development activities need satisfy only the regular four-part test in Section 41(d)(1) to qualify for the credit. Research activities related to IUS remain subject under Section 41(d)(4)(E) and the 2015 proposed regulations to a high threshold of innovation test that outlines three additional requirements for credit eligibility. IUS classification The 2015 proposed regulations do not include a presumption that software not developed to be commercially sold, leased, licensed, or otherwise marketed for separately stated consideration is IUS. Instead, IUS is defined as software developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer s trade or business. General and administrative functions are limited to: financial management functions, human resource management functions, and support services functions. The preamble explains that this list is intended to target the back-office functions that most taxpayers would have regardless of the taxpayer s industry. Non-IUS classification The 2015 proposed regulations treat software developed to be commercially sold, leased, licensed, or otherwise marketed as software not developed primarily for internal use because the resulting benefits are likely to be captured by persons other than the taxpayer developing the software. The 2015 proposed regulations add that software that enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data on the taxpayer s system does not solely benefit the taxpayer developing the software, and therefore it is appropriate to exclude such software from the definition of internal-use software. The 2015 proposed regulations provide a common-sense approach to the definition of software that needs meet only the four-part test (see Prop. Reg. sec (c)(6)(vi) for illustrative examples that distinguish IUS from non-ius, particularly Examples 4 and 6, which may be of interest to online retailers). Limiting the definition of IUS to software that supports back-office functions is an extremely helpful clarification, and may make it easier for online retailers to claim the research credit and support their position upon IRS examination. Dual-function software Because it is not always possible to distinguish software sub-components based on function, the 2015 proposed regulations provide guidance on whether software is developed primarily for internal use where a taxpayer develops software that serves both general and administrative and non-general and administrative functions. This type of software is referred to as dual-function software. These rules begin with a presumption that dual-function software is designed primarily for a taxpayer s internal use. However, that presumption will not apply if the taxpayer can identify a subset of elements of the software that only enables the taxpayer to interact with third parties or allows third parties to initiate functions or review data. The portion of expenditures allocable to this third-party subset needs meet only the less stringent four-part test. Dual-function software safe harbor For cases in which it is not possible to isolate the third-party subset, the new dual-function software rules also include a safe harbor. The safe harbor allows a taxpayer to include 25% of the potentially qualifying research expenditures associated with the dualfunction subset through meeting the four-part test, while the remaining 75% would have to meet the high threshold of innovation test discussed below. The safe harbor is met if the third-party-functional interaction is reasonably anticipated to constitute at least 10% of the dual-function subset s use. This approach is designed to minimize IRS examination challenges by providing a method to bifurcate thirdparty-facing and general administrative functionality with respect to multi-use software (i.e., when there is no natural functional break in the software platform). 3 pwc

4 Historically, some online retailers attempted to claim research credits for the entire software development project under the high threshold of innovation test, while others did not claim any credits at all. The clear distinction provided for third-partyfacing software reduces the burden of establishing credit eligibility associated with that portion of the software development. Even when that portion is not readily identifiable, taxpayers now can claim research credits for at least 25% of their development costs upon meeting only the four-part test, provided they can demonstrate third-party functionality of greater than 10%. High threshold of innovation test The legislative history of the Tax Reform Act of 1986 (TRA 86) sets forth Congressional intent that some research activities related to IUS could be credit-eligible if the three-part high threshold of innovation test is met. While the high threshold of innovation test is intended to limit credit eligibility of IUS to software development that meets a higher standard than other business components, the preamble to the 2015 proposed regulations makes clear that this test should not be impossible to meet. The 2015 proposed regulations include rules of application of the test that are designed to reflect these principles. Prong 1: Innovation In line with the TRA 86 legislative history, the 2015 proposed regulations explain that software is innovative if it would result in a reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant... The preamble states that this approach is measurable and objective, and should reduce the potential for controversy. Prong 2: Significant economic risk Also in line with the TRA 86 legislative history, the 2015 proposed regulations provide that significant economic risk exists if the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period. The 2015 regulations further clarify the application of Prong 2 as the level of uncertainty at the beginning of the development, not the degree of innovation represented by the end result. Under the 2015 proposed regulations, substantial uncertainty exists if, at the beginning of the taxpayer s activities, the information available to the taxpayer does not establish the capability or method for developing or improving the software. The uncertainty must relate to capability or methodology, not to the appropriate design. The preamble to the 2015 proposed regulations explains that this prong of the test requires both economic and technical risk. Removal of the uncertainty for appropriate design which remains embedded in the fourpart test is unique to IUS qualification and may increase the difficulty of documenting or satisfying this requirement. Prong 3: Commercially available for use Consistent with the legislative history of TRA 86, the 2015 proposed regulations provide that Prong 3 is met if commercially available software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements. While it is a positive development that the legislative requirements of the high threshold of innovation test largely have remained intact, it should be noted that with respect to the economic risk standard, removal of appropriate design as a technical uncertainty underplays the risk of failure for a project solely due to the inability to resolve design issues. There may be a significant interplay between the three types of uncertainty, and uncertainty related to capability or method may become apparent only while the taxpayer is attempting to resolve design issues. Also, the risk associated with integration may be inherently related to design uncertainty. Potentially qualifying activities of online retailers The 2015 proposed regulations serve as another reminder that the research credit is not reserved for technology companies and industrial products manufacturers. The credit is available to many different types of taxpayers, including online retailers. Similarly, qualifying research activities are not confined to designated research and development departments. In some cases, research and development activities may actually be occurring within other departments. For example, an online retailer s IT department may be involved in developing software associated with one or more of the following technologies, any one of which may qualify for the research credit, depending on the facts and circumstances: Website browse, search, and recommendation Online advertising and affiliate program Online customer support Digital media download 4 pwc

5 Online payment and other pointof-sale Order fulfillment and tracking or Online account management and customer loyalty technology. Online retailers should consider whether current software development activities associated with these technologies may qualify for the research credit, even if similar activities did not previously qualify. Given the favorable guidance found in the new 2015 proposed regulations, some of the activities that previously did not qualify for the credit may now qualify. Effective date The effective date of the new regulations, when and if finalized, remains a key issue. The regulations generally are proposed to be effective for tax years ending on or after the date the final regulations are published in the Federal Register. However, the proposed regulations state that notwithstanding the prospective effective date, the IRS will not challenge return positions consistent with these proposed regulations for taxable years ending on or after the date [January 20, 2015] these proposed regulations are published. (Emphasis added.) For tax years ending before January 20, 2015, the regulations state that taxpayers may choose to follow either all the IUS provisions in the 2001 final regulations or all the IUS provisions in the 2001 proposed regulations. The takeaway Online retailers should continue focusing on research and development in an effort to ward off competitors, increase their customer base, and improve their bottom-line. Retailers can often manage the cost and risk associated with their research and development by identifying specific activities that may qualify for the Section 41 research credit. Special attention should be given to activities related to third-party-facing software that could qualify for the credit as non-ius under the new 2015 proposed regulations. Let s talk For a deeper discussion of how this might affect your business, please contact: Retail & Consumer Products Barbra Bukovac, Chicago (312) barbra.bukovac@us.pwc.com Research & Development Kendall Fox, New York (646) kendall.b.fox@us.pwc.com Jeff Jones, San Francisco (415) jeffery.p.jones@us.pwc.com Sian Rayson, New York (646) sian.l.rayson@us.pwc.com Brett Ritter, McLean (703) brett.ritter@us.pwc.com Stay current and connected. Our timely news insights, periodicals, thought leadership, and webcasts help you anticipate and adapt in today's evolving business environment. Subscribe or manage your subscriptions at: pwc.com/us/subscriptions 2015 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 5 pwc