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New Regulations Finalized for Research Credit Related to Internal Use Software

Written by Floyd Holliman, CPA on November 11, 2016

On October 4th, 2016, final regulations were released relating to the research credit for computer software that is developed by or for the taxpayer, for the taxpayer’s internal use, known as “internal use software.”  The final regulations by and large adopt the proposed regulations issued in 2015.  Many companies have been shying away from claiming credits resulting from their software development activities used to support their business, because the area has been full of controversy for the past 15 plus years.  As a result, now is a good time for taxpayers to further review whether they may be eligible for research credits regarding software development.

In the past, software that was not sold, leased or licensed to a third party was considered internal use software.  There was additional qualifying criteria for companies to have internal use software qualify for the research credit.  The final regulations clarify what is not included in internal use software.  Software that a taxpayer offers for sale, lease or license, or otherwise markets to third parties, or developed to enable a taxpayer to interact with third parties, or allow third parties to initiate functions or review data on the taxpayer’s system, is not considered internal use and is thus subject to a lower threshold to qualify for the research credit.  Software that is “hosted” or developed but no copy of the software is transferred is included in this definition.  It is also worth noting that by statute, software that is developed for use in a production process that meets the requirements for qualified research is not considered developed for internal use.

Only development activities relating to financial management, human resource management and back office support are now activities considered internal use software.

The new rules apply as of October 4th, 2016.  The IRS rejected recommendations to make them retroactive.  However, the IRS will not challenge return positions consistent with the final regulations for any tax year that both ends on or after January 20, 2015.  Taxpayers using the new rules to calculate their current research credit will need to adjust their base year calculations using the new rules, but cannot amend returns to claim the credit using the new calculations.

By narrowing the definition of internal use software, the final regulations make it much easier for companies to claim research credit for software they have developed to provide services to customers.

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