Qualifying Research Activities: Internal-Use Software Development
Internal-Use Software ("IUS"): Qualification Analysis
To be considered a qualified research activity eligible for the research credit, the development of software created by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use may be required to satisfy the three-prong, "High-Threshold-of-Innovation Test" in addition to the standard "Four-Part Test". Whether software will be considered to be developed primarily for internal use depends on the intent of the taxpayer and the facts and circumstances at the beginning of software development.
Defining Internal-Use Software
In general, software is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use if the software is developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. Software that the taxpayer develops primarily for a related party's internal use will be considered internal use software. A related party is any corporation, trade or business, or other person that is treated as a single taxpayer with the taxpayer pursuant to section 41(f).
The regulations (Treas. Reg. § 1.41-4(c)(6)(iii)) further limit the term "general and administrative functions" to the following:
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Financial management functions, which involve the financial management of the taxpayer and the supporting recordkeeping;
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Financial management functions include, but are not limited to, functions such as 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.
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Human resources management functions, which allow the taxpayer to manage its workforce; and
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Human resources management functions include, but are not limited to, functions such as recruiting, hiring, training, assigning personnel, and maintaining personnel records, payroll, and benefits.
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Support services functions, which support the taxpayer's day-to-day operations.
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Support services include, but are not limited to, functions such as data processing, facility services (for example, grounds keeping, housekeeping, janitorial, and logistics), graphic services, marketing, legal services, government compliance services, printing and publication services, and security services (for example, video surveillance and physical asset protection from fire and theft).
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Not Internal-Use Software
Pursuant to Treas. Reg. § 1.41-4(c)(6)(iv) software is not developed primarily for the taxpayer's internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business, such as
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Software developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or
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Software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
Whether software is developed primarily for internal use or not developed primarily for internal use depends on the intent of the taxpayer and the facts and circumstances at the beginning of the software development. See Treas. Reg. § 1.41-4(c)(6)(v).
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For example, software will not be considered internal use software solely because it is used internally for purposes of testing prior to commercial sale, lease, or license. If a taxpayer originally develops software primarily for internal use, but later makes improvements to the software with the intent to hold the improved software to be sold, leased, licensed, or otherwise marketed to third parties, or to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system using the improved software, the improvements will be considered separate from the existing software and will not be considered developed primarily for internal use.
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Alternatively, if a taxpayer originally develops software to be sold, leased, licensed, or otherwise marketed to third parties, or to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system, but later makes improvements to the software with the intent to use the software in general and administrative functions, the improvements will be considered separate from the existing software and will be considered developed primarily for internal use.
Types of Internal-Use Software Not Required to Satisfy the "High-Threshold-of-Innovation Test"
Treas. Reg. § 1.41-4(c)(6)(ii) provides non-applicability of the "High Threshold of Innovation Test" for the following types of internal-use software:
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Software developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer for use in an activity that constitutes qualified research (other than the development of the internal use software itself);
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Software developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer for use in a production process to which the requirements of section 41(d)(1) are met; and
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New or improved package of software and hardware developed together by the taxpayer as a single product (or to the costs to modify an acquired software and hardware package), of which the software is an integral part, that is used directly by the taxpayer in providing services in its trade or business. In these cases, eligibility for the research credit is to be determined by examining the combined hardware-software product as a single product.
"High-Threshold-of-Innovation Test"
Software that does not meet the definition of software not for internal use under Treas. Reg. § 1.41-4(c)(6)(iv) or does not fall under one of the exemptions listed in Treas. Reg. § 1.41-4(c)(6)(ii) must meet the "High-Threshold-of-Innovation Test" (Treas. Reg. § 1.41-4(c)(6)(i)(C)). In general, Internal Use Software satisfies the High-Threshold-of-Innovation Test pursuant to Treas. Reg. § 1.41-4(c)(6)(vii) only if the taxpayer can establish the following:
(1) Software is innovative;
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Software is innovative if the software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful.
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This is a measurable objective standard, not a determination of the unique or novel nature of the software or the software development process
(2) Software development involves significant economic risk; and
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The software development involves significant economic risk if the taxpayer commits substantial resources to the development and if there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period.
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The term “substantial uncertainty” requires a higher level of uncertainty and technical risk than that required for business components that are not internal use software.
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The preamble then indicates that Treasury and the IRS believe that internal-use software research activities that involve only uncertainty related to appropriate design, and not capability or methodology, would rarely qualify as having substantial uncertainty for purposes of the high-threshold-of-innovation test.
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This standard does not require technical uncertainty regarding whether the final result can ever be achieved, but rather whether the final result can be achieved within a timeframe that will allow the substantial resources committed to the development to be recovered within a reasonable period. Technical risk arises from uncertainty that is technological in nature, and substantial uncertainty must exist at the beginning of the taxpayer's activities.
(3) Software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the requirements of Treas. Reg. § 1.41-4(c)(6)(vii)(A)(1) and (2) ("innovative" and "involves significant economic risk").
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The high threshold of innovation test takes into account only the results anticipated to be attributable to the development of new or improved software at the beginning of the software development independent of the effect of any modifications to related hardware or other software.
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The implementation of existing technology by itself is not evidence of innovation, but the use of existing technology in new ways could be evidence of a high threshold of innovation if it resolves substantial uncertainty.
Dual-Function Software
Software that was developed both for internal use and for interaction with third parties is known as "dual-function software." Software developed by (or for the benefit of) the taxpayer both for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business and to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system (dual function software) is presumed to be developed primarily for a taxpayer's internal use. See Treas. Reg. § 1.41-4(c)(6)(vi).
However, to the extent that a taxpayer can identify a subset of elements of dual function software that only enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data (third party subset), the presumption does not apply to such third party subset, and such third party subset is not developed primarily for internal use. This third party subset may be treated as non-internal-use software. See Treas. Reg. § 1.41-4(c)(6)(vi)(A) and (B).
The preamble to the regulations acknowledges that software developed for functions such as marketing or inventory management may also contain functions that enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
Safe Harbor for Dual-Function Software: For Both Internal Use & Enable Interaction with Third Parties
For software subsets for which the third-party portion and internal-use portion of the software ("dual-function subset") are interwoven such that the third-party portion cannot be segregated, a safe-harbor provision allows for 25% of the dual-function software to not be internal-use software in computing the research credit if at least 10% of the dual-function software is for third-party use based on the intent of the taxpayer and the facts and circumstances at the beginning of the software development. See Treas. Reg. § 1.41-4(c)(6)(vi)(C).
The term third party means any corporation, trade or business, or other person that is not treated as a single taxpayer with the taxpayer pursuant to section 41(f). Additionally, third parties do not include any persons that use the software to support the general and administrative functions of the taxpayer. See Treas. Reg. § 1.41-4(c)(6)(vi)(C).
An objective, reasonable method within the taxpayer's industry must be used to estimate the dual function software or dual function subset's use by third parties or by the taxpayer to interact with third parties. An objective, reasonable method may include, but is not limited to, processing time, amount of data transfer, and number of software user interface screens. See Treas. Reg. § 1.41-4(c)(6)(vi)(C)
Note, the final regulations clarify that this safe harbor applies only after the determination of whether the software is presumed developed for internal use.