Posted October 19, 2016 at 09:00 AM

Corning Pearson - Advanta Tax Advisors, LLC, Charlotte, NC

October 19, 2016

The Treasury Department issued finalized regulations under Internal Revenue Code (“IRC”) section 41 offering guidance for taxpayers claiming Research & Development Tax Credits for costs incurred to develop software primarily used for internal purposes. The 2016 Final Regulations (T.D. 9786, RIN: 1545-BC70, “2016 Final Regulations”), published on October 4, 2016, seek to:

   Define what is and what is not internal use software (“IUS”),

   Define dual function software and proscribe its tax treatment,

   Define the high threshold of innovation test and provide guidance on its applicability,

   Describe the applicable effective date for the final regulations, and

   Provide examples illustrating these provisions.

The Final Regulations closely resemble the 2015 Proposed Regulations (REG-209494-90, “2015 Proposed Regulations”) issued February 2,2015, with few changes.  Notable changes are the inclusion of design uncertainty in the high threshold of innovation’s significant economic risk test, denial of commentators’ requests for retroactive application of the regulations and a lack of clarification to the definition of dual function software found in the 2015 Proposed Regulations.  This article summarizes the 2016 Final Regulations as the current body of authority on the treatment of software development activities as it relates to the research credit. 

Definition of Internal Use Software

The 2016 Final Regulations clarify the definition of IUS in a manner that should alleviate taxpayers’ anxiety, reduce taxpayers’ risk, and reduce much of the administrative and judicial controversy encountered for research credits taken in the area of software development.  IRC section 41(d)(4)(E) states, “Except to the extent provided in the regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer” is excluded from the definition of qualified research for purposes of the research credit. However, the statute fails to define what is and what is not software used “primarily for internal use”. 

The 2016 Final Regulations take a direct approach to defining IUS.   Prior attempts by the Treasury Department at defining IUS had been ambiguous and indirect in that prior regulations sought to define IUS primarily by defining what it is not.  That is, prior guidance presumed that all software was IUS unless it was marketed or licensed to outside parties or subject to limited exceptions.  These regulations reverse course by directly defining IUS and in providing an expanded list of specific internal functions it deems to be general and administrative functions within that definition.  In defining IUS, Treas. Reg. section 1.41-4(c)(6)(iii)(A) states: 

Except as otherwise provided in paragraph (c)(6)(vi) [dual-use software] of this section, 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 developed for use by related parties, as defined by the single taxpayer rules of IRC section 41(f), is also included in this definition.  These regulations (Treas. Reg. section 1.41-4(c)(6)(iii)(B)) further define the following as general and administrative functions:

   Financial management - These include any functions that involve the financial management of the taxpayer and supporting bookkeeping.  These functions include,but are not limited to:

   Accounts payable,

   Accounts receivable,

   Inventory management,


   Cash management,

   Cost accounting,


   Economic analysis and forecasting,

   Financial reporting,


   Fixed asset accounting,

   General ledger bookkeeping,

   Internal audit,

   Management accounting,

   Risk management,

   Strategic business planning, and


   Human resource management - These functions include managing the taxpayer’s workforce through:


   Hiring, training, assigning personnel, and

   Maintaining personnel records, payroll and benefits.

   Support services - These include functions that support the day-to-day operations of the taxpayer.  Examples of support services include:

   Data processing,

   Facility services,

   Graphic services,


   Legal services,

   Government compliance services,

   Printing and publication services, and

   Security services.

Prior guidance was vague with respect to general and administrative functions and often presented a source of controversy between the Internal Revenue Service and taxpayers. The specificity provided in these final regulations should greatly reduce this uncertainty.

The 2016 Final Regulations also directly define software not developed primarily for internal use (“non-IUS”) consistent with previous guidance as software that is developed to be commercially sold, leased,licensed, or otherwise marketed to third parties. (Treas. Reg. section 1.41-4(c)(6)(iv)(A))  Also included in the direct definition of non-IUS software is software that enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayers system. (Treas. Reg. section 1.41-4(c)(6)(iv)(B)) This latter provision replaces the services exemptions to the application of the high threshold of innovation test found in the 2001 Final Regulations (T.D.  8930, “2001 Final Regulations”) and 2001 Proposed Regulations (REG 209494-90, “2001 Proposed Regulations”).  This broader definition is an attempt to bring the tax law into synchronization with industry practice.  We believe that this change gives taxpayers stronger guidance on the treatment of customer facing software and will result in a reduction in controversy between taxpayers developing customer facing software and the IRS. 

The 2016 Final Regulations also establish the time and manner of determining the characterization of software as IUS or non-IUS.  The regulations state that all of the facts and circumstances should be analyzed in making this determination at the beginning of the software development process. (Treas. Reg. section 1.41-4(c)(6)(v))  A software component initially intended to be utilized internally to manage the developer’s internal functions but later improved to be marketed to outside parties would be considered two business components.  The first would consist of the software utilized in managing the taxpayer’s internal functions while the improvements would be a separate business component and analyzed separately. 

Dual Function Software

The 2016 Final Regulations acknowledge that taxpayers often develop software that is intended to have multiple functions.  Software that is developed primarily for internal use but allows third parties to initiate functions or review data on the taxpayer’s system is defined as dual function software.  Generally, software deemed to be IUS is presumed to be 100% IUS. (Treas. Reg. section 1.41-4(c)(6)(vi)(A))  However, if Taxpayers can identify a subset of elements of the software that allow a taxpayer to interact with third parties or allow third parties to initiate functions or review data it can consider these subsets non-IUS. (Treas. Reg. section 1.41-4(c)(6)(vi)(B))  In other words, it is permissible to carve out subsets of the software that are considered non-IUS software and not subject to the high threshold of innovation test.  This subset would then be analyzed utilizing the general research credit rules.  If the taxpayer cannot readily identify a third party subset, Treas. Reg. section 1.41-4(c)(6)(vi)(C) provides for a safe harbor for expenditures related to the development of dual function software.  This safe harbor  applies where the subset of the software anticipated to be used by third parties or by the taxpayer to interact with third parties comprises more than 10% of the software’s use.  The regulation states that any reasonable, objective method used within the taxpayers industry can be used in determining the software''s anticipated use.  Enumerated examples for this metric include:processing time, amount of data transfer, and number of software user interface screens.   Third-party is again defined as a party not treated as a single taxpayer pursuant to IRC section 41(f).(Treas. Reg. section 1.41-4(c)(6)(vi)(E)) If a taxpayer develops software primarily for internal use and anticipates that a portion of this software is intended to give access to third parties to either interact with its system or to review data but the taxpayer cannot specifically identify this subset it may be able to avail itself of the dual function safe harbor.  They may do so if 10% of the software is intended to be utilized by outside parties and may include 25% of the costs of qualified research activities as qualified research expenditures in computing the its research credit.  The preamble to the 2016 final regulations makes clear that the safe harbor provisions are, “not a requirement but an option available for taxpayers who cannot identify a third party subset, or after identification of a third party subset, still have a dual function subset”.(T.D. 9786 section (V)(B))  The time and manner of these determinations are made on a facts and circumstances basis at the beginning of the development activity. (Treas. Reg. section 1.41-(c)(6)(vi)(D))

High Threshold of Innovation Test

The 2016 Final Regulations provide clarification as to the definition and applicability of the high threshold of innovation test.  The high threshold of innovation test is comprised of three elements that, if applicable, are to be satisfied inaddition to the general research credit’s 4-part test if an activity is to be considered qualified research activity and, thus, credit eligible.   It is intended to set a higher bar than the general qualification rules for software that is intended to manage taxpayers’general business functions.

In short, software satisfies the high threshold of innovation ifit is: 1) innovative, 2) developed at significant economic risk, and 3) not commercially available for use by the taxpayer. (Treas. Reg. section 1.41-4(c)(6)(vii)(A))  The regulation goes on to expand on these terms: 

1.    Innovative- Software is innovative if it results (or is anticipated to result) in a reduction in cost or improvement in speed or other measurable improvement thatis substantial and economically significant. Significantly, the regulation states, “this is a measurable objective standard, not a determination of the unique or novel nature of the software or the software development process.” (Treas. Reg. section 1.41-4(c)(6)(vii)(B))  In other words,the software development activity need not meet the discovery test.

2.    Significant economic risk  - There is significant economic risk if the taxpayer commits substantial resources to the development andif there is substantial uncertainty associated with the development of the software.  The uncertainties must be technical uncertainties.  Significant economic risk exists at the beginning of development activities if it is anticipated that if these technical uncertainties are not overcome, the resources would not be recovered within a reasonable period of time.  The regulations state that the term“substantial uncertainty” requires a higher level of uncertainty and technical risk than that required for business components not subject to the high threshold of innovation test.  The regulations address the fact that it is not necessary that the technical uncertainties never are anticipated to be overcome, but whether the final result can be achieved within a time frame that will allow the substantial resources committed to the development to be recovered within a reasonable period.  The types of uncertainty remain at those listed in the statute, i.e., capability uncertainty, methodology uncertainty and design uncertainty.  The 2015 proposed regulations proposed eliminating design uncertainty from those uncertainties that could lead to significant economic risk.  In the preamble to the 2016 final regulations, Treasury acknowledges the difficulty in delineating the types of technical uncertainties in any bright-line manner.  However, the same commentary did broadcast 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.”. (T.D. 9786 section (VII)(B))  Taxpayers would be wise to focus their documentation with regard to significant economic risk with this in mind. 

3.    Not commercially available - The regulations do not define this term nor offer guidance regarding application of this element. However, taxpayers would be wise to document any search undertaken for software suitable to its needs prior to undertaking software development that may be subject to the high threshold of innovation test.  This is a rarely contested element since the IRS understands that, wherever possible, taxpayers will typically utilize software available on the market that suits their needs rather than developing software themselves.  That being said,where software development on internal use software is undertaken, there is typically an investigation and / or research conducted to ascertain whether there is already software that exists in the market that suits the company’s needs without significant modification. 

The 2016 Final Regulations also establish situations where IUS is not subject to the high threshold of innovation test.  Treas. Reg. section 1.41-4(c)(6)(ii) states that the high threshold of innovation test does not apply to software developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer in an activity that constitutes qualified research (other than the development of the IUS itself).  It further states that the high threshold of innovation test does not apply to software for use in a production process to which the general research credit requirements are applicable.  (These two elements are somewhat redundant as they are included in the exemptions to the statutory exclusion of software developed for internal use in the general credit rules.(IRC section 41(d)(4)(E)(i)&(ii)) Also excluded from the application of the high threshold of innovation test are “new or improved package(s) of software and hardware developed together by the taxpayer as a single product (or 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”.  (Treas. Reg. section 1.41-4(c)(6)(ii)(C))  The resultant products are examined as a combined, single business component

Effective Date

Many commenters requested that the 2016 Final Regulations apply retroactively.   However, Treasury fixed the effective date of the 2016 Final Regulations for tax years beginning on or after October 4, 2016.  Treasury cited administrative burdens on the IRS and unfair advantages to taxpayers whose prior taxable years are not closed by the statute of limitations in their reasoning.  

So, as it stands, the following timeline represents the relevant guidance that can be relied upon for the treatment of software development activities for purposes of the research credit:

   Tax years ending before 1/20/2015 - taxpayersmay rely upon either,

   2001 Final Regulations, published 1/3/2001 (T.D.8930), or

   2001 Proposed Regulations, published 12/26/2001(66 FR 66362)

   Tax years that both end on or after 1/20/2015and begin before 10/4/2016 - taxpayers may rely upon either:

   2015 Proposed Regulations, published 1/20/2015(80 FR 2624),

   2016 Final Regulations, published 10/4/2016(T.D. 9786)

   Tax year that begin on or after 10/4/2016 -taxpayers may rely upon:

   2016 Final Regulations, published 10/4/2016(T.D. 9786) 

Keep in mind that if one set of regulations are selected for a given period, that set of regulations must be applied in their entirety.


The regulation contains 18 IUS related examples on subjects as summarized by subject matter below (Treas. Reg. section 1.41-4(c)(6)(vii):

1.    Computer hardware and software developed as a single product.

2.    IUS- financial management

3.    IUS- human resource management

4.    IUS- support services

5.    IUS- integrating existing systems

6.    IUS- definition of third party

7.    Non-IUS- third party interaction

8.    Non-IUS- third party interaction

9.    Non-IUS- Commercially sold, leased, licensed or otherwise marketed

10.  Improvements to existing IUS

11.  Dual function software - identification of a third party subset

12.  Dual function software - application of the safe harbor

13.  Dual function software - safe harbor inapplicable

14.  Dual function software - identification of a third party subset and the safe harbor

15.  IUS- application of the high threshold of innovation test

16.  IUS- application of the high threshold of innovation test

17.  IUS- application of the high threshold of innovation test

18.  IUS- application of the high threshold of innovation test

The 2016 Final Regulations also include several examples amendedto the general sections of these regulations illustrating processes ofexperimentation related to software research and development in general and areoutside of the scope of this summary.