IRS Releases Final Internal-Use Software Regulations

The R&D Tax Credit rules generally prohibit time and expense incurred in the development of internal-use software (IUS) with certain exceptions.  The final regulations (TD 9786) released last week address various issues regarding IUS for purposes of the R&D Tax Credit and finalize the proposed regulations issued in January 2015.  Prior to the proposed regulations, the IRS had waited more than a decade to offer guidance on IUS.  The final regulations:

  • Define IUS and adjust the definition of non-IUS;
  • Provide that certain IUS is eligible for the R&D Tax Credit if the software satisfies the high threshold of innovation (HTI) test;
  • Expand the concept of uncertainty in the “significant economic risk” component of the HTI test;
  • Provide that certain software enabling communication with third parties is not subject to the definition of IUS and must meet only the general four-part test;
  • Provide rules for computer software that is developed for both internal use and non-internal use (dual-function computer software);
  • Include examples to illustrate application of the regulations for IUS; and
  • Limit the definition of “general and administrative functions”.

The final regulations are effective for tax years beginning on or after October 4, 2016, but taxpayers can generally rely on either the proposed or final regulations for tax years that ending after January 20, 2015. The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D Tax Credit permanent and taxpayers should take advantage of the finalized regulations that offer additional clarity on qualifying activities. Please call or email us for a free consultation.