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Internal use software: Adapting to the final regulations issued in 2016

Credits & Incentives talk with Deloitte

"Credits & Incentives talk with Deloitte" is a monthly column by Kevin Potter of Deloitte Tax LLP, featured in the 'Journal of Multistate Taxation and Incentives,' a Thomson Reuters publication. The January edition, co-authored with Martin Karamon, discusses the enactment of the original federal research credit in 1981 under Internal Revenue Code (IRC) Section 41, and the recent federal regulatory developments related to internal use software.

Overview

Since the enactment of the original federal research credit in 1981 under Internal Revenue Code (IRC) Section 41, many states have developed credit and incentive regimes that are tied to research activities that take place within a state.

Over the course of the last several decades, software development has become a common activity, from both a federal and state perspective, for which the underlying labor and consulting expenses have become part of taxpayers' research credit calculations.

Because state tax authorities typically consider the analysis made by the IRS as they scrutinize state research incentive calculations, recent federal regulatory developments related to software are relevant for taxpayers with state-based research tax incentives.

On October 4, 2016, final regulations (the final regulations) were published in the Federal Register that provided rules for identifying software development activities that qualify for the federal research credit.1 Specifically, those regulations define the term "internal-use software" as software developed "for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business."2

Relative to software developed for use by third parties, qualification for the research credit is typically more difficult for activities relating to the development of internal-use software due to additional requirements specific to innovation, economic risk, and non-commercial availability.3

In that context, the final regulations indicate that the regulatory definition of internal-use software is intended to target back-office functions that many taxpayers would have regardless of the taxpayer's industry,4 which are limited to:

  • Financial management of the taxpayer and supporting recordkeeping, such as accounts payable and receivable, inventory management, budgeting, cost and fixed-asset accounting, economic forecasting, financial reporting, internal audit, risk management, and tax;
  • Human resource management of the taxpayer's workforce, including hiring, training, personnel records, payroll, and benefits; and
  • Support services that support the day-to-day operations of the taxpayer itself, such as data processing, facility services, graphic services, marketing, legal and government compliance services, and security services.5

Download the full article to learn more about adapting to the final regulations issued in 2016 for internal use software.

For more information regarding tax credits and incentives, contact: 

Kevin Potter, managing director, Deloitte Tax LLP, New York, +1 212 492 3630

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References

1 See T.D. 9786.

2 Treas. Reg. § 1.41.4(c)(6)(iii).

3 Treas. Reg. § 1.41.4(c)(6)(vii)(A).

4 See Preamble of T.D. 9786.

5 See Preamble to T.D. 9786 at p. 5.

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