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Tax Alert: Research & Development and Government Incentives 

Treasury issues final regulations on research credits for software development

We have prepared a detailed summary of the final regulations defining “internal use software” and clarifying the additional credit requirements that apply to such software that was released on October 3, 2016. These final regulations address most of the concerns raised by commentators with respect to software development activities and, as specifically acknowledged in the Preamble, are intended to expand opportunities for taxpayers to claim research credits for software-related expenses. These final regulations also provide examples of how the process of experimentation test (as defined in the regulations issued in 2004) is applied to computer software. The final regulations are effective only for taxable years beginning on or after October 4, 2016. The law applicable to pre-effective date tax years is addressed in the detailed summary of the final regulations.

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Overview

Final regulations were published in the Federal Register on October 4, 2016, providing rules for identifying software development projects that qualify for the research tax credit. See attached T.D. 9786. Specifically, these final regulations clarify the definition of the term “internal use software,” which was added by Congress to the research credit statutory regime three decades ago—that is, at a time when on-line commerce was in its infancy. The final regulations also delineate the special credit-eligibility standards governing internal use software, and contain several examples illustrating in the context of software development efforts (for internal or external use software) the application of the “process of experimentation” requirement that must be satisfied for all research credit claims. The final regulations generally follow, but differ in some respects from, proposed regulations released in January of 2015. See the overview prepared by Deloitte Tax LLP of the proposed regulations relating to software development expenses that can be accessed here, in Downloads.

Overall, the final regulations expand opportunities for businesses operating in a wide range of industries to claim tax credits for their software development expenses, by narrowing the definition of “internal use software” (“IUS”) that qualifies for the federal research credit only if it is highly innovative. The final regulations retain a so-called “dual function rule” which could create challenges in substantiating some research credit claims, but this could be offset for many taxpayers by the new, relaxed standards for determining if IUS is highly innovative. In general, the final regulations are effective prospectively for tax years beginning after October 4, 2016, with limited exceptions as discussed below. The Treasury Department and IRS rejected commenters’ recommendations to apply the final regulations retroactively back to 1986 (when the IUS concept was first enacted by Congress), which may have helped resolve ongoing examinations of research credits determined for past tax years.

The analysis focuses on the changes made in the final regulations, relative to the provisions of the proposed regulations previously released in January of 2015.

Contacts

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Abernethy, Angela

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aabernethy@deloitte.com

412-338-7667

Allen, Ryon

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ryallen@deloitte.com

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Arm, Stephanie

Los Angeles

slabacz@deloitte.com

213-553-1752

Boegh, Tori

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vboegh@deloitte.com

213-593-3716

Boulet, Bill

Denver

wboulet@deloitte.com

720-264-4805

Curran, George

Philadelphia

gcurran@deloitte.com

215-246-2524

Gogerty, Sean

Parsippany

sgogerty@deloitte.com

973-602-6560

Goldbas, Michael

Hartford

mgoldbas@deloitte.com

860-725-3028

Kane, Mick

Chicago

mkane@deloitte.com

312-486-9906

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New York

mkaramon@deloitte.com

212-436-6302

Lyness, David

San Jose &
San Francisco

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408-704-4667

Novakovic, Valentina

Houston

vnovakovic@deloitte.com

713-982-4979

Osborn, Michael

Pittsburgh

miosborn@deloitte.com

412-338-7895

Peterson, Eric

Los Angeles

ericpeterson@deloitte.com

213-553-1693

Ray, Laura

Chicago

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312-486-1807

Shelton, Marissa

Hermitage OSA

mashelton@deloitte.com

816-802-7731

Wagner, Brian

Chicago

briwagner@deloitte.com

312-486-1802

Zhang, Priscilla

Houston

przhang@deloitte.com

713-982-3609

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