8159 / How is computer software treated for purposes of the research and development tax credit?

In 1969, the IRS published Revenue Procedure 69-21, which provided that the costs of developing software in many respects so closely resemble the kind of research and experimental expenditures that fall within the purview of IRC Section 174 that they would permit current deductibility of these costs. Revenue Procedure 2000-50¹ replaced Revenue Procedure 69-21 for taxable years ending after December 1, 2000. This revenue procedure is similar to the earlier Revenue Procedure 69-21, except that it is updated technologically and is made to be consistent with IRC Sections 167(f)(1) and 197.

When the research credit was instituted in 1981, it was generally assumed that activities that qualify for deductibility under IRC Section 174 would also qualify for the research credit. However, the Tax Reform Act of 1986 established that for purposes of the research credit, on the one hand, expenses to develop computer software for sale, licensing, or lease would be granted the same treatment as all other products qualifying for the research credit, while, on the other hand, software intended for the taxpayer’s internal use would be subject to more strict standards.

On January 20, 2015, Treasury issued new proposed regulations to provide guidance on computer software that is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer (internal use software) under Section 41(d)(4)(E).² The proposed regulations also include examples to illustrate the application of the process of experimentation requirement to computer software under Section 41(d)(1)(C). To provide guidance with respect to the application of internal use software rules contained in regulations issued prior to these proposed regulations, Treasury withdrew the 2004 ANPRM effective for taxable years beginning on or after the date of issuance of the 2015 proposed regulations.

The 2015 proposed regulations provide:

(1)  A definition of software developed primarily for internal use and describes software not developed primarily for internal use;

(2)  That certain internal use software is eligible for the research credit if the software satisfies the high threshold of innovation test; and

(3)  Rules for computer software that is developed for both internal use and non-internal use (dual function computer software), including a safe harbor for determining if any of the expenditures with respect to dual function computer software are qualified research expenditures.

In the 2004 ANPRM, the Treasury Department and the IRS requested comments on whether final regulations relating to internal use software should be effective retroactively. Some commentators requested that the rules apply retroactively back to 1986, while other commentators requested that the regulations be prospective only.