On Oct. 4, 2016, the Internal Revenue Service (IRS) published T.D. 9786, final regulations that improve opportunities for businesses that engage in internal use software development to quality and claim the R&D Tax Credit.
The IRS recently finalized new regulations that could allow more businesses to take a tax credit against the costs of developing software for internal use.
Internal use software is defined as software developed to support general and administrative functions, such as financial management, human resource management and support services such as data processing.
Before now, the wages, supplies and other expenses incurred to develop such internally used software did not qualify for R&D tax credits that were otherwise available for software that a company developed for sale or lease to third parties.
The IRS regulations lay out a three-part, “High Threshold of Innovation” test. To use the credit against internal software development, the software must:
- Be highly innovative as defined in the regulations,
- Involve significant economic risk, and
- Not be commercially available.
Non-internal use software only needs to satisfy a standard four-part test, not the high-threshold test.
The new regulations also clarified guidelines for businesses that develop new and improved software intended to be sold or used for third-party interactivity. For example, many companies develop third-party-facing software that a customer might access through the internet to transact business with a company. Formerly, it was unclear if that software would qualify for R&D tax credits, or would be considered internal use.
The regulations also allow taxpayers to use the R&D tax credit for qualified costs on software that has both internal use and non-internal use components. To take advantage of this, companies must quantify a subsection of the software system that enables interactions, functionalities and data revisions between the company and third parties.
Overall, the new regulations recognize the value of investing in technology and innovation, and provide a path for a company to reduce costs through tax credits.
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