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Application of Research Credit to Internal Use Software


tax forms, IRS, internet, computer, filing taxesThe U.S. Treasury and the IRS have issued proposed regulations on the research tax credit with respect to computer software developed for internal use. The proposed regulations define "internal use software" as software developed by the taxpayer for use in general and administrative functions that facilitates or supports the conduct of the taxpayer’s trade or business. The regulations became effective as of the date of their publication, meaning that the regulations will apply for tax years beginning after January 20, 2015.

Proposed regulations

Except to the extent permitted by regulations, a taxpayer’s expenditures for software it develops for its internal use are ineligible for the research credit. The proposed regulations describe internal use software, clarify what is not internal use, and allow more internal software to satisfy a high threshold of innovation test.

Under the proposed regulations, software is not developed primarily for internal use if it is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties, or to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. Whether software is or is not developed primarily for internal use depends upon the intent of the taxpayer and the facts and circumstances at the beginning of the software development.

High threshold of innovation test

The proposed regulations maintain the high threshold of innovation test, although they remove the appropriate design component from the method of determining substantial uncertainty. (The second prong of the high threshold of innovation test requires that computer software development entail significant economic risk, which exists if the taxpayer commits substantial resources to the development and there is substantial uncertainty.) Some practitioners have predicted that the elimination of the appropriate design component from this test could introduce added complexity.

For computer software to qualify for the research and development credit, the high threshold of innovation test requires that the:

  1. Software must be innovative,
  2. Software development must involve significant economic risk, and
  3. Software must not be commercially available to the taxpayer.

Doerr_MartinFor more information, please contact your Brown Smith Wallace tax advisor, or Marty Doerr, at 314.983.1350 or

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