THE R&D TAX CREDIT
SOFTWARE AND TAX SAVINGS
By: Robert J.M. Scranton, M.T., J.D.
(719) 477-0333

For many years, the Internal Revenue Service (“IRS”) has resisted the deductibility of expenses related to the development of software to be used in-house for the purpose of enhancing a company’s competitive edge in the market place. Thus, the cost related to the creation of such software had to be capitalized in the same manner as software that was created as a marketable product. Congress modified the law but the IRS, until this past year, resisted the deductibility of software expenses related to the creation of in-house software used to assist your business in increasing its competitive edge in the marketplace. The inherent questions: Why should costs for software not intended for resale be capitalized? Capitalization of software expenses which are incurred as a result of a software project designed to increase a company’s competitive edge in the marketplace, places a company at a disadvantage, for tax purposes, when it develops software for internal use.

In 1981, Congress enacted a tax credit for research and experimental activities to encourage firms to increase Research and Development ("R&D") expenditures above existing levels. This provision, currently in § 41, subsidizes only research that represents an increase in the level of research conducted by that firm. This limitation is enforced by granting no benefit for research up to the "base amount," calculated using the firm's research expenditures from the years 1984 through 1988; above this amount, the credit is granted at a rate of 20%. Over the years, a number of adjustments have been made to how the base amount is calculated, including a reduction of the credit rate from its original level of 25%, and the adoption of the current base period structure to replace the original floating three-year period. More importantly, an alternative incremental credit was adopted in 1996 to extend the incentive of the credit to firms that had seen their economic positions change since 1989 such that they could no longer reach the base amount.

The term "internal use software" is defined as software that is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer. The legislative history and regulations list as examples of internal use software, software used for general and administrative functions (e.g., payroll, bookkeeping, or personnel management), or for providing noncomputer services (e.g., accounting, consulting, or banking services). Thus, the definition is intended to apply to a broad range of software, from the accounting control software developed by most major corporations to the financial analysis software developed by consulting and other service organizations for use with their clients. In these cases, software development costs are eligible for the credit only to the extent permitted under Treasury regulations.

The requirement that the software be developed "primarily" for internal use raises questions in situations where taxpayers who are in the business of developing software for sale, lease, or license to customers decide, with respect to a particular project, to develop software initially for internal use but intend, if the development project is successful, subsequently to sell, lease, or license the software. The regulations provide that they do apply in such a case. In contrast, any improvements to the software required after internal use or to make the software marketable should clearly not be treated as relating to internal use software.

The credit is available under certain circumstances in which research with respect to internal use software will be eligible for the Section 41 credit. Under Section 41(d)(4)(E), such research will be considered "qualified research" if it: (1) is related to software used in qualified research activities; (2) is related to software used in a production process of the taxpayer; or (3) is treated as "qualified research" under the regulations. In addition to these three circumstances, the legislative history of Section 41 and regulations provide that research with respect to software that is included in an integrated hardware-software product will be eligible for the credit.

The IRS has issued comprehensive final regulations on how to qualify for the Code Sec. 41 research credit.

The regulations make many changes to the rules in the controversial proposed regulations issued in '97 and '98. They introduce a new patent safe harbor, a new recordkeeping requirement, and a rebuttable presumption that the "discovery test" has been met. The regulations also make it easier for some companies to claim the research credit for internal-use software.

The research expense credit generally is equal to 20% of the excess (if any) of qualified research expenses for the tax year over a base amount (unless the taxpayer elects the alternative incremental credit under Code Sec. 41(e)(1)(A)). (Code Sec. 41(a)) The base amount is a fixed-base percentage (determined via a complex formula) of the taxpayer's average annual gross receipts (from a U.S. trade or business, net of returns and allowances) for the four tax years before the credit year, and can't be less than 50% of the year's qualified research expenses. (Code Sec. 41(c))

Qualifying for the research credit. An expense qualifies for the Code Sec. 41 research credit if:

it qualifies as a research and experimental expenditure under Code Sec. 174;
it relates to research undertaken for the purpose of discovering information ("discovery test") that is technological in nature and the application of which is intended to be useful in developing a new or improved business component of the taxpayer; and
substantially all of the activities of the research constitute elements of a process of experimentation ("process of experimentation test") that relates to a new or improved function, performance, reliability or quality. (Code Sec. 41(d)(1))

Additional tests apply to research costs of software developed for the taxpayer's internal use. (Code Sec. 41(d)(4)(E)) Certain activities (e.g., marketing, surveys, duplication of existing business components, post- commercial-production activities) aren't qualified expenses. (Code Sec. 41(d)(4))

The following are highlights of the key provisions in the final regulations, which are effective for expenses paid or incurred after Jan. 2, 2001, except as otherwise indicated.

The gross receipts test. Among the items excluded from the definition of gross receipts is any income received in a tax year that precedes the first tax year in which the taxpayer derives more than $25,000 in gross receipts other than investment income. For this purpose, investment income is defined as interest or distributions with respect to stock (other than the stock of a 20% owned corporation as defined in Code Sec. 243(c)(2)). (Reg § 1.41-3(c)(2)(vi)) This exclusion, which is effective for tax years beginning after Jan. 2, 2001, is designed to aid start-ups.

Revamped discovery test. Under the final regulations, the discovery test is met only if the research is undertaken to obtain knowledge that exceeds, expands, or refines the "common knowledge of skilled professionals" in a particular field of science or engineering. The effort need not succeed and the hoped-for advance need not be more than evolutionary, but the discovery test isn't met merely because an expense may be treated as an R&E expense under Code Sec. 174. (Reg § 1.41-4(a)(3)(i)) "Common knowledge" is information that should have been known to skilled professionals had they performed, before the research in question was undertaken, a reasonable investigation of the existing level of information in the particular field of science or engineering. A business doesn't have to actually conduct such an investigation to qualify for the credit. Trade secrets generally don't fall in the "common knowledge" category because they're not reasonably available to skilled professionals not employed, hired, or licensed by the owner of the trade secrets. (Reg § 1.41- 4(a)(3)(ii))

An example: Y Corp designs and builds a bridge that can hold more traffic. Its method is a closely guarded trade secret known only to Y employees. Subsequently, Z Corp also builds a high-traffic bridge. Z's technology development to build the bridge may qualify as credit-eligible research even though its method is similar or identical to Y's. (Reg § 1.41-4(a)(8), Ex. 3)

Contemporaneous documentation requirement. Effective for research projects that begin after Mar. 4, 2001, a taxpayer qualifies for the research credit only if it:

prepares and retains written documentation before or during the early stages of a research project describing the principal questions to be answered and the information it seeks to obtain to satisfy the discovery test; and
complies with the general recordkeeping requirements of Code Sec. 6001. (Reg § 1.41-4(d))

There is a new rebuttable presumption that discovery test is met. A taxpayer is presumed to meet the discovery test if:

it demonstrates with credible evidence that research activities were undertaken to obtain the information described in its contemporaneous documentation (see above), and
that contemporaneous documentation also sets forth the basis for the taxpayer's belief that obtaining this information would exceed, expand, or
refine the common knowledge of skilled professionals in the particular field of science or engineering. (Reg § 1.41-4(a)(3)(v))

The new rebuttable presumption applies only if the taxpayer cooperates with reasonable requests by IRS for witnesses, information, documents, meetings, and interviews. IRS may overcome this presumption by demonstrating that the information described in the taxpayer's documentation was within the common knowledge of skilled professionals in the particular field of science or engineering. (Reg § 1.41-4(a)(3)(v)) IRS would have to demonstrate that the information would have been known to skilled professionals had they performed (before the research was undertaken) a reasonable investigation of the existing level of information in the particular field of science or engineering.

Patent safe harbor. For purposes of the discovery test, the issuance of a patent under 35 151 (other than a patent for design issued under 35 171) is conclusive evidence that a taxpayer has obtained knowledge exceeding, expanding, or refining the common knowledge of skilled professionals. Patent issuance isn't a precondition for credit availability (Reg § 1.41-4(a)(3)(iv)), but the factors underlying the denial of a patent application may be relevant to whether the discovery test is met. (TD 8930)

Process of experimentation. This means the evaluation of more than one alternative designed to achieve a result where the capability or method of achieving that result is uncertain at the outset. In contrast to expenses qualifying under Code Sec. 174 (TD 8930), this process doesn't include the evaluation of alternatives to establish the appropriate design of a business component, if the capability and method for developing or improving the business component are not uncertain. (Reg § 1.41-4(a)(5)) In conducting this process, a taxpayer may (but does not have to) undertake a formal four-step approach (evaluate hypotheses, design an experiment, conduct an experiment, and refine or discard hypotheses in arriving at the result). (TD 8930; Reg § 1.41- 4(a)(5))

Internal-use software. This is software used internally for general administrative functions (e.g., payroll, bookkeeping or personnel management), or in providing a noncomputer service (e.g., accounting, consulting, or banking services). (Reg § 1.41-4(c)(6)(C)(iii))

Relaxed rule for internal-use software used in providing noncomputer services. Effective for post-Jan. 2, 2001 expenses, a new exception allows otherwise- eligible internal-use software to qualify for the research credit if, at the time the research was undertaken:

the software is designed to provide customers with new features with respect to a noncomputer service;
the taxpayer reasonably anticipated that customers would choose to get the noncomputer service from the taxpayer (rather than from its competitors) because of the new features provided by the software; and
those new features were not available from any of the taxpayer's competitors. (Reg § 1.41-4(c)(6)(v))

Effective for post-Jan. 2, 2001 expenses, a noncomputer service is one offered to customers who are interested primarily in the taxpayer's noncomputer services, even if the services are enabled by computer or software technology. (Reg § 1.41-4(c)(6)(iv)(B))

The final regulations illustrate the relaxed rule with the example of a company that develops an internal use software system, not used by competitors, to track the manufacture and delivery of products and to enable customers to monitor orders and when they'll be filled. (Reg § 1.41-4(c)(6)(viii), Ex. 2, effective for post-Jan. 2, 2001 expenses)

In its preamble, TD 8930 says that taxpayers may rely on the internal-use software rules that are effective for post-Jan. 2, 2001 expenses for pre-Jan. 3, 2001 expenses as well. This may create a refund opportunity for taxpayers who incurred expenses that qualify for the research credit under the new rules but didn't qualify under prior guidance.

Even if the above tests are met, the research must still meet the qualification tests explained above, and not be otherwise excluded (e.g., because it involves market research or routine testing for quality control).

Conclusion

The research credit was enacted for the purpose of stimulating economic growth through encouraging increased research activity. Studies have shown that it has been successful, at least to some degree, in advancing this goal. The IRS, concerned that the credit is being applied too broadly and is creating large administrative costs, has recently offered interpretations of several aspects of the definition of qualified research that would significantly narrow the range of eligibility for the credit. These recently enacted and proposed interpretations serve the legitimate objectives of attempting to restrict the credit to research that provides the largest spillover effects to the economy, avoiding subsidies of research that would be undertaken regardless of the credit, and reducing the administrative costs of making factual determinations about whether research qualifies for the credit.