Final regulations were published on October 4, 2016 relating to the research credit for internal use software development. These final regulations apply a majority of the rules proposed in January of 2015. The final regulations should provide guidance to resolving controversy between taxpayers and the IRS on internal use software issues. These regulations are more favorable to taxpayers than the proposed regulations with respect to defining internal-use software. Following are two key favorable changes.

Defining internal use software- To be considered internal use software under the final regulations, the software must be developed by the taxpayer for use in general and administrative functions that facilitate and support the conduct of the taxpayer’s trade or business. These functions are limited to financial management, human resources, and support services. Previously, to be exempt from the internal use software definition, the software had to be commercially sold, licensed, leased, or otherwise marketed to third parties, or software that enabled taxpayers to interact with third parties or allow third parties to initiate functions or review data on the taxpayer’s system. Now under the final regulations, as long as the software is not developed for general and administrative functions, it will not be defined as internal use software.

High threshold of innovation test- When software is defined as internal use, an additional 3 part test is required to be met to qualify for the research credit. Under the final regulations, the second of the three tests, significant economic risk, was expanded to not exclude design uncertainty as an element of technical uncertainty. Previously the taxpayer had to show uncertainty with respect to only capability or method. Now under the final regulations, a taxpayer can meet the significant economic risk test if they demonstrate design uncertainty, or uncertainty with respect to capability or method.

Effective date- The regulations will apply to tax years beginning on or after October 4, 2016. The regulations state that the IRS will not challenge return positions consistent with the final or proposed regulations for any tax year ended on or after January 20, 2015.