The Treasury and IRS have released proposed regulations governing the credit for increasing research activities (the research and development or R&D credit) with respect to computer software for internal use. The proposal also withdraws a prior advanced notice of proposed rulemaking, and asks for public comments.

1. Proposed R&D Credit Regulations
Would Clarify, Modify Tests for
Internal Use Computer Software
The Treasury and IRS have released proposed regulations governing the credit for increasing
research activities (the research and development or R&D credit) with respect to computer
software for internal use. The proposal also withdraws a prior advanced notice of proposed
rulemaking, and asks for public comments.
Comment: According to a Treasury Department News Release, the proposed regulations would:
• define internal use software,
• clarify what is not internal use, and
• allow more internal software to satisfy a high threshold of innovation test.
The proposed regulations provide that internal use software is software is developed by the
taxpayer for use in general and administrative functions that facilitate or support the conduct
of the taxpayer's trade or business. This definition extends to software that the taxpayer
develops primarily for a related party's internal use. The proposed regulations also:
Internal Use, Non-Internal Use and Dual Function Software
• eliminate the distinction between software developed to deliver computer and
non- computer services, and
• limit general and administrative functions to financial management functions, human
resource management functions, and support services functions
Comment: This list of general and administrative functions is intended to target the back-
office functions that most taxpayers have regardless of the industry. However, the
characterization of a function as back-office may depend upon the taxpayer's industry. For
instance, tax software is a back-office matter for most taxpayers, but not for those in the tax
services industry.

2. Whether software is developed primarily not for internal use depends upon the intent of the
taxpayer and the facts and circumstances at the beginning of the software development. If the
intent changes — if, for example, the taxpayer develops internal use software and then
improves it in order to offer it commercially, the improvements are considered separate from
the existing software and are not be considered to be for internal use.
The proposed regulations provide that dual function software is presumed to be developed
primarily for a taxpayer's internal use. However, to the extent that a taxpayer can identify a subset
of dual-function elements that only enable the taxpayer to interact with third parties or allow
third parties to initiate functions or review data, the portion of research expenditures allocable to
this "third party subset" may be eligible for the credit. Under a safe harbor, qualified research
expenditures may include 25 percent of the qualified research expenses for the remaining portion
if the use of this "dual-function subset" by the taxpayer or third parties is reasonably anticipated
to constitute at least 10 percent of the dual-function subset's total use.
The proposed regulations provide that 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
• enable a taxpayer to interact with third parties or to allow third parties to initiate
functions or review data on the taxpayer's system (such as third-party software
developed to execute banking transactions, track deliveries, search inventories, store
and retrieve third party's digital files, purchase tickets, and receive services over the
internet. However, third parties do not include any persons that use the software to
support a taxpayer's general and administrative functions.
Comment: The IRS declined to adopt a broad rule providing that computer software
supporting the delivery of goods or services to third parties is part of a production process,
but also recognized that under these new rules, such software might qualify as not for
internal use.
Software and Hardware as Single Product
The proposed regulations retain the exception for computer software and hardware
developed as a single product and provide that internal use software does not include a
new or improved package of software and hardware developed together as a single
product that is used directly by the taxpayer in providing services in the taxpayer's trade or
business.
High Threshold of Innovation
For computer software to qualify for the R&D credit, the high threshold of innovation test
requires that:
• the software must be innovative,
• the software development must involve significant economic risk, and
• the software must not be commercially available to the taxpayer.

3. The economic risk test is satisfied if the taxpayer commits substantial resources to the
development of the software, and technical risk poses a substantial uncertainty that those
resources will be recovered within a reasonable period. Substantial uncertainty exists if, at
the beginning of the taxpayer's activities, the information available to the taxpayer does
not establish the capability or method for developing or improving the software.
The commercially-available test is satisfied if the software cannot be purchased, leased, or
licensed and used for the intended purpose without modifications that would satisfy the
innovation and significant economic risk requirements.
Comment: In the economic risk test, the proposed regulations discard the "common
knowledge of skilled professionals" comparative assessment of uncertainty and technical
risk provided by Reg. §1.41-4(a)(3)(ii). However, the risk test requires both technical and
economic risk.
Process of Experimentation Examples
The proposed regulations provide examples of how the process of experimentation test is
applied to computer software, and also illustrate that computer software development
(including certain types of web design and the installation of enterprise resource planning
software) that generally do not qualify as a process of experimentation.
Comments and Public Hearing
Comments are requested on all aspects of these proposed regulations, in particular:
• the appropriate definition and treatment of connectivity software (also known as
bridging software, integration software, or middleware);
• the administrability of the dual function safe harbor's measurement of reasonably
anticipated use of software, and
• the facts and circumstances to be considered in determining whether internal use
software satisfies the three prongs of the high threshold of innovation test.
Comments are due by March 23, 2015. A public hearing has been scheduled for April 17,
2015, beginning at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington D.C. Written comments may be submitted to
CC:PA:LPD:PR (REG-153656-03), room 5205, Internal Revenue Service, P.O. Box 7604, Ben
Franklin Station, Washington, D.C. 20044, and electronic comments may be submitted via
the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG- 153656-03).
The regulations are proposed to apply to tax years ending on or after the date they are
published as final regulations in the Federal Register. However, the IRS will not challenge
return positions consistent with the proposed regulations for tax years ending on or after
January 19, 2015 (the publication date for the proposed regulations).

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Comment: The IRS expressly cautions that the rules in the proposed regulations should
not be viewed as an interpretation of prior regulatory guidance.
Until further guidance is published, taxpayers may continue to rely upon all of the
provisions in the 2001 proposed regulations (NPRM REG-112991-01, Proposed Reg.
§1.41-4(c)(6)), or alternatively, all of the provisions in the final regulations that were also
issued in 2001 (T.D. 8930). An advance notice or proposed rulemaking addressing
computer software that was issued in 2004 is withdrawn, effective for tax years beginning
on or after January 20, 2015. For tax years ending before that date, taxpayers may choose
to follow the 2001 final regulations or the 2001 proposed regulations.