The IRS and Treasury Department released several pieces of guidance between 2001 and 2016 regarding software that qualifies for the R&D tax credit: 1) Initial guidance in 2001 established a "three-part high threshold of innovation test" but was quickly suspended due to taxpayer backlash. 2) Revised regulations in 2003 removed the controversial "discovery test" but did not provide final rules for internal-use software. 3) Later guidance defined categories of internal-use software that qualify for the credit versus software developed for commercial purposes or third-party use. 4) The latest 2016 regulations clarified eligible software categories and provided new examples, establishing largely stable rules after over 15 years of changes to the IRS

1. The Department of the Treasury and the IRS released final guidance on what software qualifies for the
IRC §41 R&D Tax Credit. Here’s a brief history or summary of the rules:
1) Prior to the issuance of regulations, the IRS and courts held that internal-use software was
eligible for the research credit as long as it met three additional requirements provided for in the
legislative history of the Tax Reform Act of 1986 in addition to the usual four-part test. The
additional three requirements from the legislative history were:
a. The software must be innovative. As where the software results in a reduction in cost, or
improvement in speed, that is substantial and economically significant;
b. The software development must involve significant economic risk. As where the taxpayer
commits substantial resources to the development and also there is substantial
uncertainty, because of technical risk, that such resources would be recovered within a
reasonable period; and
c. The software is not commercially available for use by the taxpayer. As where the
software cannot be purchased, leased, or licensed and used for the intended purpose
without modifications that would satisfy the first two requirements.
2) Treasury Decision (TD) 8930 (Jan 3, 2001) set the standard for allowable software development.
These regulations included a “three-part high threshold of innovation” test for internal-use
software that largely mirrored the legislative history from the 1986 Act.
a. TD 8930 included language stating that satisfaction of the first two prongs of the three-
part test required comparisons to the “common knowledge of skilled professionals in the
relevant field.”
b. TD 8930 also introduced the Discovery Test which stated that the second prong of the
four-part test (undertaken for the purpose of discovering technological information) was
only satisfied when 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.”
c. TD 8930 was in place for 28 days. TD 8930 as the authority for IUS stated that the
software would satisfy the high threshold for innovation if the “software is innovative if
intended to be unique or novel and differ in a significant and inventive way from prior
software implementations or methods.”
3) IRS Notice 2001-19 (2001-10 I.R.B. 784) published on January 31, 2001 suspended
TD 8930 ( to include the Discovery Test) after receiving outcries from taxpayers expressing
concerns regarding the “common knowledge” standards, IRS Notice 2001-19 was published
announcing that IRS and Treasury would review TD 8930 and reconsider comments previously
submitted in connection with the finalization of TD 8930.
4) On December 26, 2001, new proposed regulations were issued.
a. The regulations clarified the first prong of the three-part high threshold of innovation test
by stating that internal-use software is innovative if it is “intended to be unique or novel
and is intended to differ in a significant and inventive way from prior software
implementations or methods.
b. The regulations removed the comparisons to the “common knowledge of skilled
professionals” from the first two prongs of the high threshold of innovation test.
2001
2
2004
IRS Notice 2001-19
(2001-10 I.R.B.
784)
Jan 31, 2001
Abated TD 8930
pending new rules
IUS rules remained
in place
3
TD 8930
Jan 3, 01
Discovery Test Applied
Set the rules for IUS -
“software is innovative if
intended to be unique or
novel and differ in a
significant and inventive way
from prior software
implementations or
methods.”
20032002
U.S. District
Court
FEDEX
Rule of Law
Jun 9, 09
TD 9104
Discovery Test
invalidated
Defaults to
TD 8930 for
IUS rules
TD 9104
(Final Regs)
Dec 30, 03
Terminated the Discovery
Test
IUS rules left in TD 8930
IUS =
1) Not available COTS
2) must be Innovative &
3) Involve significant risk
on return on investment
Lastly, New Regs coming
5
2009
Justice Dept
FEDEX
Abandoned Appeal
Aug 29, 13
Discovery Test
Gone
TD 8930 rules
2010 2011 2012 2013 2014 2015 2016
Proposed S/W Reg
Jan 16, 15
IUS Defined: Fin
Mgt, HR & Support
Svcs
3rd Party & Dual
Function
FSLoL or Otherwise
Marketed
TD 9786
Final S/W Reg
Oct 4, 16
IUS Defined: Fin
Mgt, HR, Support
Svcs & Dual
Function
Not IUS: 3rd Party,
FSLoL or Otherwise
Marketed
7 8 9 101
Tax Reform Act of
1986
IUS held at higher
threshold of
innovation:
1) Not available COTS
2) must be
Innovative &
3) Involve significant
risk on return on
investment
1986
New Proposed Regs
Dec 26, 2001
IUS must be “intended to be
unique or novel and is intended
to differ in a significant and
inventive way from prior
software implementations or
methods.”
– But –
“expressly disavowed the need
to be seeking to obtain
information that exceeds,
expands or refines common
knowledge of skilled
professionals from the
discovering information prong of
the four-part test”
4
2004 ANPRM
February 5,
2004
taxpayer may
rely TD 8930
for IUS
including the
heightened
discovering
information
test under the
four-part test
6

2. c. The regulations also expressly disavowed the need to be seeking to obtain information
that exceeds, expands or refines common knowledge of skilled professionals from the
discovering information prong of the four-part test.
d. However, the regulations also created a presumption that all software was internal-use
software unless it was developed to be commercially sold, leased, or licensed for
separately stated consideration to unrelated third parties.
5) The Discovery Test was formally ended under TD 9104 (December 31, 2003). TD 9104 failed to
provide final rules for Internal Use Software. The provisions relating to internal-use software were
omitted and instead “reserved” for future guidance [Reg. 1.41-4(c)(6)]. This was often interpreted
to mean that the old Discovery Test still applied.
6) In conjunction with the final TD 9104 regulations, on February 5, 2004, the IRS issued an
advance notice of proposed rulemaking (2004 ANPRM) providing interim guidance for internal-
use software [IRS Ann. 2004-9]. The 2004 ANPRM stated that until further guidance was
published, taxpayer may rely upon all of the provisions relating to internal-use software in the
2001 proposed regulations or taxpayers may rely upon all of the provisions relating to internal-use
software in TD 8930, including the heightened discovering information test under the four-part
test.
7) In 2009, FEDEX filed with U.S. District Court requesting a ruling of law. District Court rejected the
IRS’ position in the 2004 ANPRM requiring a taxpayer to use the rules for IUS in TD 8930 to also
use the heightened discovering information test set forth in TD 8930 [FedEx Corp. v. U.S., 103
AFTR 2d 2009-2722, DC TN, 2009]. These findings effectively stated the Discovery Test did not
apply to IUS (or other development) given that TD 9104 eliminated the Discovery Test.
8) The Justice Department abandoned its right to an appeal thereby rendering the Discovery Test
officially obsolete. However, the TD 8930 software rules remained in force pending finalization of
regulations governing IUS.
9) Proposed Regulation § 1.41-4 (01/16/2015) provided new guidance outlining specific categories
of software development including:
a. developed to be commercially sold, leased, licensed, or otherwise marketed to third
parties (not IUS).
b. developed 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 – whole new category: dual
function / third party computer software – a new category (not IUS).
i. enables a taxpayer to interact with third parties, or
ii. allows third parties to initiate functions or review data on the taxpayer’s system.
c. developed for use in a production process (not IUS).
d. eliminated the distinction between software developed to deliver computer and non-
computer services.
e. Created general and administrative categories – these are IUS
i. financial management functions,
ii. human resource management functions, and
iii. support services functions.
f. High threshold of innovation test for IUS
i. software would result in a reduction in cost or improvement in speed or other
measurable improvement that is substantial and economically significant.
ii. software development involves significant economic risk, which would exist if the
taxpayer commits substantial resources to the development and there is
substantial uncertainty, because of technical risk, that such resources would be
recovered within a reasonable period.
iii. software is not commercially available for use by the taxpayer in that 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.
iv. Created a separate Significant Economic Risk test stating uncertainty exists in
Design, Capability and Methodology. Design uncertainty is sufficient for non-IUS
but not for IUS. Capability and/or Methodology uncertainty must be shown for
IUS, but is not necessary for non-IUS.

3. g. Optional IUS Safe Harbor created – if the dual function software or dual function subset’s
use by third parties is anticipated to be at least 10% of the total use by third parties, then
25% of the expenses will go without IRS challenge
h. Provided several examples and illustrations.
10) TD 9786 (Oct 4, 16) finalized guidance clarifying categories of development, definitions and
examples:
a. General and administrative categories from Temp Reg carry over unchanged – these
are IUS
i. financial management functions of the taxpayer and the supporting
recordkeeping,
ii. human resource management functions that manage the taxpayer’s
workforce, and
iii. support services functions that support the day-to-day operations of the
taxpayer.
iv. The Treasury Department and the IRS continue to believe that… the benefits that
such functions may provide to third parties are collateral and secondary.
b. Software is not developed primarily for the taxpayer’s internal use (IUS) if it is:
i. not developed for use in general and administrative functions that facilitate or
support the conduct of the taxpayer’s trade or business; and
ii. developed to be commercially sold, leased, licensed, or otherwise marketed to
third parties, and developed to enable interaction with third parties or allow third
parties to initiate functions or review data
1. Note the use of ‘otherwise’ means there is no need to show ‘separate
consideration’ or payment as in TD 8930 – freeware is allowable.
iii. Software developed by (or for the benefit of) the taxpayer both for use in general
and administrative functions that facilitate or support the conduct of the
taxpayer’s trade or business and to enable a taxpayer to interact with third
parties or to allow third parties to initiate functions or review data (dual function
software) is presumed to be developed primarily for a taxpayer’s internal use –
whole new category: third party computer software (it is IUS).
1. enables a taxpayer to interact with third parties (IUS)
2. third party subset: a subset of elements of dual function software that
only enables a taxpayer to interact with third parties or allows third
parties to initiate functions or review data on the taxpayer’s system (Not
IUS)
3. Determine categorization applying the Shrink back rule
4. Application of the Substantially All Rule disallowed
iv. Whether certain software is developed to be used primarily for internal use
should be based on the function the software provides, rather than the type of
software.
c. Developed for use in a production process (not IUS).
d. Eliminated the distinction between software developed to deliver computer and non-
computer services.
e. Final Regs emphasize that whether software is developed primarily for internal use
depends on the intent of the taxpayer and the facts and circumstances at the beginning
of software development. This burden of proof remains on the taxpayer, so it’s key to
show at the onset that the software was intended to be held for sale, etc., or to show the
date that decision was made.
f. IUS Safe Harbor remains unchanged from Temp Regs
i. IRS will not challenge claims if the dual function software or dual function
subset’s use by third parties is anticipated to be at least 10% of the total use by
third parties
ii. 25% of the expenses may be claimed
iii. Test standard for the industry is sufficient to prove (good luck finding that!). Any
objective, reasonable method within the taxpayer’s industry may be used to
measure anticipated use by third parties

4. g. Removes the reference to capability and method uncertainty in the Significant Economic
Risk test because the focus should be on the level of uncertainty that exists and not the
types of uncertainty. However, IUS research activities that involve only design
uncertainty would rarely qualify as having substantial uncertainty for purposes of the high
threshold of innovation test.
h. Provided several new and updated examples and illustrations.