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IRS releases proposed IUS regulations
For nearly two decades, taxpayers, practitioners and the IRS have struggled to make sense of how the available (and often contradictory) guidance on internal use software (IUS) can be applied as part of a research credit claim. Taxand USA discusses the Treasury Department's recently published proposed IUS regulations.
As part of the Tax Reform Act of 1986, Congress amended the research tax credit to add a statutory definition of “qualified research activities.” The definition, set out in Section 41(d), is referred to as the four-part test and excludes certain activities from the definition of qualified research. Section 41(d)(4)(E) generally excludes IUS from the definition of qualified research under Section 41(d). However, the statute gave Treasury the authority to issue regulations under which IUS may qualify for the credit.
The proposed regulations address a number of topics, ranging from the reinforcement of existing IUS requirements to the introduction of new concepts and an exception from IUS for applications benefiting third parties. At the heart of the new proposed IUS regulations are clarifying definitions as to what constitutes “internal use” software, the introduction of a new category of software referred to as “dual function computer software,” and modifications to the high threshold of innovation test.
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While there are a number of positive developments, there will likely be many comments on the regulations. In particular, the economic risk standard, the application of the dual function software rules and the narrow focus on the customer as a third party will likely draw comments. However, in an area of tax that has been known for being very contentious, the proposed regulations should be embraced as a starting point for better settlements for IUS.