Research to develop computer software for internal use (internal use software) is excluded from the definition of qualified research for purposes of the Research and Experimentation Tax Credit (R&E). The IRS issued proposed regulations on January 16, 2015 on various aspects of internal use software. Whether software is not developed primarily for internal use would depend upon the intent of the taxpayer and the facts and circumstances at the beginning of the software development.

It is important to understand the distinction of what is and is not internal use software in order to maximize your allowable R&E credit, as the following example demonstrates:

Scenario One:

Company X, a multinational manufacturer, installs enterprise resource planning (ERP) system that runs off a single database so X can track orders more easily, and coordinate manufacturing, inventory, and shipping among many different locations at the same time. X evaluates its business needs and the processing power, memory, storage, and network resources of the software, evaluates the available templates, reports, and other standard programs and chooses among these alternatives in configuring the system to match its business process and in reengineering its business process to match the available alternatives in the ERP system. X performs some data transfer from its old system, involving routine programming and one-to-one mapping of data to be exchanged between each system.

This is NOT qualified research because X did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the development of software. X’s activities in choosing between available templates, reports, and other standard programs and conducting data transfer are NOT elements of a process of experimentation.

Scenario Two:

Now let’s assume the same facts as above, except that X determines that it must interface part of its legacy software with the new ERP software because the ERP software does not provide a particular function that X requires for its business. As a result, X must develop an interface between its legacy software and the ERP software, and X evaluates several data exchange software applications and chooses one of the available alternatives. X is uncertain as to how to keep the data synchronized between the legacy and ERP systems.

A subset of X’s activities ARE qualified research because they do satisfy the requirements for a process of experimentation. X’s activities to develop the data caching software and keeping the data on the legacy and ERP systems synchronized meet the requirements of qualified research. X identified uncertainties related to the development of a business component, identified alternatives intended to eliminate those uncertainties, and evaluated alternatives to achieve a result where the appropriate design of that result was uncertain as of the beginning of the taxpayer’s research activities.

Software would not be excluded from the R&E credit as internal use software if either: (a) it is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or (b) it is 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.