Internal-use software and the research credit.

EXECUTIVE SUMMARY

* FOR YEARS THERE HAS BEEN LITTLE TAX GUIDANCE for corporations to follow in determining whether internal-use software is eligible for the IRC section 41 research tax credit. In 1997 the Treasury Department released proposed regulations. In the past few years, two court cases, Norwest v. Commissioner and United Stationers, Inc. v. U.S. have shed some additional light on the subject.

* TO QUALIFY INTERNAL-USE SOFTWARE FOR THE CREDIT, companies must essentially meet seven requirements; four come from section 41 itself and three can be found in the proposed regulations. Based on the two court cases, it appears the biggest hurdles are the statutory requirements of discovery and process of experimentation, and the significant economic risk requirement found in the proposed regulations.

* IN UNITED STATIONERS, THE DISTRICT COURT SAID the taxpayer did not qualify for the research credit because its software development activities did not satisfy the discovery and process of experimentation requirements. The court also found the projects did not involve a significant amount of economic risk.

* THE TAX COURT'S NORWEST DECISION REACHED essentially the same conclusion. The court said only one of Norwest's software projects satisfied the requirements for the section 41 research credit. The other projects did not involve significant technical risk, the court said.

* NOT ALL COMPANIES WILL BE HAPPY WITH THE guidance now available on qualifying internal-use software for the research tax credit. The proposed regulations essentially repeat previous guidance, and the court cases do not provide any bright-line tests for taxpayers to follow.

A gray area becomes a little less so.

Computers often need software tailored to a company's needs, but businesses that develop internal-use programs have struggled for years with scant corporate-tax guidance on how to qualify such software for the IRC section 41 research tax credit. A financial manager whose employer plans to develop software in-house may be able to structure such a project more advantageously after looking at the rules and how the courts interpret them.

Although the code does not define internal-use software, the legislative history describes it as software that "supports general and administrative functions (such as payroll, bookkeeping or personnel management) or provides noncomputer services (such as accounting, consulting or banking services)." Enacted as part of the Economic Recovery Tax Act of 1981, the original credit made no direct provision for internal-use software. The accompanying House of Representatives report, however, indicated the credit applied to only new or significantly improved software.

Congress created an opportunity for internal-use software in the Tax Reform Act of 1986 (TRA `86), but ended up leaving it a gray area. The amended credit expressly excluded internal-use software from the definition of qualified research, but included it in two statutory exceptions and in exceptions the regulations would provide. In 1997--more than 1(10 years later--the Treasury Department finally released proposed regulations. Treasury didn't go out on a limb, and the proposals do little more than echo the TRA `86 conference report. Most companies already apply these requirements, so the proposed regulations still don't resolve questions about the eligibility of internal-use software for the research credit.

Case law on the treatment of internal-use software under section 41 is limited. However, two recent cases--Norwest v. Commissioner [110 T.C. 454 (1998)] and United Stationers, Inc. v. U.S. [982 F. Supp. 1279 (N.D. Ill. 1997), on appeal (7th Cir., Dec. 23, 1997)]--provide insight into how the courts qualify internal-use software for the research credit, based on statutory and regulatory requirements. These cases (particularly Norwest, because of its extensive analysis), administrative rulings and the credit's legislative history give CPAs some insight into how these rules are applied, which is critical given the explosive growth of software development today.

THE REQUIREMENTS

Section 41 (d)(1) says "qualified research" must meet four requirements:

1. The related expenditures qualify for a deduction under IRC section 174.

2. The purpose of the research is to discover information that is technological in nature.

3. The taxpayer's intended use of the discovered information is to develop a new or improved business component.

4. The research involves a process of experimentation that relates to a new or improved function, performance, reliability or quality.

Section 41 (d)(4)(E) excludes internal-use software from this definition unless it is provided for in the regulations or if the taxpayer develops the software for a use that otherwise qualifies for the credit.

Proposed regulations section 1.41(e)(5) adds three more requirements, which appear in the TRA `86 conference report:

1. The software is innovative. (It results in a reduction in cost or an improvement in speed that is substantial and economically significant.)

2. Developing the software involves significant economic risk. (The taxpayer commits substantial resources to software development and, due to technical risk, there is substantial uncertainty it will recover the resources in a reasonable time period.)

3. The software is not commercially available. (The taxpayer cannot purchase, lease or license and use the software for the intended purpose without modifications that satisfy the first two requirements.)

Proposed regulations section 1.41-4(e)(6) adds two concepts not found in the conference report to clarify these requirements.

1. The internal-use software must have a high threshold of innovation.

2. All facts and circumstances must be considered in determining whether a taxpayer satisfies the requirements for qualified research in developing internal-use software.

THE COURTS' VIEW

The analyses in Norwest and United Stationers suggest that the three biggest hurdles taxpayers face are the statutory requirements of discovery and process of experimentation and the significant economic risk requirement in the proposed regulations. Because the criteria to satisfy these three requirements relate to the less-difficult ones, companies that meet them usually satisfy the others. With all the requirements, however, the greatest problem companies face is that--if audited--they must provide evidence of the nature of the development activities and document the related technical and economic risks.

Discovery requirement. IRC section 41(d) (1) (B) (i) requires that a taxpayer conduct research to discover information that is technological in nature. While the statute does not define discover or technological in nature, the legislative history indicates that research is technological if it depends on principles of the physical or biological sciences, engineering or computer science. Research to expand or refine existing computer science principles may satisfy this requirement.

In Norwest the Tax Court noted that the knowledge a company gains from its research must exceed the knowledge in the field in which the taxpayer performs the research--in this case, computer science. The discovery of information new to the taxpayer but not to others is not sufficient. In other words, if skilled technicians use known methodologies to produce software there can be no discovery of information that is technological in nature, even if the taxpayer doesn't know whether the software will produce the desired benefits.

The Tax Court determined that section 41 does not limit research to development of new technology but also encompasses use of existing technology in new and dynamic ways. Norwest, a banking corporation, developed software for its strategic banking system (referred to as the customer module) that was

1. Customer based (rather than based on an account or financial product).

2. Designed to interface with other bank databases.

3. Designed to handle large volumes of transactions.

The record does not indicate that Norwest developed previously unknown technologies or employed new languages or programming techniques. Norwest passed the discovery test by using existing technology in a new and dynamic way to expand existing computer science principles.

In United Stationers, where the taxpayer customized software acquired from a vendor, the district court concluded that the company did not discover information that was technological in nature. Using dictionary definitions of technological and discover, the court found the taxpayer merely applied, modified and built on existing information.

Process of experimentation requirement. IRC sections 41 (d)(1)(c) and 41 (d)(3) prescribe that substantially, all the research activities that are part of a process of experimentation relate to a new or improved function, performance, reliability or quality. Process of experimentation means a process in which alternative methods are designed, tested, refined and modified as needed to reach a goal (such as developing or improving a business component) that is uncertain at the outset. In Norwest the Tax Court elaborated on the importance of requiring uncertainty at the outset. The focus of the process of experimentation must be on eliminating uncertainty about the technical ability to develop the product--not on eliminating uncertainties related to business or economic constraints.

To ferret out its meaning here, the Tax Court borrowed the regulations' definition of substantially all in the context of qualified wages. Regulations section 1.41-2(d)(2) defines the term as meaning at least 80% of the wages the taxpayer pays or incurs for an employee. Thus, the Tax Court concluded, at least 80% of the research activities the taxpayer engages in must involve the development, testing and analysis of hypotheses designed to eliminate technical uncertainty about that product (at least 80% of the activities must be part of an experimentation process).

In United Stationers the district court cited the legislative history and found it was necessary to determine the extent of the uncertainty in the taxpayer's projects. The court concluded that although the expected benefits were in doubt, the development of the means that would enable the company to achieve those benefits was not. Accordingly, United Stationers did not meet the process of experimentation test.

Significant economic risk requirement. The third critical test is found in proposed regulations section 1.41-4(e)(5)(ii). It requires the taxpayer to establish that the software development involves significant economic risk because the company has committed substantial resources and because of substantial uncertainty, due to technical risk, that the company will recover those resources in a reasonable period. In Norwest the Tax Court did not define substantial resources, significant economic risk, substantial uncertainty or technical risk. The court did, however, reject the taxpayer's definition of significant economic risk (a 20% chance the project will fail due to technical risks), concluding that developing internal-use software demands a higher threshold of technological advancement than other fields.

In United Stationers the district court focused its analysis on technical risk, disagreeing with the taxpayer's claim that uncertainty of outcome creates technical risk. Instead it held that technical risk refers to a taxpayer's ability to develop the software. The court conceded that although spending more than $1 million is inherently risky, the amount of the expenditure is not the deciding factor. The technical risk in this case was minimal (the feasibility of developing the software was not in doubt), and the development activities therefore did not meet the substantial uncertainty condition. Apparently, taxpayers must show there is doubt about the ability to develop the software and doubt about the software's ability to produce the desired results.

Section 174 requirement. IRC section 41(d) (1) (A) requires research expenditures to qualify as expenses under section 174, which generally allows taxpayers to currently deduct research and experimental expenditures paid or incurred in connection with operating a trade or business.

Section 174 does not define research and experimental expenditures, but regulations section 1.174-2(a) (1) describes them as expenditures for activities intended to discover information that will eliminate uncertainty about the development or improvement of a product. Whether the expenditures qualify as research depends on the activity the expenditures relate to, not on the product or improvement being developed or the level of technological advancement the product or improvement represents. Thus, unlike the section 41 discovery test, the section 174 test does not depend on the product's level of technological advancement. Rather, the test relates to uncertainty about the development or improvement of a product. The section 41 discovery test concerns information that is technological in nature and basically relies on principles of the (hard) sciences. A taxpaying entity meets the section 174 requirement if its research applies to the development or improvement of a business component using currently existing technical knowledge. The section 41 discovery requirement, however, calls for an advance in a technical field (such as computer science).

In Norwest the Tax Court concluded that Congress intended to make the section 41 discovery test narrower than the section 174 test. A taxpayer complying with section 41 may find the section 174 test is not an issue. The IRS decision not to contest the section 174 requirement in either Norwest or United Stationers adds credence to this.

Business component requirement. IRC section 41 (d) (1) (B) (ii) requires that the taxpayer engage in research to discover information expected to be useful in developing a new or improved business component. Section 41 (d) (2) (B) defines business component as any product, process, computer software, technique, formula or invention.

In Norwest the taxpayer developed software that significantly increased the volume of transactions the company could process. The Tax Court noted that the increase in volume met the requirement of a new or improved business component. The Tax Court did not try to quantify' or qualify the level or type of functional improvement required by section 41 but said that, at a minimum, Congress intended such research activities to provide some level of functional improvement.

Innovativeness requirement. The innovativeness requirement in proposed regulations section 1.41-4(e)(5)(i) requires the taxpayer to show that the internal-use software is innovative (a substantial and economically significant reduction of cost or improvement of speed). Further, proposed regulations section 1.41-4(e)(6) requires the software to exhibit a high threshold of innovation.

In Norwest the taxpayer argued that a 5% to 20% improvement was substantial and economically significant. However, the Tax Court refused to quantify substantial and significant, noting instead that the improvement Congress required for internal-use software is greater than that required in other fields (presumably the research fields such as chemistry, medicine or engineering, as specified in section 41's legislative history). For example, the innovativeness requirement calls for greater improvement than does the business component requirement, which demands only a new or improved business component. The Tax Court agreed with the IRS that a high threshold of innovation is required but stopped short of clarifying the meaning of the phrase.

In United Stationers the district court did not seem to require as high a threshold. In rejecting a magistrate judge's findings that the taxpayer did not satisfy the requirement, the court agreed with the judge that the taxpayer's projects simply increased efficiency and revenues. The court concluded that all the projects fell under the plain meaning of innovative included in section 41's legislative history. However, given the stance taken by the Tax Court, a taxpayer may want to gather evidence of improved efficiencies, cost reductions and revenue generation to substantiate innovativeness.

Commercial availability requirement. Proposed regulations section 1.41-4(e)(5)(iii) requires a taxpayer to establish that the software is not commercially available. This means it cannot be purchased, leased or licensed and used for the intended purpose without modifications that will satisfy the innovativeness and significant economic risk requirements. In Norwest the Tax Court said this requirement was self-explanatory. In United Stationers the district court did not address it because the parties agreed the software was not commercially available. To satisfy this requirement, a taxpayer should conduct an extensive search for suitable commercially available software. Records of these efforts can be used as evidence.

THE DECISIONS

In United Stationers the district court denied the taxpayer a research credit primarily because its software development activities did not satisfy the discovery and process of experimentation requirements. The court also found that the projects did not involve significant economic risk. In fact, the only contested requirement United Stationers satisfied was the innovativeness test.

The Tax Court's Norwest decision came eight months after United Stationers but the court chose not to rely on it. In .Norwest the evidence was more detailed and included expert testimony on behalf of both the taxpayer and the IRS. Despite this, the conclusions did not differ significantly. The Tax Court considered eight Norwest software projects but found that only one--the strategic banking system, with its customer module--satisfied the seven requirements for the section 41 research credit. In allowing the credit for this project, the Tax Court seemed impressed with the improvement the current system offered over existing software and the taxpayer's ability to use existing technology in a new and dynamic way.

The other projects failed to qualify for the credit because they did not involve significant technical risk, according to the court. The only risk some projects faced was that competitors would have their systems in operation before Norwest's. The court also found that some of the projects did not use a process of experimentation.

WHAT NOW?

Companies seeking guidance on qualifying internal-use software for the section 41 research credit finally have at their disposal the long-awaited regulations (albeit proposed) and the much-anticipated Norwest and United Stationers decisions. The guidance the Treasury and the courts have provided will disappoint some. The proposed regulations merely track the language in the legislative history. Others will be concerned the conclusions in Norwest parallel those in United Stationers, and neither decision provides bright-line tests for taxpayers to follow. The proposed regulations and the two decisions do, however, give CPAs and financial managers a better idea of the magnitude of their tasks and the proper focus for their efforts.

Companies usually develop internal-use software, directly or through contract research, because commercially available software does not do a good enough job. The most difficult hurdle for these taxpayers is demonstrating that the software development activities are based on a process of experimentation that results in technological discovery at a significant economic risk. Taxpayers must show a higher threshold of technological advancement and functional improvement than is expected in other research fields.

Although some argue that these rigid requirements are discriminatory, they are consistent with the general exclusion of internal-use software from the research credit. Hopefully the recent developments and others that follow--final regulations and additional case law--will enhance a company's chances of qualifying for the credit. But as the Tax Court concluded in Norwest, "Congress sought to limit the development of internal-use software under section 41 only to those endeavors that ventured into uncharted territory."

Accounting Guidance

Guidance on how to account for internal-use software on a company's financial statements is now easier to find. In early 1998 the AICPA Accounting Standards Executive Committee issued SOP 98-1, Accounting for the Costs of Computer software Developed or Obtained for Internal Use.

Y2K Software Costs and the Section 41 Research Credit

Many companies have incurred significant costs to develop software to deal with Y2K problems. Do these expenses qualify for the section 41 research credit? In revenue procedure 97-50, the IRS ruled that such costs generally are not eligible for the credit because they do not

1. Relate to activities that constitute a process of experimentation.

2. Involve the discovery of information that is technological in nature. Companies resolved most Y2K software problems with current programming methods that did not require a process of experimentation extending the boundaries of computer science. The IRS ruled, however, that the costs are deductible in the year incurred as research expenditures under section 174.

LEE G. KNIGHT, PhD, is professor of accounting at Samford University in Birmingham, Alabama. Her e-mail address is [e-mail]. RAY A. KNIGHT, CPA, JD, is a principal with Ernst & Young LLP in Charlotte, North Carolina. His e-mail address is [e-mail]. WAYNE E. NIX, CPA, DBA, JD, is assistant professor of accounting at Delta State University in Cleveland, Mississippi. His e-mail address is [e-mail].