Qualifications for use of research tax credit modified.

In Norwest, 110 TC No. 34 (1998), the Tax Court has held that costs incurred in internal-use software development require a higher threshold of technological advancement and functional improvement to qualify for the Sec. 41 research tax credit.

Norwest and the IRS agreed that seven tests must be satisfied to obtain the Sec. 41 qualified research credit. The first four tests, found in Sec. 41 (d), require that:

1. The expenditure must qualify as a Sec. 174 expense (the Sec. 174 test);

2. The taxpayer must discover information that is technological in nature (the discovery test);

3. The application must be useful in the development of a new or improved business component (the business component test); and

4. Substantially all the research activities must constitute elements of a process of experimentation (the process-of-experimentation test).

In the case, the Service conceded the Sec. 174 test.

The additional three tests for internal-use software, set forth in the Conference Report accompanying the Tax Reform Act of 1986, are:

1. The software must be innovative (the innovativeness test);

2. The software development must involve significant economic risk (the significant economic risk test); and

3. The software must not be commercially available (the commercial availability test).

The Tax Court agreed with the IRS that the Sec. 41 discovery test is narrower than the discovery test in Sec. 174. To satisfy the discovery test, the court stated, "[T]he fact that the information is new to the taxpayer, but not new to others, is not sufficient for such information to come within the meaning of discovery." To satisfy the discovery test, the court concluded that the taxpayer must go "beyond the preexisting knowledge of the principles of the hard sciences."

As to the process-of-experimentation test, the Tax Court agreed with the Service that "substantially all" of the experimentation activities means "at least 80 percent of the activities that constitute elements of a process of experimentation," i.e., development, testing and analysis. For the innovativeness test, the court believed that quantification would not be materially helpful; based on House and Senate reports, it concluded that "the extent of the improvements required by Congress with respect to internal use software is much greater than that required in other fields."

The Tax Court determined that the significant economic risk test also raises a threshold higher than in other fields, because Congress used the term "substantial uncertainty," rather than only the term "uncertainty" found elsewhere. Addressing the commercial availability test, the court rejected the IRS's position that expenses incurred in the implementation of commercially available software can never satisfy this test, finding that "Congress clearly anticipated that some modifications to commercially available software can satisfy the fifth and sixth tests of our seven-test analysis." In reaching its decision, the Tax Court did look at United Stationers Inc., 982 FSupp 1279 (DC Ill. 1997), but concluded that the decision in that case was "of little benefit," as there was no detailed record to compare to the facts in Norwest.

The Tax Court concluded that, of Norwest's eight internal-use software activities, only development of a "strategic banking system" satisfied all seven tests. The remaining activities at issue in the case were determined not to have satisfied the tests. These activities included: developing software to maintain trust accounts; designing a system to improve the speed and efficiency of data processing for Norwest's equipment-leasing business; designing an integrated collection of software applications to support general ledger accounts and to produce balance sheets, income statements and other financial reports; developing a software package to move funds electronically in real time from Norwest's accounts, through the Federal Reserve System, to destination financial institutions; designing a payroll management system; developing a system to make disbursements from pension trust accounts, maintain trust account records and report tax-related information; and developing a software system to support the issuance of Norwest's debit card.

FROM ROSEMARY BECCHI, J.D., LL.M., WASHINGTON, D.C.