[Federal Register Volume 69, Number 1 (Friday, January 2, 2004)]
[Proposed Rules]
[Pages 43-47]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31819]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-153656-03]
RIN 1545-BC70


Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: This document invites comments from the public regarding 
certain rules and standards relating to internal-use software under 
section 41(d)(4)(E) of the Internal Revenue Code. All materials 
submitted will be available for public inspection and copying. This 
document also addresses the effective date for final rules relating to 
internal-use software.

DATES: Comments are requested on or before March 2, 2004.

ADDRESSES: Send written comments to: Internal Revenue Service, Attn: 
CC:PA:LPD:PR [REG-153656-03], room 5203, POB 7604, Ben Franklin 
Station, Washington, DC 20044. In the alternative, taxpayers may submit 
comments in writing, by hand delivery to CC:PA:LPD:PR [REG-153656-03], 
Courier's Desk, Internal Revenue Service, 1111 Constitution Ave., NW., 
Washington, DC, or electronically, via the IRS Internet site at: http://www.irs.gov/regs.

FOR FURTHER INFORMATION CONTACT: Nicole R. Cimino at (202) 622-3120 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Introduction

    On December 31, 2003, the Treasury Department and the IRS issued 
final regulations (TD 9104) for the credit for increasing research 
activities under section 41 (research credit). TD 9104 provides rules 
relating to the definition of qualified research under section 41(d) 
but does not finalize rules relating to internal-use software under 
section 41(d)(4)(E). This advance notice of proposed rulemaking (ANPRM) 
invites comments from the public regarding the proposed regulations 
issued in 2001 relating to internal-use software under section 
41(d)(4)(E). Although the Treasury Department and the IRS welcome 
comments on all aspects of those proposed regulations, the Treasury 
Department and the IRS specifically request comments concerning the 
definition of internal-use

[[Page 44]]

software. In addition, the Treasury Department and the IRS request 
comments on whether final rules relating to internal-use software 
should have retroactive effect.

Background

    Section 41(d)(4)(E) provides that, except to the extent provided by 
regulations, research with respect to computer software which is 
developed by (or for the benefit of) the taxpayer primarily for 
internal use by the taxpayer (internal-use software) is excluded from 
the definition of qualified research under section 41(d). (Software 
that is developed for use in an activity which constitutes qualified 
research and software that is developed for use in a production process 
with respect to which the general credit eligibility requirements are 
satisfied are not excluded as internal-use software under the 
provisions of section 41(d)(4)(E).) The statutory exclusion for 
internal-use software and the regulatory exceptions to this exclusion 
have been the subject of a series of proposed and final regulations.

Legislative History

    The legislative history to the Tax Reform Act of 1986, Public Law 
99-514 (100 Stat. 2085) (1986 Act), states that ``the costs of 
developing software are not eligible for the credit where the software 
is used internally, for example, in general and administrative 
functions (such as payroll, bookkeeping, or personnel management) or in 
providing noncomputer services (such as accounting, consulting, or 
banking services) except to the extent permitted by Treasury 
regulations.'' See H.R. Conf. Rep. No. 841, at II-73 (1986 legislative 
history). The 1986 legislative history further states that Congress 
intended that regulations would make the costs of new or improved 
internal-use software eligible for the credit only if the research 
satisfies, in addition to the general requirements for credit 
eligibility, an additional, three-part high threshold of innovation 
test (i.e., that the software was innovative, that the software 
development involved significant economic risk, and that the software 
was not commercially available for use by the taxpayer).
    Congress has extended the research credit a number of times since 
the 1986 Act but has not made any changes to the statutory definition 
of qualified research or to the statutory exclusion for internal-use 
software in section 41(d)(4)(E). When Congress extended the research 
credit in the Tax Relief Extension Act of 1999, Public Law 106-170 (113 
Stat. 1860) (1999 Act), however, the legislative history stated the 
following with respect to internal-use software:

    The conferees further note the rapid pace of technological 
advance, especially in service-related industries, and urge the 
Secretary to consider carefully the comments he has and may receive 
in promulgating regulations in connection with what constitutes 
``internal use'' with regard to software expenditures. The conferees 
also wish to observe that software research, that otherwise 
satisfies the requirements of section 41, which is undertaken to 
support the provision of a service, should not be deemed ``internal 
use'' solely because the business component involves the provision 
of a service.

H.R. Conf. Rep. No. 106-478, at 132 (1999).

1997 Proposed Regulations

    On January 2, 1997, the Treasury Department and the IRS published 
proposed regulations (REG-209494-90, 1997-1 C.B. 723) in the Federal 
Register (62 FR 81) under section 41 relating to internal-use software 
(1997 proposed regulations). In relevant part, the 1997 proposed 
regulations stated:

    Research with respect to computer software that is developed by 
(or for the benefit of) the taxpayer primarily for the taxpayer's 
internal use is eligible for the research credit only if the 
software satisfies the requirements of paragraph (e)(2) of this 
section. Generally, research with respect to computer software is 
not eligible for the research credit where software is used 
internally, for example, in general and administrative functions 
(such as payroll, bookkeeping, or personnel management) or in 
providing noncomputer services (such as accounting, consulting, or 
banking services).

Prop. Sec.  1.41-4(e)(1) (1997).

    The 1997 proposed regulations contained an exception to the 
internal-use software rules for certain software developed by the 
taxpayer as a part of a new or improved package of computer software 
and hardware developed together as a single product. Such software 
would not be subject to the high threshold of innovation requirements 
for internal-use software under the 1997 proposed regulations. The 1997 
proposed regulations, however, did not contain a specific definition of 
internal-use software. Instead, the 1997 proposed regulations provided 
that the determination of whether software was internal-use software 
would depend on the facts and circumstances of each case:

    All relevant facts and circumstances are to be considered in 
determining if computer software is developed primarily for the 
taxpayer's internal use. If computer software is developed primarily 
for the taxpayer's internal use, the requirements of this paragraph 
(e) apply even though the taxpayer intends to, or subsequently does, 
sell, lease, or license the computer software.

Prop. Sec.  1.41-4(e)(4) (1997).

2001 Final Regulations (TD 8930)

    On January 3, 2001, the Treasury Department and the IRS published 
in the Federal Register (66 FR 280) final regulations (TD 8930) 
relating, in relevant part, to the definition of internal-use software 
for purposes of section 41(d)(4)(E). With respect to the general 
definition of internal-use software, TD 8930 provided:

    Software is developed primarily for the taxpayer's internal use 
if the software is to be used internally, for example, in general 
administrative functions of the taxpayer (such as payroll, 
bookkeeping, or personnel management) or in providing noncomputer 
services (such as accounting, consulting, or banking services). If 
computer software is developed primarily for the taxpayer's internal 
use, the requirements of this paragraph (c)(6) apply even though the 
taxpayer intends to, or subsequently does, sell, lease, or license 
the computer software.

Sec.  1.41-4(c)(6)(iv). TD 8930, therefore, did not provide a specific 
definition of internal-use software but instead identified two general 
categories of software as examples of internal-use software: software 
``used internally'' and software used ``in providing noncomputer 
services.'' TD 8930 eliminated the general facts and circumstances 
standard contained in the 1997 proposed regulations.
    The preamble to TD 8930 addressed the requests made by some 
commentators that the definition of internal-use software exclude 
software used to deliver a service to customers and software that 
includes an interface with customers or the public. The preamble stated 
that after careful analysis of the legislative history, the Treasury 
Department and the IRS had concluded that such broad exclusions would 
be inconsistent with the statutory mandate, because the exclusion would 
extend to some software that Congress clearly intended to treat as 
internal-use software. The preamble, however, continued by highlighting 
changes that had been made in TD 8930 to take into account the 
commentators' concerns as well as the legislative history to the 1999 
Act.
    First, TD 8930 provided that the high threshold of innovation test 
applicable to internal-use software does not apply to software used to 
provide computer services (defined in TD 8930 generally as a service 
offered by a taxpayer to customers who conduct business with the 
taxpayer primarily for the use of the taxpayer's computer or software 
technology). In contrast, software used

[[Page 45]]

to provide a noncomputer service (defined in TD 8930 generally as a 
service other than a computer service, even if such other service is 
enabled, supported, or facilitated by computer or software technology) 
would be subject to the high threshold of innovation test under TD 
8930.
    Second, TD 8930 contained a new exception to the high threshold of 
innovation test for internal-use software for software used to provide 
a noncomputer service if the software, among other things, contained 
features or improvements not yet offered by a taxpayer's competitors. 
In describing this exception, the preamble to TD 8930 stated:

    This exercise of regulatory authority [to create the exception 
for certain software used to provide non-computer services] is based 
on a determination that the development of software containing 
features or improvements that are not available from a taxpayer's 
competitors and that provide a demonstrable competitive advantage is 
more likely to increase the innovative qualities and efficiency of 
the U.S. economy (by generating knowledge that can be used by other 
service providers) than is the development of software used to 
provide noncomputer services containing features or improvements 
that are already offered by others. IRS and Treasury believe that 
drawing such a line is an appropriate way to administer the credit 
with a view to identifying and facilitating the credit availability 
for software with the greatest potential for benefiting the U.S. 
economy, an important rationale for the research credit.

    In response to taxpayer concerns, on January 31, 2001, the Treasury 
Department and the IRS published Notice 2001-19 (2001-10 I.R.B. 784), 
announcing that the Treasury Department and the IRS would review TD 
8930 and reconsider comments previously submitted in connection with 
the finalization of TD 8930.

2001 Proposed Regulations

    On December 26, 2001, the Treasury Department and the IRS published 
in the Federal Register (66 FR 66362) a notice of proposed rulemaking 
(REG-112991-01) reflecting their review of TD 8930 (2001 proposed 
regulations). The 2001 proposed regulations revised the definition of 
internal-use software as compared to the definitions contained in the 
1997 proposed regulations and TD 8930. The definition in the 2001 
proposed regulations was based on a presumption that turns on whether 
the software is developed to be commercially sold, leased, licensed, or 
otherwise marketed for separately stated consideration:

    Unless computer software is developed to be commercially sold, 
leased, licensed, or otherwise marketed, for separately stated 
consideration to unrelated third parties, computer software is 
presumed developed by (or for the benefit of) the taxpayer primarily 
for the taxpayer's internal use. For example, the computer software 
may serve general and administrative functions of the taxpayer, or 
may be used in providing a noncomputer service. General and 
administrative functions include, but are not limited to, functions 
such as payroll, bookkeeping, financial management, financial 
reporting, personnel management, sales and marketing, fixed asset 
accounting, inventory management and cost accounting. Computer 
software that is developed to be commercially sold, leased, licensed 
or otherwise marketed, for separately stated consideration to 
unrelated third parties is not developed primarily for the 
taxpayer's internal use. The requirements of this paragraph (c)(6) 
apply to computer software that is developed primarily for the 
taxpayer's internal use even though the taxpayer subsequently sells, 
leases, licenses, or otherwise markets the computer software for 
separately stated consideration to unrelated third parties.

Prop. Sec.  1.41-4(c)(6)(iv) (2001) (emphasis added).

    As explained in the preamble to the 2001 proposed regulations, this 
``separately stated consideration'' standard reflected the Treasury 
Department and the IRS' determination that software that is sold, 
leased, licensed, or otherwise marketed, for separately stated 
consideration to unrelated third parties is software that is intended 
to be used primarily by the customers of the taxpayer, whereas software 
that does not satisfy this requirement is software that is intended to 
be used primarily by the taxpayer for its internal use or in connection 
with a noncomputer service provided by the taxpayer. The 2001 proposed 
regulations modified the hardware-software exception and continued to 
provide that software used to provide computer services was not 
required to satisfy the additional qualification requirements imposed 
on internal-use software. The new proposed regulations, however, 
eliminated the special rule in TD 8930 for certain software used to 
provide noncomputer services. The preamble to the 2001 proposed 
regulations explained that ``[d]ue to other revisions contained in 
these proposed regulations, Treasury and the IRS believe that the 
computer software targeted by this rule generally would be credit 
eligible without this rule.''
    The preamble to the 2001 proposed regulations also addressed the 
continued concerns expressed by some commentators that the definition 
of internal-use software should not include software used to deliver a 
service to customers and software that includes an interface with 
customers or the public. In addition to repeating the Treasury 
Department and IRS' concern that such exclusions may conflict with 
Congress' intent regarding software used in the provision of 
noncomputer services, the preamble stated that an exclusion for 
software that includes an interface with customers or the public would 
entail substantial administrative difficulties and ``may 
inappropriately permit certain categories of costs (e.g., certain web 
site development costs) to constitute qualified research expenses 
without having to satisfy the high threshold of innovation test.''

Discussion

    Prior regulatory guidance generally reflects three approaches to 
the definition of internal-use software. First, the 1997 proposed 
regulations closely mirrored the language contained in the legislative 
history but did not provide a specific definition of internal-use. 
Instead, the 1997 proposed regulations used the ``general and 
administrative functions'' and ``noncomputer services'' language from 
the legislative history as examples of internal-use software and 
provided that the determination of whether particular software was 
internal-use software required an evaluation of ``all relevant facts 
and circumstances.''
    TD 8930 then attempted to provide greater specificity regarding the 
definition of internal-use software. Although TD 8930 eliminated the 
facts and circumstances test in the 1997 proposed regulations, TD 8930 
continued to provide a general definition of internal-use software that 
incorporated the legislative history's examples of general and 
administrative functions and non-computer services. Additionally, TD 
8930 provided that software used by the taxpayer to provide ``computer 
services'' was not subject to the high threshold of innovation test 
applicable to internal-use software, and provided definitions of 
computer services and noncomputer services. The exception for computer 
services software, however, required a determination of the primary 
reason why a taxpayer's customers conduct business with the taxpayer. 
TD 8930 also applied this exception to certain software used to provide 
``noncomputer services'' provided that the software satisfied 
additional requirements intended to identify software containing new 
features or improvements that provide a competitive advantage to the 
taxpayer.
    Finally, the 2001 proposed regulations prescribed a bright-line, 
separately-stated consideration rule for determining which software is 
treated as

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internal-use software for purposes of the research credit. (The 2001 
proposed regulations retained the exception for software used to 
provide computer services, but removed the special rule for noncomputer 
services. Additionally, the 2001 proposed regulations expanded upon the 
list of general and administrative functions contained in the 
legislative history and expanded the exception for integrated software-
hardware products.) The purpose of this rule was to provide a clear 
definition of internal-use software that could be readily applied by 
taxpayers and more readily administered by the IRS.
    Numerous comments were received in response to the 1997 proposed 
regulations, TD 8930 and Notice 2001-19, and the 2001 proposed 
regulations regarding the provisions relating to internal-use software. 
Although commentators addressed virtually all aspects of the internal-
use software provisions in the various iterations of regulations, most 
of the comments focused on the definition of internal-use software. As 
previously stated, many commentators believed that the definition of 
internal-use software should exclude any software used to deliver a 
service to customers and any software that includes an interface with 
customers or the public. Some commentators suggested, as an 
alternative, that the statutory production process exception be 
extended to software used in connection with the provision of services.
    With respect to the definition of internal-use software in the 2001 
proposed regulations, commentators stated that the separately-stated 
consideration test was a poor indication of when computer software was 
developed ``primarily for internal use by the taxpayer'' and directly 
conflicted with the legislative history to the 1999 Act. In support of 
a narrower definition of internal-use software, these commentators 
pointed to technological advancements and changes to the role of 
computer software in business activities since the exclusion for 
internal-use software was enacted in 1986, including the increased 
development of computer software by taxpayers, the increased use of 
computer software in all aspects of business activity, and the role of 
computer software (often integrated across a business) in providing 
goods and services in addition to the internal operations of a 
business. Commentators further argued that the definition should be 
based on the underlying functionality of the software (i.e., whether 
the software, in light of the facts and circumstances, is used to 
deliver services or goods to a taxpayer's customers). Commentators 
urged that a functionality rule is preferable to a bright-line rule 
(such as the separately-stated consideration rule in TD 8930) even 
though a bright-line rule provided a clearer rule for identifying 
internal-use software for purposes of the research credit.
    The Treasury Department and the IRS are continuing to consider the 
concerns raised by commentators in response to the definition of 
internal-use software contained in the 2001 proposed regulations, 
including the concern that the separately-stated consideration test is 
over-inclusive. Nevertheless, the Treasury Department and the IRS are 
concerned that the alternatives, including expanded or modified 
exceptions, proposed by commentators generally would make the 
definition of internal-use software more complex without providing 
additional clarity. Several commentators suggested similar definitions 
that would exclude software that, for example, is ``integral and 
essential'' to the provision of services with integral defined as 
software that directly ``enables, supports, or facilitates'' a service. 
Some commentators suggested a definition that would exclude software 
that is ``primarily used'' by customers, suppliers, or other third 
parties. Other commentators suggested a definition that would limit 
internal-use software to software that is developed primarily for use 
in general and administrative functions that enable, facilitate, or 
support the taxpayer's conduct of the taxpayer's trade or business, but 
would exclude certain customer interface software. These suggestions 
would introduce many terms (including enable, support, facilitate, 
primarily) that, due to their subjective nature, the Treasury 
Department and the IRS believe would be prone to controversy and could 
not be readily applied by taxpayers or administered by the IRS. Another 
commentator suggested limiting the definition of internal-use software 
to software used to perform a specifically enumerated list of general 
and administrative functions. Some commentators, however, have noted 
that the often highly integrated nature of software development today 
makes it difficult, if not impossible, to divide software development 
projects into separate components, and thus a list approach may not be 
administrable. Finally, as part of their review of these comments, the 
Treasury Department and the IRS also reviewed the possibility of using 
definitions of internal-use software contained in prior guidance.
    In light of the statute, the legislative history, the history of 
the regulations regarding internal-use software, and the comments 
received, the Treasury Department and the IRS have decided not to 
finalize in TD 9104 the provisions in the 2001 proposed regulations 
relating to internal-use software. Instead, the Treasury Department and 
the IRS are issuing this ANPRM to solicit further comments regarding 
the definition of internal-use software as well as other provisions 
affecting the qualification of internal-use software for the research 
credit. The Treasury Department and the IRS are mindful that Congress 
specifically intended that computer software ``developed by (or for the 
benefit of) the taxpayer primarily for internal use by the taxpayer'' 
be subject to additional requirements before the software could qualify 
for the research credit. At the same time, the Treasury Department and 
the IRS recognize that there have been changes in computer software, 
and its role in business activity, since the mid-1980s. In light of 
these changes, the Treasury Department and the IRS are concerned about 
the difficulty of effecting Congressional intent behind the exclusion 
for internal-use software with respect to computer software being 
developed today. Despite Congress' broad grant of regulatory authority 
in section 41(d)(4)(E), the Treasury Department and the IRS believe 
that this authority may not be broad enough to resolve those 
difficulties.
    Accordingly, the Treasury Department and the IRS request comments 
regarding a definition of internal-use software that appropriately 
reflects the statute and legislative history, can be readily applied by 
taxpayers and readily administered by the IRS, and is flexible enough 
to provide continuing application into the future. In submitting 
comments, commentators are invited to address any of the definitions 
included in prior guidance as well as other definitions that have been 
proposed to the Treasury Department and the IRS by commentators.
    In addressing these alternatives, commentators also are invited to 
discuss how software development efforts that encompass both internal-
use software and non-internal use software should be addressed under 
any particular definition. The Treasury Department and the IRS are 
concerned that the tendency toward the integration of software across 
many functions of a taxpayer's business activities may make it 
difficult for both taxpayers and the IRS to separate internal-use 
software from non-internal use software (or software not subject to 
additional

[[Page 47]]

qualification requirements) under any particular definition of 
internal-use software. In addition, the Treasury Department and the IRS 
are concerned that a definition of internal-use software that relies 
upon the ``primary'' or ``principal'' use of that software would be 
difficult to apply and administer. The Treasury Department and the IRS' 
continuing goal is that any final rule must provide clear, objective 
guidance on what software is treated as internal-use software for 
purposes of the research credit.

Effective Dates

    On December 31, 2003, the Treasury Department and the IRS issued 
final regulations (TD 9104) relating to the definition of qualified 
research under section 41(d). The final regulations apply to taxable 
years ending on or after December 31, 2003. The final regulations do 
not contain final rules for research with respect to computer software 
``which is developed by (or for the benefit of) the taxpayer primarily 
for internal use by the taxpayer'' for purposes of section 41(d)(4)(E) 
(i.e., internal-use software).
    The Treasury Department and the IRS have announced in prior 
guidance, including Notice 87-12 (1987-1 C.B. 432) and more recently in 
the 2001 proposed regulations, that final regulations relating to 
internal-use software generally will be effective for taxable years 
beginning after December 31, 1985. In light of the length of time that 
has passed since 1986, as well as the developments with respect to 
computer software discussed in this ANPRM, the Treasury Department and 
the IRS request comments on whether final regulations relating to 
internal-use software should have any retroactive effect.
    With respect to internal-use software for taxable years beginning 
after December 31, 1985, and until further guidance is published in the 
Federal Register, taxpayers may continue to rely upon all of the 
provisions relating to internal-use software in the 2001 proposed 
regulations (66 FR 66362). Alternatively, taxpayers may continue to 
rely upon all of the provisions relating to internal-use software in TD 
8930 (66 FR 280). For example, taxpayers relying upon the internal-use 
software rules of TD 8930 must also apply the ``discovery test'' as set 
forth in TD 8930.

Request for Public Comment

    The Treasury Department and the IRS invite interested persons to 
submit comments (in the manner described in the ADDRESSES caption) on 
issues arising under the provisions for internal-use software. The 
Treasury Department and the IRS invite comments that address any of the 
definitions included in prior guidance as well as other definitions 
that have been proposed to the Treasury Department and the IRS by 
commentators. Specifically, the Treasury Department and the IRS invite 
comments that provide a definition of internal-use software that--
    1. Appropriately reflects the statute and legislative history;
    2. Can be readily applied by taxpayers and readily administered by 
the IRS; and
    3. Is flexible enough to provide continuing application in the 
future.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 03-31819 Filed 12-31-03; 8:45 am]
BILLING CODE 4830-01-P