Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA 90028

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1 The IRS has announced changes that expand and clarify the activities that can be claimed under the Research and Development Tax Credit On Friday, January 16, 2015, the Treasury and IRS released proposed regulations (REG ) governing the R&D tax credit as it regards the development of computer software. The proposed regulations are generally taxpayer favorable and may afford new opportunities for taxpayers to reevaluate their software development expenses for eligibility under I.R.C. 41. The proposed regulations: 1. Clarify the definition of internal use software (IUS) 2. Retain and modify the single product and production process exceptions to IUS 3. Modify the significant economic risk prong of the high threshold of innovation test applicable to IUS 4. Provide examples illustrating the process of experimentation requirement as it pertains to software development; and 5. Withdraw Announcement I. IUS DEFINITION 1. General and Administrative Software: IUS is defined as software developed for use in general or administrative functions that facilitates or supports the conduct of the taxpayer s trade or business. General and administrative functions include financial management/recordkeeping, HR management, and support services (such as data processing or facilities services) intended to cover back office functions that a taxpayer would have regardless of industry. 2. Computer and Noncomputer Distinction Eliminated: The proposed regulations eliminate the distinction between software developed to deliver computer and noncomputer services. 3. IUS Presumption Eliminated: Software developed for sale, lease or license is still presumed to be external use software. However, software that is not held for sale, lease or license is no longer automatically presumed to be IUS. 4. Dual Function Software Presumed to be IUS: Dual function software (i.e., used by the taxpayer and third parties) is presumed to be IUS. The burden of proof is on the Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA 90028

2 taxpayer to identify the external use portion (and the associated QREs). If the taxpayer cannot identify the non-ius portion, there is a safe harbor provision allowing the taxpayer to claim 25% of the costs if the external use portion is reasonably anticipated to constitute 10% of the system s total use. 5. Software Enabling Third Party Interaction: Software that enables a taxpayer to interact with third parties or allows third parties to interact with the taxpayer s systems does not solely benefit the taxpayer, and thus should not be considered IUS. However, third parties do not include any persons that use the software to support a taxpayer s general and administrative functions that facilitate or support the conduct of the taxpayer s trade or business. 6. Taxpayer Intent Controls: Whether software is developed for internal use depends on the intent of the taxpayer and the facts and circumstances at the beginning of software development. For example, if a taxpayer initially develops software for internal use but later makes improvements to the software with the intent to sell, lease or license the improved software or to allow third parties to initiate functions or review data, the improvements can be considered separate and will not be deemed IUS. Alternatively, if a taxpayer originally develops software to sell, lease or license or to interact with third parties, but later makes improvements for internal use, the former activities will be considered non-ius while the latter will be considered separate and deemed IUS. II. IUS EXCEPTIONS: SINGLE PRODUCT AND PRODUCTION PROCESS 1. Single Product Exception Retained: The proposed regulations retain the exception that computer software and hardware developed as a single product used directly by the taxpayer in providing services in the taxpayer s trade or business is not considered IUS. 2. Production Process Exception Clarified: Software that is developed for use in a production process is not IUS. However, computer software supporting the delivery of goods or services to third parties is not part of a production process and would not fall within this exception. Nonetheless, such software development would not be IUS to the extent that the software enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data. III. HIGH THRESHOLD OF INNOVATION TEST 1. Elimination of Unique or Novel Requirement: Under the proposed regulations, the high threshold of innovation test requires the following: Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA

3 (i) (ii) (iii) Innovative: Software is considered innovative if it would result in a reduction in cost, improvement in speed, or other measurable improvement, that is substantial and economically significant. (The innovative requirement no longer requires that the software be (1) unique or novel, and (2) intended to differ in a significant and inventive way from prior software implementations or methods.) Significant Economic Risk: The taxpayer commits substantial resources to the project, and there is substantial technical uncertainty. Substantial technical uncertainty is defined as uncertainty of capability or uncertainty of methodology. Appropriateness of design uncertainty is not sufficient to meet this requirement. Thus, the level of risk required is higher than that required to meet uncertainty under I.R.C. 174 and the four-part test. Commercial Availability: No commercially available software provides the necessary functionality without modification that would satisfy the first two requirements. IV. PROCESS OF EXPERIMENTATION 1. Examples under Treas. Regs (a): The proposed regulations add six examples to Treas. Regs (a) to illustrate what constitutes a process of experimentation for software development. V. EFFECTIVE DATES 1. The proposed regulations will be prospective only, applicable for tax years ending on or after the date final regulations are published in the Federal Register. 2. The IRS will not challenge return positions consistent with the proposed regulations for tax years ending on or after January 20, Consistent with FedEx Corporation v. United States of America, 108 AFTR 2d (W.D.Tenn. Mar 28, 2011), denying reconsideration of 103 AFTR 2d , USTC paragraph 50,435 (W.D.Tenn. 2009), for tax years ending before January 20, 2015, taxpayers may choose to follow all of the internal-use software provisions in the 2001 final regulations (without applying the discovery test ) or the 2001 proposed regulations. The IRS has withdrawn its advance notice of proposed rulemaking issued on January 2, Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA

4 About Tax Credit Co: Tax Credit Co. provides tax incentive consulting, administration and technology for small business to Fortune 100 companies. Since 1996, Tax Credit Co. has been helping clients increase earnings by optimizing the process of obtaining a broad range of state and federal tax incentives. Tax Credit Co. provides complimentary assessments of credit value, and works closely with you and your team to maximize credits and deductions, with reduced audit risk. Team with Industry Experience. Our team is comprised of individuals with specialized technical expertise tax attorneys review third-party contracts, relevant industry experts conduct interviews, and CPAs with R&D credit specialization review each calculation and tax return. Innovative Solutions to High Value Problems. There is the easy way and the best way, which are not always the same. Tax Credit Co. works to ensure the best result for your business. This includes digging through boxes to find old records. But it can also include complex technical work such as obtaining a Pre Filing Agreement ( PFA ) with the IRS to have your methodology and credit amount pre-approved prior to filing your return. Aligned Interests. Whereas many firms charge for this phase, Tax Credit Co. provides a complimentary assessment (Phase I) to determine your estimated benefit and utilization. TCC also offers flexible fee arrangements that allow us to structure fees including audit defense services to better align interests. Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA

5 About the Authors Peter Mehta, J.D., LLM is Managing Director of R&D Credits at Tax Credit Co. Peter has 20 years of experience with the Big 4, including 12 years with Deloitte in Tax Controversy where he worked in a national group of 5 attorneys supporting clients R&D audit defense needs. Peter has extensive R&D credit study and audit experience with IRS specialists at Exam and Appeals, as well as with MITRE on software audits. Peter has a B.S. in Biology with a specialization in Chemistry from UC Irvine. Chris Petros, M.S. is the lead Manager of R&D Credits at Tax Credit Co. Chris joined Tax Credit Co. as a subject matter expert after spending four years as a project manager at Northrop Grumman Aerospace in manufacturing, lean processes, production and design. Chris received his B.S. in Aerospace Engineering with a minor in Mathematics from UCSD and his M.S. in Systems Engineering from UCLA. More information can be found at Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA