Group Seeks Changes to Terms Under Proposed Research Credit Regs

This clarification will lead to a more efficient and consistent application of Section 41. However, the proposed language neglects to account for the fact that the definition of "internal use software," specifically the "high threshold of innovation test," may disproportionately affect certain financial institutions and further increase costs. Moreover, both the definition of "third party" and the "objective, reasonable method" under the safe harbor provisions fail to account for the unique aspects of the financial sector's qualified research activities. Therefore, we request the IRS and Treasury consider the burden that the "high threshold of innovation test" may impose on the financial sector and consumers. We also recommend clarifying the language with respect to the definition of third parties and adding industry-specific language to the "objective, reasonable method."

In 1981 Congress passed the Economic Recovery Tax Act, which allowed taxpayers and businesses to receive tax credits for qualified research expenditures paid or incurred after June 30, 1981 and before January 1, 1986. During those four years Congress planned to evaluate the efficacy of the provision while simultaneously encouraging domestic companies to engage in research activities and promoting economic growth and competitiveness in world markets.² Specifically, the research credit applied to activities that were deemed "qualified research" under a three-prong test for research credit eligibility. The test requires that: (1) the research expenses qualify as Section 174 research and experimental expenditures; (2) the research must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved component of the taxpayer; and (3) substantially all of the research activities must constitute element so a process of experimentation for a new or improved function, performance, or reliability or quality.³

The Economic Recovery Tax Act of 1981 defined qualified research within the parameters of "research or experimental under Section 174 [of the Internal Revenue Code], except that such term shall not include: (1) qualified research conducted outside the United States; (2) qualified research in the social sciences or humanities; and (3) qualified research to the extent funded by any grant, contract, or otherwise by another person (or any governmental entity)."⁴ In 1986 Congress renewed and revised the enacted law by clarifying the definition of qualified research" and placing limitations on the availability of the credit for the cost of developing '"internal use software."

The Tax Reform Act of 1986 clarified "qualified research" as research with respect to which expenditures may be treated as expenses under Section 174 so long as it: (1) is undertaken for the purpose of discovering information; (2) is technological in nature, and, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and (3) substantially all of the activities of which constitute elements of a process of experimentation for a qualified purpose.⁵ This language modified the definition of qualified research so that the credit applied to research intended to produce new technical knowledge deemed useful in the commercial development of new products and processes. 'The definition of "qualified research" was further expanded in the Tax and Trade Relief Extension Act of 1999 (P.L. 105-277) by including qualified research performed in "the Commonwealth of Puerto Rico, or any possession of the United States."⁶

The final 2004 regulations interpret research "undertaken for the purpose of discovering information" as research intended to eliminate uncertainty concerning the development or improvement of a business component.⁷

Additionally, the final 2004 regulations abandon the requirement that research activities be undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.⁸

Concurrent with the final 2004 regulations, the IRS and Treasury invited public comment on the 2001 proposed regulations relating to "internal use software" under Section 41(d)(4)(E). Under the suspended regulations (issued in January of 2001) the software was considered innovative (and creditable) if it was intended to result in a reduction of cost, improvement in speed, or other improvement, that is substantial and economically significant.⁹ The proposed regulations (issued in December of 2001) modified the first prong and deemed creditable software to be innovative only if the software was intended to be unique or novel and was intended to differ in a significant and inventive way from prior software implementations and methods.¹⁰

Commentators addressed multiple aspects of the "internal use software" provisions in the various iterations of regulations, although the majority of the comments related to the definition of internal use software. In particular, the commentators suggested that the definition of "internal use software" should depend on the facts and circumstances rather than a specific definition. Such an approach is flexible enough to provide continuing application into the future and correlates with the legislative purpose of the research credit to encourage job creation and technological developments. In addition, commentators suggested that third-party facing software that enables a taxpayer to deliver goods or services to third parties should not be presumed to be "internal use software," since the software does not solely benefit the taxpayer developing that software.

Case law

First, in United Stationers, Inc. v. United States, the court addressed the issue of whether the development of certain invoices, record keeping and inventory control systems to which the taxpayer's customers had limited access was "internal use software" development.¹¹ The taxpayer claimed that the internal use exclusion under Section 41(d)(a) did not apply to software development activities relating to the taxpayer's core revenue-gathering activities, which encompassed this development. The court rejected this argument, concluding that, under the totality of the circumstances, the software that the taxpayer developed was designed principally to track its inventory and was "the type of "internal use software" that Congress specifically sought to exclude from the Section 41 research credit."¹² The court relied on the statutory language history of Section 41 to explain the discovery of information that is technological in nature. This decision was referenced in the Conference Report in 1986, which stated that the determination of whether the research is undertaken for the purpose of discovering information that is technological in nature depends on whether the process of experimentation utilized in the research fundamentally relies on principles of the physical and biological sciences, engineering, or computer science. Research does not rely on the principles of computer science merely because a computer is employed. "Research may be treated as undertaken to discover information that is technological in nature, however, if the research is intended to expand or refine existing principles of computer science."¹³

Next, the Tax Court addressed a similar issue in Norwest Corp. v. Commissioner when the Tax Court considered the application of Section 41 to the costs incurred in the development of "internal use software," holding that expenditures represented research and development costs in the experimental or laboratory sense if they were for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.¹⁴ In Tax and Accounting Software Corp v. United States, the court further noted the word "discover" required discovered information to be something new or previously unknown.¹⁵ This information must not only be "new to the taxpayer, but also be information that is generally unknown to the public, as well."¹⁶

The final 2004 regulations eliminated the requirement that research be undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. The court in United States v. McFerrin held that the lower court erred in inappropriately applying the 2001 "discovery" test.¹⁷ However, in FedEx Corp. v. United States, the court held that the 2001 regulations were appropriate, since there had been no new regulation altering the definition of "internal use software."¹⁸

Administrative Guidance

In addition to the judicial precedent, the Service has also provided guidance on the "internal use software" definition. Prior to the release of the proposed regulations, the IRS issued Chief Counsel Advice 201423023 ("CCA 201423023") (dated May 29, 2014) addressing the eligibility of "internal use software" costs, stating that the IRS should not challenge taxpayers for choosing to follow the "internal use software" provisions in either the January 2001 Final Regulations (TD 8930) of the 2001 Final Regulations (TD 8930) so long as the general eligibility rules for qualified research are followed in accordance with the 2004 Final Regulations (TD 9140).¹⁹ This internal guidance is consistent with the decision of FedEx Corp., and allows taxpayers to use the favorable "internal use software" provisions in T.D. 8930 along with the favorable definition of qualified research in T.D. 9104.

Moreover, Chief Counsel Advice 200038013 ("CCA 200038013") (dated June 16, 2000) addressed the applicability of the "discovery test" and "process of experimentation" standards to the facts and circumstances of the taxpayer in light of the judicial decisions on that issue at that time.²⁰ Specifically, GCA 200038013 in its analysis of the "Discovery Test" stated "the legislative history to the 1986 Act states that the purpose of enacting the credit was to encourage business firms to perform the research necessary to increase the innovative qualities and efficiency of the U.S. economy."²¹ The CCA went on to note that "the determination of whether the research is undertaken for the purpose of discovering information that is technological in nature depends on whether the process of experimentation utilized in the research fundamentally relies on principles of the physical or biological sciences, engineering, or computer science -- in which case the information is deemed technological in nature -- or on other principles, such as those of economics -- in which case the information is not to be treated as technological in nature to perform the research necessary to increase the innovative qualities and efficiency of the United States economy."²²

I. It is inequitable to require highly-regulated financial institutions to satisfy the "high threshold of innovation test" for their technological development to be qualified under the "internal use software" regulations, since some industry participants, including unregulated financial competitors, may not have to comply with the same requirements.

Since the enactment of Section 41 in 1981. technological activities have become an integral part of various businesses, particularly for service providers and financial institutions. Not only did the use of technology enable the United States to increase its economic productivity and become more competitive globally, but it also allowed financial institutions to increase efficiency, promote compliance and maintain public trust in the financial system.

The proposed regulations define "internal use software" as "research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use" so long as it meets the requirements of Section 41(d)(1) and is not excluded under Section 41(d)(4).²³ The proposed regulations exclude computer software and hardware developed as a single product from the definition of "internal use software," allowing businesses to qualify for the Section 41 tax credit without satisfying stringent requirements under the newly proposed rules. Moreover, the proposed regulations also allow businesses to take advantage of the tax credit by utilizing purchased and modified or newly improved packages of computer software and hardware as a single product.²⁴

However, the proposed regulations fail to account for the fact that the majority of regulated financial institutions will be developing computer software under the general definition of internal use software. The proposed regulations exclude software and hardware developed as a single product from the definition of internal use, but retain the higher threshold for internally developed software. Indeed, there has been ample debate over the exact types of computer software categorized as internal use software.²⁵ This debate results from the fact that computer software advances and developments since 1986 obscure the particularities that distinguish internal and external use software. The debate is especially heightened in the financial services industry, where financial services are being offered directly to customers via computer and the Internet.

When a financial institution develops software for internal use, prior to qualifying for the Section 41 research credit, the institution will be subjected to a higher burden and stringent set of requirements. First, the financial institution will have to satisfy the "internal use software" definition. Second, the software will have to meet all the prongs of the "high threshold of innovation test." Third, the financial institution will have to show that the software "results in reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant, if the development is or would have been successful." Finally, the IRC and Treasury will measure the uniqueness and novelty of the product using a "measurable objective standard." On the other hand, if a financial institution develops software and hardware as a single product, the financial institution will not be subjected to various tests and standards under Treas. Reg. § 1.41-4(c)(6) because the IRS and Treasury exclude the software and hardware developed as a single product from the definition of internal use software.

Moreover, it is important to consider that the development and enhancement of new software and technologies may be required due to recent changes in the regulatory framework of banking systems.²⁶ While Basel III changes the way banks determine how much capital reserves they need to manage potential losses, it also drives banks to integrate data sources and adopt new forms of data modeling.²⁷ Such changes will add more complexity to internal risk rating models, which ultimately will require new risk modeling software or modification to the prior models.²⁸

The cost of compliance is rising, and continuing to impose higher thresholds in the qualification of research activities will only further burden financial institutions and continue to increase costs not only for banks but also for individual taxpayers.²⁹ IT budgets have recovered since the stock market downturn of 2002,³⁰ but technological development is now significantly diverted to new compliance and security mandates. Since 2007 the financial industry has been facing challenges such as increased capital requirements, more consumer protection and market demands for technological upgrades to meet standards of the digital economy. As a result, IT infrastructure strategy has turned to various short-term solutions including the use of less expensive open-source software by outsourcing software upgrades and coding to overseas. If one were to compare the total cost of internal development against the cost of outsourcing open-source software, the costs of developing internal software will be higher.³¹ The higher cost is associated with internal software's use and design. The development of internal software, unlike open-source software, focuses on customizing and integrating a product for business's needs. Since the development of open-source software allows broader application among industries, the cost associated with developing it meets current budgets.³² To keep costs in line with changing revenue lines, financial firms have to adopt new research and development models.

Therefore, the requirement for financial institutions to satisfy the "high threshold of innovation test" to qualify relevant "internal use software" technological development is unfair and arbitrary when other industries and financial competitors may not be required to comply with the same threshold. Moreover, by further imposing stringent requirements and standards, financial institutions are forced to outsource many technological developments overseas. It may not seem an issue today, but ultimately it may impact the United States economic growth and competitiveness in world markets. This result is diametrically opposed to the original purpose of Section 41.

II. The definitions of "third party" and the "objective, reasonable method" are too vague, since their application may be different in the financial sector and they fail to account for unique aspects of financial sector qualified research activities.

The IRS and Treasury do not consider software to be developed for internal use if "the software 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."³³ Further, "third party" is defined to include a corporation, trade or business or other person that is not treated as a single taxpayer under Section 41(f).

Anti-money laundering provisions, sanctions programs, consumer protection laws and further stringent regulatory requirements placed on financial institutions, have made paramount the development of internal technologies and their use in day-to-day activities within the financial sector.³⁴

Consider the example of a financial institution that develops software to enable enhanced due diligence and compliance with anti-money laundering provisions. The new or improved software would require interaction and communication with third parties in order review individual and commercial accounts. This software should pass the '"high threshold of innovation test" because it results in a "reduction in costs or improvement in speed or other measurable improvement that is substantial and economically significant"³⁵ to the financial institution. It also benefits the institution, and not a third party, even though the software was developed to enable the financial institution to interact and obtain information from third parties. We submit that the proposed regulations do not take into account the purpose of such software, because the third parties do not directly benefit from its development.

Further, to qualify for the research tax credit under the safe harbor provision for expenditures related to computer software developed for both internal use and to enable interaction with third parties ("dual function"), the proposed regulations require an "objective, reasonable method" of cost estimation at the beginning of the computer software development.³⁶ The proposed regulations provide examples where a taxpayer is able to use an "objective, reasonable method" to estimate the cost at the beginning of the computer software development. However, these examples fail to provide a set of facts when the taxpayer is unable to identify a third party subset or determine the "objective, reasonable method" at the beginning of the software development. Moreover, the "objective, reasonable method" is vague. Adopting an objective standard would better account for the particularities or characteristics of each industry. For instance, the "objective, reasonable method" used by financial institutions may differ from a similar "objective, reasonable method" used by service-provider companies. A service-provider may use the same computer software as a financial institution but the purpose and interaction with third parties may differ. For example, financial institutions benefit from Kaseya IT automation where software controls daily workflow tasks to maintain regulatory compliance and reduce risk.³⁷ However, the product used by a non-financial institution will serve a different purpose, which is usually focused on security services and reliability of IT management solutions.

Due to the vague nature of the "objective, reasonable method," we propose that the IRS and Treasury adopt language that will clearly reflect the objective criteria for each industry. Therefore, adding "an objective, reasonable method within each industry" will help clarify the application of the safe harbor rules with respect to the dual function of the developed software.

² General Explanation of the Economic Recovery Tax Act of 1981, (H.R. 4242, 97^th Congress. Public Law 97-34). The Joint Committee on Taxation Publication.

³ Section 41(d)(1), (3).

⁴ Economic Recovery Tax Act of 1981, Sec. 221(a)(H.R. 4242, 97^th Congress, Public Law 97-34).

⁵ Tax Reform Act of 1986, (H.R. 3838, 99^th Congress, Public Law 99-514).

⁶ Tax and Trade Relief and Extension Act of 1999, (H.R. 4328, 106^th Congress, Public Law 106-170).

⁷ Internal Revenue Bulletin 2004-6, February 9, 2004, T.D. 9104 Credit for Increasing Research Activities, stating "In order for activities to constitute qualified research under Section 41(d)(1), substantially all of the activities must constitute elements of a process of experimentation that relates to a qualified purpose. The "substantially all" requirement . . . is satisfied only if 80 percent or more of a taxpayer's research activities, measured on a cost or other consistently applied reasonable basis . . . constitute elements of a process of experimentation for a purpose described in Section 41(d)(3). Accordingly, if 80 percent (or more) of a taxpayer's research activities with respect to a business component constitute elements of a process of experimentation for a purpose described in Section 41(d)(3), the substantially all requirement is satisfied even if the remaining 20 percent (or less) of a taxpayer's research activities with respect to the business component do not constitute elements of a process of experimentation for a purpose described in Section 41(d)(3), so long as these remaining research activities satisfy the requirements of Section 41(d)(1)(A) and are not otherwise excluded under Section 41(d)(4). The substantially all requirement is applied separately to each business component."

⁸ Section 41(d). To be considered "qualified research," the taxpayer must be able to establish that the relevant research activity meets all four of the below tests: (1) the expenditures must meet the Section 174 criteria (also known as the Section 174 test); (2) the research must be undertaken for the purpose of discovering information which is technological in nature (also known as the discovering technological information test); (3) the research is intended to be useful in the development of a new or improved business component of the taxpayer (also known as the business component test); and (4) substantially all of the activities of should constitute elements of a process of experimentation for a qualified purpose (also known as the process of experimentation test).

⁹ Federal Register, Vol. 66, No. 2, Wednesday, January 3, 2001, p. 293. Section 41(d)(2)(c)(6)(vi)(A).

¹⁰ federal Register, Vol. 66, No. 2, Wednesday, January 3, 2001, p. 283.

¹¹United Stationers, Inc. v. United States, 982 F. Supp 1279 (N.D. III. 1997), aff'd. 163 F.3d 440 (7th Cir 1998).

¹²United Stationers, Inc., 163 F.3d at 446.

¹³ H.R. Conf. Rep. No. 99-841, at 11-71 (1986).

¹⁴Norwest Corp v. Commissioner, 110 T.C. 454 (1998).

¹⁵Tax and Accounting Software Corp v. United States, 301 F.3d 1254 (10^th Cir. 2002).

¹⁶Tax and Accounting Software Corp., 301 F.3d at 1256.

¹⁷United States v. McFerrin, 570 F.3d 672 (5^th Cir. 2009).

¹⁸FedEx Corp. v. United States, 103 A.FT.R.2d (RIA) 2722 (W.D. Tenn. 2009).

¹⁹ C.C.A. 2014-23-023 (May 29, 2014).

²⁰ C.C.A. 20000-38-013 (June 16, 2000).

²¹ C.C.A. 20000-38-013 (June 16, 2000).

²² C.C.A. 20000-38-013 (June 16, 2000).

²³ Prop. Treas. Reg. § 1.41-4(c)(6)(i).

²⁴ Prop. Treas. Reg. § 1.41-4(c)(6)(ii).

²⁵Supra. The suspended regulations issue in January of 2001 and proposed regulations issued in December of 2001 both reference the debate over the definition of "Internal use software."

²⁶ Basel Committee on Banking Supervision, Basel III A Global Regulatory Framework for more Resilient Banks and Banking Systems (Dec. 2010); Federal Register, Vol. 78, No. 198, Friday, October 11, 2013, p. 62018.

²⁷ Douglas E. Elliot, Basel III, the Banks, and the Economy, Brookings (Jul. 26, 2010). https://www.bnymellon.com/_global-assets/pdf/investor-relations/investor-day-2014/investor-day-2014.pdf

²⁸ Penny Grosman. Top 7 Ways Basel III Affects U.S. Banks and Their IT Departments. Bank Systems & Technology (Oct. 15, 2010). http://www.banktech.com/compliance/top-7-ways-basel-iii-affects-us-banks-and-their-it-departments/d/d-id/1294129?

²⁹ Basel Committee on Banking Supervision, Compliance and the Compliance Function in Banks (Apr. 2005); Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376-2223.

³⁰ Also known as the Internet bubble bursting.

³¹Gartner Worldwide IT Spending Forecast, Gartner (2015). http;//www.gartner.com/technology/research/it-spending-forecast/; Al Gillen. The Opportunity for Linux in a New Economy, IDC (Apr. 2009); Dean S. Petracca, Software Pricing Trends, PricewaterhouseCoopers (Jan. 2007).

³²Id.

³³ Prop. Treas. Reg. § 1.41-4(v)(6)(iv).

³⁴ Money Laundry and Financial Crimes Strategy Act of 1998, Pub. L. No. 105-310, 112 Stat. 2941, 2942, 2943. 2944. 2945, 2946, 2947, 2948 and 2949, Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 200. Pub. L. No. 107-56. 115 Stat 272, improving communication between law enforcement agencies and financial institutions and expanding record keeping and reporting requirements.

³⁵ Prop Treas. Reg § 1.41-4(c)(6)(v).

³⁶ Prop Treas Reg § 1.41-4(c)(6)(iv)(C)(3), stating "an objective, reasonable method must be used to estimate the dual function subset's use by third parties and such use is estimated at the beginning of the computer software development."

³⁷Kaseya Products (2014). http://www.kaseya.com/solutions; Kaseya White Paper, IT Systems Management for Financial Institutions (2014), http://www.kaseya.com/download/en-us/white_papers/WhitePaper.BankingIT.Kaseya.pdf