Internal-use software credit requires complete rule set

Plain-English summary

Chief Counsel analyzed the research credit for internal-use software in years before the 2015 proposed regulations. It concluded that section 41(d)(4)(E) was not self-executing, so internal-use software research could qualify only through applicable regulatory guidance. For the relevant years, a taxpayer could choose either all of the internal-use software provisions in the 2001 final regulations or all of those in the 2001 proposed regulations. A taxpayer choosing the final regulations also had to apply their common-knowledge-of-skilled-professionals standard and could not substitute the 1986 legislative history.

Ruling snapshot

• Question: Which high-threshold-of-innovation rules govern internal-use software research before the 2015 proposed regulations?
• Outcome: advice given
• Key authorities: IRC § 41(d)(4)(E); Treas. Reg. § 1.41-4(c)(6) under T.D. 8930; 2001 proposed regulations; 2004 ANPRM

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201650012
       Release Date: 12/9/2016
       CC:PSI:B06:JARecords
       POSTF-102328-16

UILC: 41.00-00

date: August 22, 2016

 to:   Borislava A. Semkova
       Attorney, (Manhattan, Group 1)
       (Large Business & International)

from: Patrick S. Kirwan
Chief, Branch 6
(Passthroughs & Special Industries)

subject: Applicable High Threshold of Innovation Test For Taxable Years Ending Prior to the
Issuance of the 2015 NPRM

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       LEGEND

       Taxpayer     =      -------------------------------------

       Date 1       =      ----------------------------

       Date 2       =      ----------------------------

       ISSUES

       1. Is § 41(d)(4)(E) of the Internal Revenue Code self-executing for purposes of
       determining whether research with respect to computer software developed primarily for
       internal use (IUS) is qualified research?

       2. Given that § 41(d)(4)(E) is not self-executing for purposes of determining whether
       research with respect to IUS is qualified research, what may Taxpayer rely on to
       determine the three-part high threshold of innovation test for taxable years ending prior

POSTF-102328-16 2

to the issuance of the 2015 proposed IUS regulations (2015 NPRM) and for which there
are no final regulations in effect?

3. If Taxpayer chooses to apply the 2001 final IUS regulations (T.D. 8930), is the
   common knowledge of skilled professionals standard under § 1.41-4(c)(6)(vii) applicable
   to Taxpayer?

CONCLUSIONS

1. Section 41(d)(4)(E) is not self-executing for purposes of determining whether
   research with respect to IUS is qualified research. In the absence of final regulations,
   research with respect to IUS is not qualified research (except for the limited exceptions
   provided in the statute that do not apply to Taxpayer).

2. As provided in the 2004 advance notice of proposed rulemaking (2004 ANPRM) and
   2015 NPRM, Taxpayer may choose to apply either all of the IUS provision in T.D. 8930
   or all of the IUS provisions in the 2001 proposed IUS regulations (2001 NPRM) for
   purposes of the three-part high threshold of innovation test with respect to taxable years
   ending prior to the issuance of the 2015 NPRM and for which there are no final
   regulations in effect.

3. If Taxpayer chooses to apply T.D. 8930, the common knowledge of skilled
   professionals standard under § 1.41-4(c)(6)(vii) in those final regulations is applicable.

FACTS

Taxpayer claimed research credits under § 41 for the taxable years ended Date 1 and
Date 2, which include qualified research expenses (QREs) related to research with
respect to IUS. Taxpayer’s position is that if Taxpayer chooses to apply the IUS
provisions of T.D. 8930, the “common knowledge of skilled professionals” standard in
§ 1.41-4(c)(6)(vii) of those regulations does not apply. Alternatively, Taxpayer argues
that it may apply the 1986 legislative history, which does not reference the “common
knowledge of skilled professionals” standard as part of the three-part high threshold of
innovation test. Conversely, your office asserts that Taxpayer must either choose to
apply either all of the IUS provision of T.D. 8930 or all of the IUS provisions of the 2001
NPRM. If Taxpayer chooses to apply the IUS provisions provided in T.D. 8930, it must
apply all of those provisions, including the common knowledge of skilled professionals
standard. You have asked whether we concur with your office’s conclusion.

LAW AND LEGISLATIVE HISTORY

Section 41(d)(4)(E) provides that “[e]xcept to the extent provided in regulations, any
research with respect to computer software which is developed by (or for the benefit of)
the taxpayer primarily for internal use by the taxpayer” is excluded from the definition of
qualified research under § 41(d), other than for use in -- (i) an activity which constitutes
POSTF-102328-16 3

qualified research (determined with regard to this subparagraph), or (ii) a production
process with respect to which the requirements of § 41(d)(1) are met. (emphasis
added).

Generally, research with respect to IUS may be eligible for the research credit under
§ 41 only if it satisfies certain criteria provided in regulations, including the requirements
collectively referred to as the three-part high threshold of innovation test.

Regulations under § 41(d)(4)(E)

On January 2, 1997, the Treasury Department and the Service published a notice of
proposed rulemaking (1997 NPRM) to provide guidance on IUS under § 41(d)(4)(E).
T.D. 8930 (66 FR 280) finalized and substantially modified the 1997 NPRM and was
published on January 3, 2001.

Section 1.41-4(c)(6)(vi) of T.D. 8930 provides that software satisfies the high threshold
of innovation test only if the taxpayer can establish that: (A) The software is innovative
in that the software is intended to result in a reduction in cost, improvement in speed, or
other improvement, that is substantial and economically significant; (B) The software
development involves significant economic risk in that the taxpayer commits substantial
resources to the development and there is a substantial uncertainty, because of
technical risk, that such resources would be recovered within a reasonable period; and
(C) The software is not commercially available for use by the taxpayer in that the
software cannot be purchased, leased, or licensed and used for the intended purpose
without modifications that would satisfy the requirements of (A) and (B).

T.D. 8930 also includes, as part of the three-part high threshold of innovation test, a
requirement to compare the intended result with software that is within the common
knowledge of skilled professionals in the relevant field. Section 1.41-4(c)(6)(vii) of T.D.
8930 provides:

   The determination of whether the software is intended to result in an
   improvement or cost reduction that is substantial and economically
   significant is based on a comparison of the intended result with software
   that is within the common knowledge of skilled professionals in the
   relevant field of science or engineering, see §1.41-4(a)(3)(ii).

Section 1.41-4(c)(6)(vii) of T.D. 8930 further provides:

   The extent of uncertainty and technical risk is determined with respect to
   the common knowledge of skilled professionals in the relevant field of
   science or engineering.

In response to taxpayer concerns regarding T.D. 8930, the Treasury Department and
the Service published Notice 2001-19, 2001-1 C.B. 784, announcing that the Treasury
POSTF-102328-16 4

Department and the Service would review T.D. 8930 and reconsider comments
previously submitted. Notice 2001-19 also provides that, upon the completion of this
review, the Treasury Department and the Service would announce changes to the
regulations, if any, in the form of new proposed regulations.

On December 26, 2001, the Treasury Department and the Service published the 2001
NPRM (66 FR 66362) relating to IUS. With respect to the high threshold of innovation
test, the 2001 NPRM clarifies the first requirement of the test and provides that IUS is
innovative if the software is intended to be unique or novel and is intended to differ in a
significant and inventive way from prior software implementations or methods.
However, the second and third requirements of the high threshold of innovation test are
the same as under T.D. 8930. The 2001 NPRM also removed explicit references to the
common knowledge of skilled professional standard for application of the high threshold
of innovation test.

On January 2, 2004, the Treasury Department and the Service published final
regulations (T.D. 9104). T.D. 9104 (69 FR 22) finalized the 2001 NPRM’s rules relating
to the definition of qualified research under § 41(d) but removed the IUS provisions and
marked § 1.41-4(c)(6) as “Reserved.” T.D. 9104 applies to taxable years ending on or
after December 31, 2003.

Concurrently with T.D. 9104, the Treasury Department and the Service issued the 2004
ANPRM (69 FR 43). The 2004 ANPRM requested comments concerning the definition
of IUS. Recognizing that taxpayers needed guidance with respect to IUS while the
Service worked on new regulations, the 2004 ANPRM provides that 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 provisions of the 2001 NPRM,
or all provisions of T.D. 8930 with respect to their IUS research activities. The 2015
NPRM similarly provides that for taxable years ending prior to publication of the 2015
NPRM, taxpayers may choose to follow either all of the IUS provisions of § 1.41–4(c)(6)
under T.D. 8930 or under the 2001 NPRM. However, the 2015 NPRM provides that the
proposed rules, when finalized, will be prospective only.

Legislative History

The legislative history of the Tax Reform Act of 1986, Public Law 99-514 (100 Stat.
2085 (1986)) (1986 legislative history), provides that “[a]ny other research activities
[other than narrow activities provided in the statute] with respect to internal-use software
are ineligible for the credit except to the extent provided in Treasury regulations.
Accordingly, the costs of developing software are not eligible for the credit where the
software is used internally . . . except to the extent permitted by Treasury regulations.”
H.R. Conf. Rep. No. 99-841, at II-73 (emphasis added).

Congress intended that regulations would make the costs of new or improved IUS
eligible for the credit only if the research satisfies, in addition to the general
POSTF-102328-16 5

requirements for credit eligibility, an additional three-part high threshold of innovation
test:

   (1) the software must be innovative (as where the software results in a reduction
   in cost, or improvement in speed, that is substantial and economically
   significant);

   (2) the software development involves significant economic risk (as where the
   taxpayer commits substantial resources to the development of the software and
   there is substantial uncertainty, because of technical risk, that such resources
   would not be recovered in a reasonable period of time); and

   (3) the software is not commercially available for use by the taxpayer (as where
   the software cannot be purchased, leased, or licensed and used for the intended
   purpose without modifications that would satisfy the first two requirements).

Id.

The 1986 legislative history also provided that “these regulations are to apply as of the
effective date of the new specific rule relating to internal-use software; i.e., internal-use
computer software costs that qualify under the three-part test . . . are eligible for the
research credit even if incurred prior to issuance of such final regulations.” Id. at II-73-
74.

Self-executing Statute Jurisprudence

Where the Code grants the Service regulatory authority, courts have frequently
determined whether the statutory provision is self-executing or, in other words, whether
the statutory provision at issue is operative in the absence of regulations. See, e.g., Int’l
Multifoods Corp v. Commissioner, 108 T.C. 579 (1997); Estate of Neumann v.
Commissioner, 106 T.C. 216 (1996); Occidental Petroleum Corp. v. Commissioner, 82
T.C. 819 (1984). In making this determination, courts draw a distinction between a
“how” statute and a “whether” statute. See, e.g., Sundance Helicopters, Inc. v. United
States, 104 Fed. Cl. 1, 11 (2012); Neumann 106 T.C. at 219-21.

A statute is self-executing when regulations are not necessary to determine “whether”
the statute applies in the first instance, but Congress leaves the mechanics or details
affecting the application of the statute to the Secretary. See Id. In such case, the
promulgation of regulations only constitutes a means of arriving at “how,” not whether
the provision applies. See Id.

Conversely, a statute is not self-executing if the statue requires a “whether” regulation.
See, e.g., Neumann, 106 T.C. at 219-21. That is, the promulgation of regulations is a
necessary condition precedent to determining “whether” the statutory provision applies.
See id. For example, the statute at issue in Alexander v. Commissioner is illustrative of
POSTF-102328-16 6

a “whether” provision. See 95 T.C. 467, 473 (1990), affd. without published opinion sub
nom. Stell v. Commissioner, 999 F.2d 544 (9th Cir. 1993). In Alexander, the Tax Court
analyzed the language in § 465(c)(3)(D) that provided that § 465(b)(3) “shall only apply
to the extent provided in regulations prescribed by the Secretary.” 95 T.C. at 473-74.
The Tax Court found that because regulations had not been prescribed, § 465(b)(3) did
not apply. Id. at 473.

Courts will look to the text of the regulations and the legislative history to determine if
regulations are a precondition to applying the statute. See, e.g., Temsco Helicopters,
Inc. v. United States, 409 F. App’x 64, 67 (9th Cir. 2010); Francisco v. Commissioner,
119 T.C. 317, 322-23 (2002), aff’d on other grounds, 370 F.3d 1228, 1230 n.1 (D.C. Cir.
2004). If a court finds a statue to be self-executing, and the Service has failed to
provide guidance, courts may nevertheless apply the statute as they determine reflects
Congressional intent. See, e.g., Int’l Multifoods, 108 T.C. at 587 (“the absence of
regulations is not an acceptable basis for refusing to apply the substantive provisions of
a section”); Occidental, 82 T.C. at 829 (determining that in the absence of regulations 8
years after the issuance of § 58(h), the court must “do the best [it] can” with the
provision).

ANALYSIS

Like the statute at issue in Alexander, the issuance of regulations under § 41(d)(4)(E)
determines whether, rather than how, research with respect to IUS qualifies for the
research credit. Both the statutory provision at issue in Alexander and § 41(d)(4)(E)
contain language that provides that the provision will be operative only to the extent
provided in regulations. Compare § 41(d)(4)(E) (providing that “[e]xcept to the extent
provided in regulations” research with respect to IUS is not qualified research) with
Alexander, 95 T.C. at 473 (considering § 465(c)(3)(D), which provided that § 465(b)(3)
“shall only apply to the extent provided in regulations”). The delegation of authority from
Congress to the Secretary to provide regulations under § 41(d)(4)(E) involves a policy
call to be made by the Treasury Department concerning whether, and under what
circumstances, IUS should be eligible for the credit. Thus, the issuance of regulations is
a precondition to the determination of whether research with respect to IUS is qualified
research.

In addition to the statutory text itself, the legislative history to § 41(d)(4)(E) also supports
the view that Congress intended for the Treasury Department and the Service to issue
regulations under § 41(d)(4)(E) with respect to the three-part high threshold of
innovation test to make the provision operative. See H.R. Conf. Rep. No. 99-841, at II-
73 (“the costs of developing software are not eligible for the credit where the software is
used internally . . . except to the extent permitted by Treasury regulations.”) (emphasis
added). Regulations are, therefore, required to determine whether research with
respect to IUS qualifies for the research credit.
POSTF-102328-16 7

Although courts have been willing to exercise broad discretion to find statutes that grant
authority to the Treasury Department to issue regulations to be self-executing, this
exercise appears contrary to statutory construction principles. These principles provide
that the plain meaning of a statute must control. See United States v. Ron Pair Enters.,
Inc., 489 U.S. 235, 241 (1989); Caminetti v. United States, 242 U.S. 470, 485 (1917) (If
the statutory text is not ambiguous, “the rules which are to aid doubtful meanings need
no discussion”). Thus, if the statutory text plainly requires the issuance of regulations to
be operative, courts are not free to ignore that language. Moreover, courts have
employed more restraint in other areas of the law relying on these principles. See, e.g.,
Gholston v. Hous. Auth. of Montgomery, 818 F.2d 776, 785-86 (11th Cir. 1987) (“The
express language of [the statute] simply indicates that local housing authorities shall
comply with such procedures and requirements as the Secretary may prescribe.”)
(internal quotations omitted). See also Dunlap v. United States, 173 U.S. 65, 72 (1899)
(in a case involving alcohol tax rebates decided prior to the Administrative Procedure
Act finding that the “plain words” of the statute required regulations and because none
had been issued the claimant had no rights under the statute).

Moreover, unlike the statutory provisions at issue in cases like Occidental and Int’l
Multifoods, the Treasury Department and the Service have not left taxpayers without
guidance. Although T.D. 9104 reserved the IUS regulations as of December 31, 2003,
the Treasury Department and the Service provided taxpayers with interim guidance. To
provide relief to taxpayers while the Department of Treasury and Service worked to
issue further guidance, the Service has consistently provided that taxpayers could
choose to follow either all of the IUS provisions of T.D. 8930 or all of the IUS provisions
of the 2001 NPRM. See the 2004 ANPRM and the 2015 NPRM. This guidance applies
to taxable years ending prior to the issuance of the 2015 NPRM and for which there are
no final regulations in effect. Id. However, because § 41(d)(4)(E) is not self-executing
for purposes of determining whether research with respect to IUS is qualified research,
choosing to apply either all of the IUS provisions of T.D. 8930 or all of the IUS
provisions of the 2001 NPRM for purposes of the three-part high threshold of innovation
test is the only way research with respect to IUS can be qualified research during this
period.

Thus, in this case, Taxpayer can choose to apply either all of the IUS provisions of T.D.
8930 or all of the IUS provisions of the 2001 NPRM for purposes of the three-part high
threshold of innovation test, but cannot apply the legislative history to create rules in the
absence of regulations. Accordingly, if Taxpayer chooses to apply T.D. 8930, it must
apply all of T.D. 8930 for purposes of the three-part high threshold of innovation test,
including the common knowledge of skilled professionals standard.

CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS
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