"IRC § 41 Research and Development", hereinafter referred to as "research" or "research activity" is one of several types of activities that constitute a qualified high technology business (QHTB) as defined by § 235-110.9, Hawaii Revised Statutes (HRS).

All research activity must satisfy the criteria of the Four-Part Test. In addition, internal-use software (IUS) -- including non-computer services -- must satisfy the criteria of the IUS Three-Part Test with certain exceptions including computer services. Make sense? If yes, you don't need to read any further. If not, you may have the following questions which we will attempt to answer:

1. What is the definition of research?
2. What is the "Four-Part Test"?
3. What is "internal-use" software?
4. What is the "Three-Part Test"?
5. What are "non-computer services"?
6. What are "computer services"?
7. What are the exceptions to the Three-Part Test?

IRC § 41(d) and IRS Regulations

To understand how software qualifies as research activity, one must first understand that the Hawaii statute relies on the definition of research described in IRC § 41(d). Further, the Tax Department is instructed to follow the guidance of the IRS, much of which is found in regulations.

There are two regulations which contain the lion's share of currently relevant IRS interpretation:

• January 2001 Final Regulations ("January Regulations")
• December 2001 Proposed Regulations ("December Regulations")

The most recent regulations, the 2003 Final Regulations ("2003 Final"), also provide some guidance but note that the section on internal-use software is reserved meaning that at some future date, the IRS will publish additional information.

IRC § 41(d) provides the initial criteria by which activity, including software, constitutes a QRA. These criteria are commonly partitioned into four "tests", referred to in the aggregate as the "Four-Part Test" (explained below).

Software receives somewhat special treatment in that it is the only activity type that is further subdivided into two categories: "commercial" ^[15], held for sale, lease, or license, and "internal use software" (IUS), which is everything else.

Commercial software is subject only to the Four-Part Test. However, IUS activity is disallowed except to the extent provided in regulations other than for use in (i) an activity which constitutes qualified research (determined with regard to § 41(d)(4)(E)), or (ii) a production process with respect to which the requirements of paragraph § 41(d)(1) are met.

In general, regulations provide that IUS must, in addition to satisfying the Four-Part Test, meet the criteria of the "high threshold of innovation" test commonly known as the IUS "Three-Part Test".

IUS criteria for qualification is complicated. For example, regulations discuss the concept of IUS Computer Services, which are not subject to the Three-Part Test, and IUS Non-Computer Services, which are. Other exceptions are also allowed. (All the criteria by which the relevant regulations provide for IUS to be a QRA are described below.)

Why is it significant that some activity is subject to only the Four-Part Test and others to the additional Three-Part Test?

Remember that IUS is excluded unless regulations provide otherwise. The IRS interprets legislative intent as limiting the credit for the costs of developing internal-use software to software meeting, as mentioned above, a "high threshold of innovation" ^[16]. This means that the IUS requirements are more stringent than that of not only commercial software, but other qualified activity as well.

The Four-Part Test of IRC § 41(d)

IRC § 41(d) prescribes the requirements that activity must meet in order to be considered qualified research. The activity must meet the following elements under § 41(d) known as "The Four-Part Test":

(1) The Elimination of Uncertainty Test. "With respect to which expenditures may be treated as expenses under section 174"^[1]

The Elimination of Uncertainty Test is satisfied if research expenditures may be treated as expenses under § 174, which holds that research must be undertaken to eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.^[2]

(2) The Technological in Nature Test. "Which is undertaken for the purpose of discovering information which is technological in nature"^[3]

Research is technological in nature if the process of experimentation used to discover such information fundamentally relies on the principles of the physical or biological sciences, engineering, or computer science. ^[4]

(3) The Business Component Test. "The application of which is intended to be useful in the development of a new or improved business component of the taxpayer"^[5]

The taxpayer must intend to apply the information it discovers to develop a new or improved business component related to functionality, performance, reliability, or quality.^[6]

(4) The Process of Experimentation Test. "Substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3)" ^[7]

A process of experimentation with respect to software is an evaluative process (for example, through modeling, simulation, or a systematic trial and error methodology) capable of evaluating more than one alternative that resolves uncertainty of capability, method, or design directly related to the principles of computer science whose purpose is to achieve a new or improved business function, or enhance performance, reliability, or quality.^[8]

Note that the specifics of which activity is likely or unlikely to meet the criteria of a process of experimentation is explained more fully by the IRS "Audit Guidelines on the Application of the Process of Experimentation for all Software"^[21]

Internal-Use Software (IUS)

As mentioned, § 41(d)(4)(E) explains that IUS does not constitute qualified research "except as provided in regulations" other than for use in:

1. An activity which itself constitutes qualified research. [§ 41(d)(4)(E)(i)]
2. A production process with respect to which the requirements of paragraph (1) are met. [§ 41(d)(4)(E)(ii)]

These and other aspects of IUS are discussed more fully in regulations. Therefore, we will examine how relevant regulations determine the criteria by which IUS qualifies.

IUS Defined

First of all, what is "internal-use software"? Starting with the statute, we find this at § 41(d)(4)(E):

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

The January Regulations concur:

Research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use^[9]

The December Regulations expand on this definition as follows:

Under these proposed regulations, software that is developed by (or for the benefit of) the taxpayer primarily to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties is not treated as internal use software. All other software is presumed to be developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use. This distinction reflects the view 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. (emphasis added)^[10]

The IRS devotes much attention to IUS in both the January and December Regulations. Since the Hawaii Tax Department follows the guidance of the IRS, it is important to note that the IRS states that taxpayers may rely on all of the provisions of the January Regulations or alternatively, all of the provisions of the December Regulations.

The IRS states this position in a January 2, 2004 Advanced Notice of Proposed Rulemaking (ANPRM):

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. (emphasis added)

The discovery test is as follows:

For purposes of section 41(d) and this section, research is undertaken for the purpose of discovering information only if it is undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. (emphasis added)

The requirement that research exceed, expand or refine the common knowledge of skilled professionals sets a high standard. The IRS subsequently eliminated the discvovery test requirement with the December Regulations.

The IUS Three-Part Test

Of particular importance for IUS is the "high threshold of innovation test" consisting of three components, which is known as "The Three-Part Test".

The three tests are as follows:

(1) Innovativeness Test. The Innovativeness Test is described differently in the January and December Regulations as follows:

January Regulations:

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^[17]

December Regulations:

The software is innovative in that 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^[18]

(2) Significant Economic Risk. The text for this test is the same for either the January or December Regulations:

The software development involves significant economic risk in that the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period^[19]

(3) The Not Commercially Available Test: The text for this test is the same for either the January or December Regulations:

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 paragraphs (c)(6)(vi)(A) and (B) of this section.^[20]

IUS Criteria, All Permutations

While the Three-Part Test is the most important of the criteria by which IUS qualifies, it is not the only criteria. For both the January and December Regulations, § 1.41-4(c)(6)(ii) defines all the criteria by which internal use software is eligible for the tax credit as follows:

All IUS activity must:

1. Satisfy the requirements of § 41(d)(1).
2. Otherwise not be excluded under § 41(d)(4) (other than § 41(d)(4)(E)).

In addition, one of the following conditions must be met:

1. The software is developed for use in an activity that constitutes qualified research (other than the development of the internal-use software itself).
2. The software is used in a production process that satisfies the requirements of section 41(d)(1).
3. The taxpayer develops a new or improved package of computer software and hardware together as a single product, of which the software is an integral part, that is used directly by the taxpayer in providing technological services in its trade or business to customers. In these cases, eligibility for the research credit is to be determined by examining the combined hardware-software product as a single product.
4. The taxpayer develops the software for use in providing computer services to customers.
5. The software satisfies the high threshold of innovation test, known as the Three-Part Test, of paragraph § 1.41-4(c)(6)(vi). (Non-computer services are included in this category.)

Exceptions to the Three-Part Test

Of these conditions, 1-3 are excepted from the Three-Part Test. Note that what is at issue is the fact that the software is part of another process which itself qualifies.

Condition 4, computer services, is also given an exception. In this case, the software activity itself is provided the exception.

Computer and Non-Computer Services

The issue of computer and non-computer services is of particular importance given the current state of software development because the boundaries between traditional commercial and internal-use software is increasingly blurred.

Section 1.41-4(c)(6)(iv)(A) of the January Regulations explain that a computer service is

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. A taxpayer does not provide a computer service merely because customers interact with the taxpayer's software. (emphasis added)

Later, § 1.41-4(c)(6)(iv)(B) explains that a noncomputer services is

a service offered by a taxpayer to customers who conduct business with the taxpayer primarily to obtain a service other than a computer service, even if such other service is enabled, supported, or facilitated by computer or software technology. (emphasis added)

The January Regulations explain why the IRS considers noncomputer service to be IUS (and therefore subject to the Three-Part Test):

The conclusion that software used to provide noncomputer services is internal-use software is consistent with the legislative history to the 1986 Act, which defined internal-use software as software used in general administrative functions and software used in providing noncomputer services (such as accounting, consulting, or banking services). See H.R. Conf. Rep. No. 841, at II-73

In the December Regulations, the IRS acknowledged that commentators objected to how the January Regulations distinguished between the two:

Several commentators objected to the distinction between computer services and noncomputer services and urged that the definition of internal-use software exclude any software used to deliver a service to customers or any software that includes an interface with customers or the public. (emphasis added)

However, the December Regulations go on to say:

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.

Unclear Distinction

Ultimately, the December Regulations retained the January Regulations definition of both computer and noncomputer services (without the latter's exception for non-coumputer services noted below). But, the IRS has not clearly explained how to distinguish between a computer and noncomputer service.

For example:

• The January Regulations have minimal guidance on what constitutes a noncomputer service. § 1.41-4(c)(6)(iii) provides the following list: accounting, consulting or banking services. Otherwise, there are no examples. With respect to computer services, there are no examples whatsoever.
• The December Regulations provide more guidance on noncomputer services in that four examples are provided in § 1.41-4(c)(6)(viii).^[14] However, once again, there are no examples provided for computer services.

Hence (unfortunately), there is scant guidance provided to assist in understanding how to distinguish between the two.

January Regulations Exception^[11] for Non-Computer Services^[12]

We should note that the the January Regulations provided that a non-computer service is deemed to satisfy the requirements for internal-use software, i.e., it is not subject to the Three-Part Test, if all of the following conditions are met. (The December Regulations subsequently repealed it):

1. The software is designed to provide customers a new feature with respect to a noncomputer service;
2. The taxpayer reasonably anticipated that customers would choose to obtain the noncomputer service from the taxpayer (rather than from the taxpayer's competitors) because of those new features provided by the software; and
3. Those new features were not available from any of the taxpayer's competitors.

Summary

In summary, we repeat the introduction. Hopefully, it makes much more sense:

All research activity must satisfy the criteria of the Four-Part Test. In addition, internal-use software, must satisfy the criteria of the IUS Three-Part Test with certain exceptions.

Footnotes

• ^[1] IRC § 41(d)(1)(A)
• ^[2] Reg. § 1.174-2(a)(1)
• ^[3] IRC § 41(d)(1)(B)(i)
• ^[4] H.R. Conf. Rep. No. 99-841, at II-71 (1986)
• ^[5] IRC § 41(d)(1)(B)(ii)
• ^[6] IRC § 41(d)(3)(A)
• ^[7] IRC § 41(d)(1)(C)
• ^[8] 2003 Final Regulations
• ^[9] January Regulations § 1.41-4(c)(6)
• ^[10] December Regulations, prolog
• ^[11] January Regulations § 1.41-4(c)(6)(v)
• ^[12] With the December Regulations, the non-computer service exception was eliminated: "These proposed regulations, however, eliminate the special rule contained in TD 8930 for software used to deliver noncomputer services to customers with features that are not yet offered by a taxpayer's competitors. Several commentators stated that this rule is too limited and subjective in its application to have significant value to taxpayers. Due 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."
• ^[14] § 1.41-4(c)(6)(viii), examples 3, 5, 10, and 13.
• ^[15] The term "commercial software" is not found in IRC § 41. However, we use it here as shorthand to distinguish activity from internal-use software.
• ^[16] (Coordinated Issue All Industries Research Credit - Internal Use Software UIL 41.51-10, August 26, 1999)
• ^[17] January Regulations § 1.41-4(c)(6)(vi)(A)
• ^[18] December Regulations § 1.41-4(c)(6)(vi)(A)
• ^[19] January, December Regulations § 1.41-4(c)(6)(vi)(B)
• ^[20] January, December Regulations § 1.41-4(c)(6)(vi)(C)
• ^[21] "Audit Guidelines on the Application of the Process of Experimentation for all Software", http://www.irs.gov/businesses/article/0,,id=138989,00.html