The Tax Policy Division of the Texas Comptroller of Public Accounts issued guidance summarizing certain federal statutes and regulations related to Internal Use Software (IUS) that are now incorporated-by-references into Texas’ research and development (R&D) laws. Specifically, for purposes of the franchise tax R&D credit laws and the sales tax R&D exemption, the Comptroller incorporates-by-reference certain definitions that, prior to the amendment, were only recognized if taxpayers were required to apply those regulations to the 2011 federal income tax year. Instead, the Comptroller now recognizes these federal laws if taxpayers were allowed to apply those regulations to the federal 2011 income tax year.
In federal tax year 2011, taxpayers were given the election between two different versions of Treas. Reg. § 1.41-4(c)(6): the version adopted in 2003 (contained in IRB 2001-5) and the version proposed in 2022 (contained in IRB 2002-4). Both versions of Treas. Reg. § 1.41-4(c)(6) have some identical provisions, including: (1) the general rule and exemptions from IUS treatment; (2) the definition of “computer services”; and (3) most—but not all—of the language and application of the High Threshold of Innovation Text (which must be satisfied in addition to the Four-Part Test).
The two versions, however, contain some differences: (1) how IUS is defined; (2) details on the treatment of hardware and software developed together as a single product; (3) applicability of a portion of the High Threshold of Innovation Test; (4) the exception for software used to provide noncomputer services; and (5) the examples used in each version of the regulation.
- Definition of IUS. IRB 2001-5 is more limited, defining IUS as any software developed to be used internally and clarifying that the sale of the software does not remove its IUS classification. Instead, IRB 2002-4 establishes a presumption that software is IUS unless it is developed to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties, as determined at the start of the research.
- Hardware and Software Developed Together as a Single Product. Both versions of the regulation state a new or improved package of hardware and software developed together as a single product, of which the software is an integral part, will be exempt from treatment as an IUS, so long as the product is used directly by the taxpayer to provide services to customers in its trade or business. IRB 2001-5, however, states that the services provided by the taxpayer must be “technological services,” whereas IRB 2002-4 provides that the services can be any services.
- High Threshold of Innovation Test. While most of the High Threshold of Innovation Test is the same between both versions, IRB 2001-5 has detailed rules for its application. Note that both versions provide that only the activities related to the new or improved software are considered for the test (i.e., the effect of modifications to related hardware or other software are not taken into account).
- Exception for Software Used to Provide Noncomputer Services. IRB 2001-5 uniquely exempts software used in providing noncomputer services to customers from the IUS exclusion. The exception was eliminated entirely in IRB 2002-4—the IRS considered that software eligible for the exception would be credit-eligible under other provisions, making the exception unnecessary.
- Examples. IRB 2002-4 eliminated one of the two examples provided in IRB 2001-5, and uniquely modified the other. IRB 2002-4 also includes twelve additional examples.
The memo clarifies that taxpayers have the option to elect between the two versions—but any version they select will be applied in full (i.e., they may not elect between different provisions within both versions). The memo also clarifies that additional provisions from the 2016 regulations are not incorporated-by-reference.