The Internal Revenue Code (IRC) allows companies to claim an R&D tax credit for research and development activities related to new or improved software products. The research activities need to at least satisfy the broad tax definition of “research” and be qualified under the four-part test. In addition, software developed primarily for internal use that’s not sold, licensed or leased to third-party customers is only deemed to involve qualified activities for the credit if these activities meet the “high threshold of innovation” test, commonly known as the additional three-part test. How should taxpayers treat embedded software development expenses? Furthermore, should the research activities be qualified under only the four-part test or three-part internal-use software (IUS) tests?
Embedded software is computer software written to control machines or other devices not typically thought of as computers. This software is specialized for a particular hardware platform that frequently has time and memory constraints, while also being a critical component to the platform working properly as designed and intended. (Embedded software is sometimes used interchangeably with the term “firmware.”)
New proposed final regulations for internal-use software add clarity and examples of software development activities that are eligible for the R&D tax credit. This has already helped developers of software to determine if their research activities need to satisfy the more stringent IUS requirements or only have to meet the general software development tests.
An Example Of Hardware And Software As A Single Product
Companies often design and build embedded software in the electronics of numerous consumer products, such as automobiles, telephones, modems, robots, appliances and computers.
For embedded software, the proposed final regulations illustrate this point with an example of computer hardware and software developed as a single product:
A telecom develops high-tech telephone switching hardware, while also developing software that interfaces directly with the hardware, and has the functionality to initiate and terminate a call, along with other advanced functions. The telecom designed and developed the hardware and software to work together.
The conclusion is that the software is part of a single product. Specifically, the software interfaces directly with the hardware, as part of a computer hardware and software end product. To this end, the software and hardware product only has to satisfy the four-part test eligibility requirements.
The Challenge Of Capturing R&D Credits For Embedded Software
The proposed final regulations and extensive legislative history has shown that research and development activities involving embedded software, in conjunction with hardware development, should be considered as a single product. When considering R&D tax credit eligibility, the restrictions under the IUS requirements should not apply.
Qualifying software research and development activities (and related expenses) for software development projects can be a challenging exercise. And yet, it’s a critical component of financial return to justify the investment in current projects and future innovations. That’s why it’s highly recommended you use R&D tax credit experts for these types of services. They identify tax credit opportunities, guide you on gathering necessary documentation and show you how to properly claim R&D tax credits.
Ready to learn if your embedded software development activities quality for an R&D tax credit? Download your complimentary, educational guide.
