Software developed primarily for the taxpayer's own internal use is excluded from qualified research by statute, except as provided in regulations. The regulations provide a route back in: internal use software can qualify if it passes the four-part test and an additional high threshold of innovation test. Because most software developed by companies outside the software industry is for internal use, the rule decides a large share of claims from banks, retailers, insurers, manufacturers and service businesses.
What it is
Internal use software is software developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. The regulations define general and administrative functions as financial management, human resource management and support services. Software is not internal use software if it is developed to be commercially sold, leased, licensed or otherwise marketed to third parties, or if it is developed to enable the taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
| Software | Classification | Why |
|---|---|---|
| A product sold to customers | Not internal use | Developed to be commercially marketed |
| A customer portal where clients place orders and view accounts | Not internal use | Allows third parties to initiate functions and review data |
| An internal finance consolidation system | Internal use | Financial management function |
| An HR and scheduling platform for staff | Internal use | Human resource management function |
| Warehouse routing software used only by the taxpayer's own operations | Depends | Not a general and administrative function if it is part of the production or service delivery process rather than support services |
| A platform that serves both staff and customers | Dual function | Allocation rules apply |
Who it applies to
Any taxpayer that develops software for its own general and administrative use and wants to claim the development costs. The classification is made at the time development begins, based on the intended use. Section G of Form 6765 asks each software business component to be identified as internal use software, dual function software, or neither, so the classification is now disclosed on the return.
How it works
The high threshold of innovation test. Internal use software qualifies only if, in addition to the four-part test, all three of the following are met:
- Innovative. The software would result in a reduction in cost or improvement in speed or other measurable improvement that is substantial and economically significant, if the development succeeds.
- Significant economic risk. The taxpayer commits substantial resources and there is substantial uncertainty, because of technical risk, whether the resources would be recovered within a reasonable period.
- Not commercially available. The software cannot be purchased, leased or licensed and used for the intended purpose without modifications that would themselves satisfy the first two requirements.
Exceptions. The additional test does not apply to software developed for use in an activity that itself constitutes qualified research, or to software developed for use in a production process to which the four-part test applies. A simulation tool built to run the experiments in a qualifying engineering project is in the first exception.
Dual function software. Software that serves both general and administrative functions and third-party interaction is presumed to be internal use. The presumption can be overcome by identifying a subset of elements that only enables third-party interaction, which is then treated as not internal use; and where that cannot be done, a safe harbour allows 25% of the dual function software's QREs to be claimed if at least 10% of its use is reasonably anticipated to be by third parties.
Worked example
Illustrative example. Coleridge Logistics, a hypothetical freight company, develops three systems in a year.
| System | Classification | Test applied | Result |
|---|---|---|---|
| Shipper portal: customers book, track and pay | Not internal use | Four-part test only | Qualifies if the four-part test is met |
| Internal payroll and expenses system replacing a vendor product | Internal use | Four-part test plus high threshold of innovation | Fails: a commercially available product existed and the development involved little technical risk |
| Dispatch optimisation engine used by staff, with a customer-facing module showing live ETAs | Dual function | Identify the third-party subset; apply the four-part test to the staff-facing part and then the high threshold test | ETA module qualifies as third-party software; the staff optimisation engine passes the high threshold test on its novel routing algorithm, which no available product offered and which risked US$1,200,000 of development |
Coleridge claims the portal, the ETA module and the optimisation engine, and leaves the payroll system out. Its Section G entries identify each software component's classification.
Common questions
Is any software used only by our staff automatically internal use? No. Only software for general and administrative functions is. Software used in producing goods or delivering services to customers is judged under the ordinary four-part test.
Does buying a vendor platform and customising it count? Customisation with vendor tools rarely passes the technological in nature test, and where the platform was commercially available the third high threshold requirement fails.
Do the rules apply to earlier years? The current regulations apply to tax years beginning on or after 3 October 2016; earlier years are governed by the prior proposed regulations and case law.
Related pages
- The four-part test
- Software and other sectors
- Section G classification of software components
- Guide: software development and R&D
- Program: Technical Teams Program
Official sources
Educational content only, not tax advice. See the disclaimer.