1. I.R.C. Section 41 – R&D Tax Credit 2015 Proposed Regulations: Internal Use Software (REG-153656-03) Hosted by Chris Petros, Director Presented by Peter Mehta, Managing Director Tax Credit Co. September 18, 2015

2. 2 Agenda  Introductions  R&D Tax Credit Requirements Applicable to Internal Use Software  Overview of Proposed Software Regulations (REG-153656-03)  Comparison to Prior Requirements  Questions

3. 3 Introductions Peter Mehta Managing Director, Research & Development Tax Incentives Peter’s 20 years of experience in tax controversy and R&D tax credit matters includes all aspects of tax controversy from Exam through the Appellate-level with both the IRS and California State taxing authorities. His experience includes audit examinations, technical advice requests, preparing and reviewing protests, IRS Appeals proceedings, and refund claims. Chris Petros Manager, Research & Development Tax Incentives Chris Petros brings experience from industry in various capacities, including manufacturing and design engineering. Today, Chris’s clients span a variety of industries and sizes. He has worked on small and medium-sized enterprise engagements, as well as engagements for Fortune 500 companies. His client’s industries include manufacturing, engineering services, software, medical and testing laboratories, cosmetics, and retail.

4. I.R.C. Section 41 Eligibility Requirements for Internal Use Software

5. 5 Federal R&D Credit Rules  I.R.C. § 41 provides a credit for 20% of Qualified Research Expenditures (QRE’s) over a historical base period amount or can elect the Alternative Simplified Credit (“ASC”) method.  To be eligible, the taxpayer must engage in activities that meet the “four-part” test of § 41(d): ‒Permitted Purpose: The company must be working to develop a product, process, computer software, technique, formula, or invention (“Business Component”) which is to be held for sale, lease, or license, OR used by the taxpayer in a trade or business of the taxpayer ‒Elimination of Uncertainty: Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component ‒Process of Experimentation: A process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities ‒Technological In Nature: The process of experimentation used to discover information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science

6. 6 Internal Use Software (“IUS”) Requirements  Internal use software projects must meet 3 additional requirements known as the “high-threshold of innovation” test [Prop. Treas. Reg. Sections 1.41- 4(c)(6]): ‒Innovative ‒Significant economic risk ‒Not commercially available  Prior to the proposed regulations, both the definition of IUS as well as the requirements under the high-threshold of innovation test were in flux.  Announcement 2004-9 reflects IRS position prior to proposed regulations: ‒Taxpayers may follow either all of the internal software provisions of: 2001 final regulations (REG-112991-01, Jan. 3, 2001); or 2001 proposed regulations (T.D. 8930, Dec. 26, 2001) o For T.D. 8930, taxpayers need not follow old “discovery test”

7. Proposed IUS Regulations (REG-153656-03)

8. 8 Overview of New Regulations  Why are they important? ‒Clarify definition of IUS ‒Clarify application of high-threshold of innovation test (“HTIT”) Innovative Significant Economic Risk Not Commercially Available ‒Provide examples illustrating the process of experimentation requirement

9. 9 Definition of IUS under Proposed Regulations  4 categories of software ‒General and administrative ‒Held for sale, license or lease ‒Software that enables third-party interactions ‒Dual function software  Each category is designated as internal use or external use based on a “primary purpose” test ‒IUS = Developed primarily for internal use of the taxpayer ‒External = Not developed primarily for internal use of the taxpayer

10. 10 Definition of IUS – External Use Software  2 Categories of External Use Software ‒Software held for sale, license or lease to unrelated third-parties ‒Software enabling third party interactions

11. 11 Definition of IUS – External Use Software  Category 1: Software held for sale, license or lease to unrelated third parties is not IUS ‒2 important points Old IUS presumption eliminated: Software not held for sale is not automatically presumed to be IUS “Separately stated consideration” language eliminated: The requirement under previous guidance that the consideration for sale or license be separately stated is eliminated.  Category 2: Software enabling third party interactions ‒Software that enables the taxpayer to interact with third-party systems or vice versa is not primarily for benefit of taxpayer and should not be treated as IUS ‒Caution: Third-parties do not include any persons that use the software to support the general and administrative functions of the taxpayer, thereby facilitating the conduct of the taxpayer’s trade or business ‒Intent controls: Whether software is IUS depends on the intent of the taxpayer and the facts and circumstances when the software was developed. Example: Original software was developed by taxpayer for internal use. Later it is improved so it can be sold. The original software would be IUS. The enhancements would not. Example: Original software developed for sale. Later it is customized so that the taxpayer can use in its trade or business. The original software is not IUS. The customizations would be.

12. 12 Definition of IUS  Preamble to regulations provide examples of third party interaction software and includes software that: ‒Executes banking transactions ‒Tracks the progress of a delivery of goods ‒Provides goods and services to third parties ‒Searches a taxpayer’s inventory of goods ‒Stores and retrieves a third party’s digital files ‒Purchases tickets or makes reservations ‒Receives services over the internet (SaaS)

13. 13 Definition of IUS – Internal Use  General and Administrative = Internal Use ‒Software facilitating or supporting the conduct of taxpayer’s trade or business Includes related parties that are treated as single taxpayer under I.R.C. 41(f) ‒Examples: Financial management/recordkeeping HR management functions – workforce management Support services intended to cover the day-to-day back office functions that a taxpayer would have regardless of industry

14. 14 Definition of IUS - Dual Function Software  Dual Function Software ‒Definition: Software developed for both internal general and administrative functions and to enable interaction with third parties ‒Rule: Presumption that entire development is for internal use ‒Rebutting Presumption – “Third-Party Subset”: Taxpayer can show that a subset of the elements of the dual function software only enables a taxpayer to interact with third parties or allows third parties to initiate functions or review data. If taxpayer can identify subset, the portion of research expenditures allocable to the subset may be eligible if four-part test is met. ‒Safe Harbor if taxpayer cannot identify third party subset Taxpayer can claim 25% of dual function software expenses as QREs if the taxpayer can show that external use portion is reasonably anticipated to constitute 10% of the system’s total use. o Objective, reasonable method to estimate third party use; and o Such use is estimated at beginning of the development (often overlooked)

15. 15 High Threshold of Innovation Test (“HTIT”)  Innovative ‒Software is considered innovative if it would result in a: Reduction in cost Improvement in speed Any other measurable improvement that is measurable and economically significant ‒This is a measurable objective standard and is not based on the unique or novel nature of the software being developed ‒Current definition aligns with legislative history ‒Differs from 2001 proposed regulations which defined software as innovative if the software is intended to be 1) unique or novel and 2) differ in a significant and inventive way from prior software implementations or methods.

16. 16 High Threshold of Innovation Test  Significant Economic Risk ‒3 requirements Taxpayer commits substantial economic resources to the project Due to technical risk there is substantial uncertainty That such resources would be recovered within a reasonable period if the project fails ‒Technical risk exists if the information available to the taxpayer does not establish the capability or method for developing the software Note: Design uncertainty, while permissible under I.R.C sections 174 and 41, is not sufficient in establishing “technical risk” for this purpose. ‒Clarifies prior guidance and approach taken by Examiners in field (especially IRS MITRE experts) Observation: One of the most common reasons that MITRE would disallow internal use software projects

17. 17 High Threshold of Innovation Test  Commercially Available ‒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 innovativeness and significant economic risk requirements ‒No change from prior guidance.

18. Qualification of IUS  Software developed primarily for internal use is qualified if: -High threshold of innovation test is met -If software falls within following exceptions to IUS Software for use in production process Delivery of goods or services not part of the production process, post- production activity Software developed along with hardware as a single product not subject to the proposed regulation Software used in the performance of qualified research

19. Effective Date  Effective Date: Taxable years ending on or after January 20, 2015: -Applicable to fiscal years ending in 2015 -Note: Credit expired on 12/321/2014, therefore only the qualifying activities occurring in calendar year 2014 would qualify.  Pre-Effective Date -Taxpayers may choose to apply all of the provisions of the internal use software provisions in the 2001 final regulations (“without the discovery test) or all of the provisions in the 2001 proposed regulations. -No need to comply with the discovery test if applying the 2001 final regulations (T.D. 8930). See, FedEx v. United States, 2009-1 USTC par.50,435 (W.D. Tenn. 2009), reh’g denied 108 AFTR2d 2001-5669 (W.D. Tenn. 2009)

20. Effective Date  IRS Exam practice: If taxpayers do not choose to follow one of these versions of the law, the examiner will apply the 2001 proposed regulations.  Two different standards could theoretically apply to projects involving software that interacts with third parties where the development took place before and after effective date.  Impact at Appeals of IRS Bifurcated pre-effective/post-effective date approach: ₋Proposed regulations reflect Treasury’s interpretation of IRC § 41(d)(4)(E) ₋IRS position that taxpayers apply either 2001 proposed regulations or 2001 final regulations raises litigation hazards to the Service i.e., relying on proposed regulations or final regulations that were withdrawn is a false choice. Until final regulations promulgated, the legislative history definition of IUS and HTIT control. Observation: Successful with this argument at both Exam and Appeals level.

21. Comparison of Proposed Regulations vs. Prior Requirements

22. 22 IUS Requirements  Internal use software must meet 3 additional requirements of the high- threshold of innovation test [Prop. Treas. Reg. Sections 1.41- 4(c)(6]): ‒Innovative ‒Significant economic risk ‒Not commercially available  Prior to proposed regulations, both the definition of IUS as well as the requirements under the high-threshold of innovation test were in flux.  Announcement 2004-9 reflects IRS position ‒Taxpayers may follow either all of the internal software provisions of 2001 final regulations (REG-112991-01, Jan. 3, 2001); or 2001 proposed regulations (T.D. 8930, Dec. 26, 2001) o For T.D. 8930, taxpayers need not follow old “discovery test”

23. IUS Definition – Proposed Regs. vs. Prior Requirements Date PublishedDescriptionIUS DefinitionNon-IUS DefinitionExceptions to IUS Jan. 2, 19971997 proposed Regulations (Notice of Proposed Rulemaking – REG- 209494-90) No. Facts and circumstances test + legislative history No. Single hardware/software product Jan. 3, 20012001 final regulations (T.D. 8930) No. provides examples that G&A software and non- computer services are IUS No. Single product Computer services Non-computer services for competitive advantage Dec. 26, 20012001 proposed regulations (Reg-112991-01) None. But presumed IUS if not held for sale, license, lease for separately stated consideration Software held for sale, license, lease or otherwise marketed for separate consideration Single product Computer services Jan. 20, 2015Notice of Proposed Rulemaking (REG153656-03) Yes. IUS is limited to G&A software. Software sold, leased or licensed or otherwise marketed to 3 rd parties (no requirement for separately stated consideration) 3 rd party interaction Single product 3 rd party interaction Dual function Production process Used in qualified research

24. HTIT – Proposed Regs. vs. Prior Requirements HTIT Requirement 2001 Final Regulations (TD 8930)2001 Proposed Regulations (REG-112991-01) 2015 Proposed Regulations (REG- 153656-03) InnovativeThe software is innovative in that the software is intended to result in: 1.a reduction in cost 2.improvement in speed, or 3.other improvement that is substantial and economically significant 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. The software is innovative if the software would result in a reduction in cost or improvement in speed or other measurable improvement, which is substantial and economically significant, if the development is or would have been successful. Significant Economic Risk 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. Same as TD 8930The software development involves significant economic risk if the taxpayer commits substantial resources to the development and if there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period. Substantial uncertainty exists if, at the beginning of the taxpayer’s activities, the information available to the taxpayer does not establish the capability or method for developing or improving the software. NOTE: Design uncertainty, while permissible under I.R.C sections 174 and 41, is not sufficient in establishing “technical risk” for this purpose. Commercially Available No change from T.D. 8930. 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 innovativeness and significant economic risk requirements.

25. 25 Framework for Analyzing an IUS Issue  3-Step Analysis: ‒Step 1: Should the software be treated as IUS? Does software meet IUS definitional requirements? Do exceptions apply? ‒Step 2: If IUS, what legal standards apply? Post-Effective Date: Proposed Regulations Pre-Effective Date: 2001 final regulations or 2001 proposed regulations Query: Given lack of final regulations, can taxpayer apply all 3 sets of regulations and/or legislative history ‒Step 3: Does the software meet the high-threshold of innovation test?

26. Questions