Editor: Kevin D. Anderson, CPA, J.D.
In December 2015, the IRS released Chief Counsel Advice (CCA) 201549024, relating to the federal income tax treatment of software development costs. Although this type of authority may not be used or cited as precedent, the CCA provides helpful insight into the IRS's approach when examining the deductibility or capitalization of software-related costs. The issuance of the CCA affirms that not all computer software development and implementation costs are deductible when paid or incurred and that certain software-related costs must be capitalized and recovered through amortization for federal income tax purposes.
Most guidance for dealing with software development costs can be found in two IRS pronouncements from the early 2000s. In Rev. Proc. 2000-50, the IRS provided guidelines on the treatment of the costs of computer software and in Section 2 defined the term "computer software" as any program or routine (i.e., any sequence of machine readable code) that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. Rev. Proc. 2000-50 is particularly well-known for the following language:
The costs of developing computer software (whether or not the particular software is patented or copyrighted) in many respects so closely resemble the kind of research and experimental expenditures that fall within the purview of [Sec. 174] as to warrant similar accounting treatment.
Thus, because software development costs are similar to, but may not necessarily constitute, research and experimentation expenditures under Sec. 174, the IRS prescribes three methods of accounting for treating computer software development costs. According to Rev. Proc. 2000-50, the IRS will not disturb a taxpayer's treatment of costs paid or incurred in developing software for any particular project, either for the taxpayer's own use or to be held by the taxpayer for sale or lease to others, where:
1. All of the costs properly attributable to the taxpayer's development of software are consistently treated as current expenses and deducted in full in accordance with rules similar to those applicable under Sec. 174(a); or
2. All of the costs properly attributable to the taxpayer's development of software are consistently treated as capital expenditures that are recoverable through deductions for ratable amortization in accordance with rules (a) similar to those provided by Sec. 174(b) and the regulations thereunder, over a period of 60 months from the date of completion of the development, or (b) provided in Sec. 167(f)(1) and the regulations thereunder, over 36 months from the date the software is placed in service.
Aside from software development costs, Rev. Proc. 2000-50 addressed the treatment of acquired computer software costs. If the costs of computer software are included in the cost of the hardware without being separately stated, then those costs are treated as part of the hardware that is capitalized and depreciated. If the costs of computer software are separately stated, then those costs are amortized ratably over 36 months beginning with the month the software is placed in service.
Soon after the issuance of Rev. Proc. 2000-50, the IRS, in Letter Ruling 200236028, addressed the tax consequences of the purchase, development, and implementation of enterprise resource planning (ERP) software a taxpayer acquired from a third-party vendor as well as acquired computer hardware. Implementing an ERP system typically involves various costs, including, among others, costs to purchase the software, costs to install the software on the taxpayer's computer hardware and to configure the software to the taxpayer's needs through the use of options and templates embedded in the software, and costs to develop computer software through a technical consulting contract.
The IRS concluded that the costs to acquire the software package are capitalized under Sec. 263(a) and amortized under Sec. 167(f) ratably over 36 months. In addition, the costs of option selection and implementation of embedded templates (and the allocable portion of the costs of modeling and design of additional software to prepare for this process) are part of the installation and modification costs of the ERP software necessary to make it compatible with the taxpayer's business, without which the ERP software cannot be operated. Therefore, the IRS determined that those costs did not meet the machine readable code requirements of Rev. Proc. 2000-50, concluding instead that the costs for option selection and implementation of templates must be capitalized as part of the underlying purchased software and amortized ratably over 36 months, beginning with the later of the month the taxpayer places the purchased software in service or the month the template work is available for the taxpayer's use.
The IRS concluded, however, that the consulting costs related to software development (i.e., writing machine readable code) will constitute the taxpayer's developed software and, thus, are currently deductible under Rev. Proc. 2000-50, if the taxpayer is solely responsible for the creation and performance of the software project covered by the consulting contract.
Since the issuance of Rev. Proc. 2000-50 and Letter Ruling 200236028, Treasury and the IRS have not issued specific guidance for treating computer software costs other than brief mentions in preambles connected with the proposed and final intangible regulations under Regs. Sec. 1.263(a)-4. On Jan. 5, 2004, Treasury issued final regulations concerning the application of Sec. 263(a) to amounts paid to acquire, create, or enhance intangible assets, which include computer software. Although these final regulations do not specifically provide for the treatment of computer software development and implementation costs, the preamble announced that those issues are more appropriately addressed in separate guidance dedicated exclusively to computer software issues and, until such guidance is issued, taxpayers may continue to rely on Rev. Proc. 2000-50.
Analysis of CCA 201549024
In CCA 201549024, the IRS revisits the authorities and issues associated with computer software. The IRS cautions that some taxpayers are improperly taking the position that Rev. Proc. 2000-50 allows the current deduction of all software costs. Citing the scope provision of Rev. Proc. 2000-50, the IRS notes that this revenue procedure applies to all costs of computer software as defined in Section 2 of Rev. Proc. 2000-50. Therefore, the principles and conclusions reached in Letter Ruling 200236028 continue to apply. Moreover, the IRS notes that other taxpayers are improperly taking the position that the conclusions set forth in Letter Ruling 200236028 no longer apply since the promulgation of Regs. Sec. 1.263(a)-4.
In this regard, the IRS states that Regs. Sec. 1.263(a)-4 did not render Letter Ruling 200236028 obsolete. The IRS reiterates that the costs of option selection and implementation of templates, without which the ERP software is unusable, are capitalized as part of the purchased ERP software. Therefore, the capitalization of those costs is consistent with Regs. Sec. 1.263(a)-4, which requires a taxpayer to capitalize amounts paid to another party to acquire computer software from that party in a purchase or similar transaction.
The issuance of the CCA affirms the IRS's existing view in Letter Ruling 200236028 that not all computer software development and implementation costs are currently deductible under Rev. Proc. 2000-50 and that certain software-related costs must be capitalized and recovered through amortization for federal income tax purposes. When acquiring and implementing new computer software, taxpayers are advised to identify and allocate the software-related costs. Internal software development costs are generally deductible as a current Sec. 162 expense under Rev. Proc. 2000-50. Further, if the software development is performed through a consulting contract, these costs can also be currently deductible if the taxpayer is solely responsible for the creation and performance of the software project covered by the contract.
However, any costs related to option selection and implementation of embedded templates necessary to make the software usable are capitalizable as part of the purchased software and amortized. A change in the taxpayer's treatment of software development and implementation costs to a method prescribed under Rev. Proc. 2000-50 is a change in method of accounting to which Secs. 446 and 481 apply. To the extent that all eligibility requirements under Rev. Proc. 2015-13 are met, the taxpayer may file an automatic consent Form 3115, Application for Change in Accounting Method, under Section 9.01 of Rev. Proc. 2015-14 to request the IRS's permission to change its method of accounting for the costs of computer software development and implementation costs to a method described in Rev. Proc. 2000-50.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or [email protected]
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.
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