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State of California Franchise Tax Board

Seven Tests for Internal Use Software

Pursuant to California Revenue and Taxation Code sections 17052.12 and 23609, in order for an activity or project to qualify for the research credit, the taxpayer must show that it meets all of the requirements in Internal Revenue Code section 41(d).

Under IRC section 41 and the committee reports to the '86 Tax Reform Act, internal-use software must pass seven tests to be eligible for the credit, as follows:

  1. The research must have qualified as a business deduction under IRC §174. [IRC §41(d)(1)(A)]
  2. The research must be undertaken to “discover information which is technological in nature.” [IRC §41(d)(1)(B)(i)]
  3. The taxpayer must intend to use the information to develop a new or improved business component. [IRC §41(d)(1)(B)(ii)]
  4. The taxpayer must pursue a “process of experimentation” during substantially all of the research. [IRC §41(d)(1)(C)]
  5. The software must be innovative. [H.R. Rep. 99-841, Tax Reform Act of 1986. IRC §41(d)(4)(E)]
  6. The software development must involve significant economic risk. [H.R. Rep. 99-841, Tax Reform Act of 1986. IRC §41(d)(4)(E)]
  7. The software must not be commercially available for use by the taxpayer. [H.R. Rep. 99-841, Tax Reform Act of 1986. IRC §41(d)(4)(E)]

Note: Qualified research shall only include research conducted in California.

California Research Credit

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