Opinion ID: 760150
Heading Depth: 2
Heading Rank: 2

Heading: The Internal Use Exclusion

Text: 33 Section 41(d)(1) excludes from the qualified research credit any computer software developed primarily for internal use by the taxpayer. 26 U.S.C. § 41(d)(4)(E). For lack of other authority, the district court consulted the legislative history and proposed Treasury regulations to determine what internal use means. See United Stationers II, 982 F.Supp. at 1286. The district judge employed a totality of the circumstances test and concluded that USI's programs were the type of internal use software that Congress specifically sought to exclude from the § 41 research credit. Id. at 1287. USI, of course, contests this conclusion and constructs two elaborate arguments in an attempt to rescue the projects from this internal use exclusion. Neither argument, despite its admirable ingenuity, is particularly compelling. 34 Again, nothing in the Code or in case law 4 explicitly defines internal use. We therefore plunge again into the muddy waters of legislative history. USI points us to 1981 Congressional records to support its reading of the exclusion. Only software intended exclusively for internal use, USI argues, should be excluded because the original intent of the research credit was to stimulate the economy; therefore, any program that provides a stimulus to or has an impact on the economy, however indirect or insubstantial, should escape the internal use exclusion. This proposed analysis sweeps too broadly. Congress intended the original credit to reward taxpayers for a significant contribution to the store of public technological knowledge. See S.REP. NO. 97-144 (1981); H. R EP. N O. 97-201 (1981). To avoid this exclusion, then, a taxpayer claiming a credit for developing software must to an appropriate extent make the program available to the public. Something more than a speculative or attenuated impact on the economy is required. 35 USI also pins its hope on the 1986 Conference Report which explicitly states that software development projects would constitute internal use software where they are used internally, for example, in general and administrative functions (such as payroll, bookkeeping, or personnel management) or in providing noncomputer services (such as accounting, consulting, or banking services). H.R. C ONF. R EP. N O. 99-841, at II-73 (1986). USI relies on this language to urge us to draw elusive distinctions between the provision of general and administrative services and a taxpayer's core revenue-generating activities. Core business activities have an external impact and should not be subject to the internal use exclusion, USI asserts. It maintains that the projects at issue here--inventory controls and the like--are integral to its core revenue activities as a wholesale distributor. USI therefore concludes that its eight projects cannot be internal use software. 36 We cannot accept this analysis. USI seems to be asking us to view cost accounting methodology (specifically, the difference between general overheads and directly assigned costs) as a determinative principle in identifying internal use. In effect, USI appears to be arguing that, if the programs involve activities that directly impact parties outside the taxpayer, they are not for internal use. As we stated before, however, this formulation does not fully capture the idea of contributing to the store of public technological knowledge. In any event, we agree with the district court that all the relevant facts--the totality of the circumstances--must be taken into account. See United Stationers II, 982 F.Supp. at 1286-87; see also Prop. Treas. Reg. § 1.41-4(e)(4), 62 Fed.Reg. 81, 83 (Jan. 2, 1997) (Credit for Increasing Research Activities). And, on the record before us, the district court's conclusion that the software development projects were for internal use is not clearly erroneous. USI developed all of the software to help it track its huge inventory. Even the two programs to which customers have limited access, DRRS and Unilink, were developed primarily for use by USI in streamlining its operations. The services these software programs expedite--marketing, ordering, invoicing, shipping, receiving, pricing, etc.--even though they may have a direct impact on customers, suppliers and other third parties do not rescue the programs from the internal use exclusion. 37