Tax Treatment of Year 2000 Costs
For further information on this Revenue Procedure, please contact tax partner Brian Wainwright now in the Palo Alto office of Pillsbury Winthrop Shaw Pittman LLP.
On November 10, 1997, the Internal Revenue Service released Revenue Procedure 97-50, in which the IRS set forth its views as to the proper tax treatment of expenses paid or incurred to modify computer software to avoid the so-called "year 2000 problem." If you have or can obtain the Acrobat Reader, or have an Acrobat 3.0-enabled web browser, you may wish to download our pdf versions of Revenue Procedure 97-50 [50K] and Revenue Procedure 69-21 [54K]. Those pdf files are also available via ftp at ftp.pmstax.com/irb/rp9750.pdf and ftp.pmstax.com/irb/rp6921.pdf, respectively.
SummaryThe IRS recognizes that numerous taxpayers may incur considerable expense in modifying or replacing computer software to correct the so-called "year 2000 problem," arising because many computer programs utilize a two-digit, as opposed to four-digit, field to represent the year component of dates. In Revenue Procedure 97-50, the IRS states that costs paid or incurred to convert existing software, to develop new software to replace existing software, to purchase or lease new software to replace existing software or to develop or purchase software tools to assist in converting existing software ("year 2000 costs") should be treated just like any other computer software costs in accordance with the rules of Revenue Procedure 69-21.
Thus, the IRS will not challenge a taxpayer's treatment of "year 2000 costs"
The IRS also notes that due to the nature of "year 2000 costs" such costs will not be eligible for the research credit of Internal Revenue Code section 41, "except in those extraordinary circumstances in which those costs satisfy the definition of 'qualified research' in § 41(d) and otherwise meet all the requirements of § 41."
.01 This revenue procedure provides guidelines to be used in connection with the examination of federal income tax returns involving the costs paid or incurred by a taxpayer in its trade or business to convert or replace computer software to recognize dates beginning in the year 2000.
.02 This revenue procedure also provides procedures for a taxpayer to obtain automatic consent to change to a method of accounting described in this revenue procedure.
Section 2. Background
Many computer systems use two digits rather than four digits to represent the year in a date field (for example, "97" to represent 1997). A two-digit year field, however, may be inadequate to represent years after 1999. For data involving the year 2000, for example, computer systems may not recognize "00" as a year, or may treat that year as 1900 instead of 2000. Thus, many computer systems may fail to operate, or may operate improperly, if the software is not converted or replaced to recognize four-digit years (i.e., made "year 2000 compliant"). In order to ensure that their computer systems are year 2000 compliant, taxpayers may pay or incur costs to manually convert their existing software, to develop new software to replace their existing software, to purchase or lease new software to replace their existing software, or to develop or purchase software tools to assist them in converting their existing software to be year 2000 compliant ("year 2000 costs").
Section 3. Treatment of Year 2000 Costs
Rev. Proc. 69-21, 1969-2 C.B. 303, provides guidelines to be used in connection with the examination of federal income tax returns involving the costs paid or incurred to develop, purchase, or lease computer software. Year 2000 costs fall within the purview of Rev. Proc. 69-21. Accordingly, the Internal Revenue Service will not disturb a taxpayer's treatment of its year 2000 costs if the taxpayer treats these costs in accordance with section 3 of Rev. Proc. 69-21 (in the case of developed software, including converted software), section 4 of Rev. Proc. 69-21 (in the case of purchased software), or section 5 of Rev. Proc. 69-21 (in the case of leased software).
Section 4. Research Credit
Section 41 of the Internal Revenue Code provides a credit against tax for increasing research activities. To be eligible for the research credit, expenditures must be for activities satisfying the requirements of § 41 including the definition of "qualified research" in § 41(d). Except in extraordinary circumstances, year 2000 costs will not satisfy the definition of "qualified research" in § 41(d). For example, year 2000 costs generally do not involve research undertaken for the purpose of discovering information that is technological in nature where substantially all of the research activities constitute elements of a process of experimentation. Thus, a taxpayer that pays or incurs year 2000 costs may not claim the research credit except in those extraordinary circumstances in which those costs satisfy the definition of "qualified research" in § 41(d) and otherwise meet all the requirements of § 41.
Section 5. Application
Any change in a taxpayer's treatment of year 2000 costs to conform with section 3 of this revenue procedure is a change in method of accounting to which the provisions of §§ 446 and 481 and the regulations thereunder apply. A taxpayer wanting to change its method of accounting for year 2000 costs to conform with section 3 of this revenue procedure must follow the automatic change in accounting method provisions of Rev. Proc. 97-37, 1997-33 I.R.B. 18.
Section 6. Effect On Other Documents
Rev. Proc. 69-21 is amplified. Rev. Proc. 97-37 is amplified to include this change in the Appendix.
The principal author of this revenue procedure is Kimberly L. Koch of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue procedure, contact Ms. Koch on (202) 622-4950 (not a toll-free call).
Section 1. Purpose.
The purpose of this Revenue Procedure is to provide guidelines to be used in connection with the examination of Federal income tax returns involving the costs of computer software.
Section 2. Background.
For the purpose of this Revenue Procedure, "computer software" includes all programs or routines used to cause a computer to perform a desired task or set of tasks, and the documentation required to describe and maintain those programs. Computer programs of all classes, for example, operating systems, exceutive systems, monitors, compilers and translators, assembly routines, and utility programs as well as application programs are included. "Computer software" does not include procedures which are external to computer operations, such as instructions to transcription operators and external control procedures.
.01 The costs of developing 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 section 174 of the Internal Revenue Code of 1954 as to warrant accounting treatment similar to that accorded such costs under that section. Accordingly, the Internal Revenue Service will not disturb a taxpayer's treatment of costs incurred in developing software, either for his own use or to be held by him for sale or lease to others, where: 1. All of the costs properly attributable to the development of software by the taxpayer are consistently treated as current expenses and deducted in full in accordance with rules similar to those applicable under section 174(a) of the Code; or 2. All of the costs properly attributable to the development of software by the taxpayer are consistently treated as capital expenditures that are recoverable through deductions for ratable amortization, in accordance with rules similar to those provided by section 174(b) of the Code and the regulations thereunder, over a period of five years from the date of completion of such development or over a shorter period where such costs are attributable to the development of software that the taxpayer clearly establishes has a useful life of less than five years.
.01 With respect to costs of purchased software, the Service will not disturb the taxpayer's treatment of such costs if the following practices are consistently followed: 1. Where such costs are included, without being separately stated, in the cost of the hardware (computer) and such costs are treated as a part of the cost of the hardware that is capitalized and depreciated; or 2. Where such costs are separately stated, and the software is treated by the taxpayer as an intangible asset the cost of which is to be recovered by amortization deductions ratably over a period of five years or such shorter period as can be established by the taxpayer as appropriate in any particular case if the useful life of the software in his hands will be less than five years.
Where a taxpayer leases software for use in his trade or business, the Service will not distrub a deduction allowable under the provisions of section 1.162-11 of the Income Tax Regulations, for rental.
Section 6. Application.
.01 The costs of development of software in accordance with the above procedures will be treated as a method of accounting. Any change in the treatment of such costs is a change in method of accounting subject to the provisions of sections 446 and 481 of the Code and the regulations thereunder.
.02 For taxable years ending after October 27, 1969, the date of publication of this Revenue Procedure, the Service will not disturb the taxpayer's treatment of software costs that are handled in accordance with the practices described in this Revenue Procedure.
.03 For taxable years ending prior to the date of publication of this Revenue Procedure, the Service will not disturb the taxpayer's treatment of software costs except to the extent that such treatment is markedly inconsistent with the practices described in this Revenue Procedure. For the purpose of applying the preceding sentence, the absence of any formal election similar to that required by section 174 of the Code, or the amortization of capitalized software costs over a period other than the five-year period specified in section 174(b) of the Code, will not characterize the taxpayer's treatment of such costs as markedly inconsistent with the principles of this Revenue Procedure.
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