Earlier ERP software cost treatment still applies

Plain-English summary

Chief Counsel considered whether later intangible-property regulations displaced the IRS's earlier treatment of enterprise resource planning software costs. It concluded that the principles in PLR 200236028 still apply, although that ruling itself cannot be cited as precedent. Purchased ERP software and the option-selection and template-implementation work needed to make it usable must be capitalized. Rev. Proc. 2000-50 can permit current deductions for qualifying self-developed software costs, but it does not allow a deduction for every software-related cost. The advice also preserves the earlier distinctions for training costs, hardware, and acquired software amortization.

Ruling snapshot

• Question: Do the principles governing acquired and developed ERP software costs in PLR 200236028 remain applicable?
• Outcome: Advice given
• Key authorities: IRC §§ 162, 167(f), 174, 263(a); Treas. Reg. §§ 1.167(a)-14(b)(1), 1.263(a)-4; Rev. Proc. 2000-50

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201549024
       Release Date: 12/4/2015
       CC:ITA:B07: CJMagee
       POSTN-124481-15

UILC: 167.28-00

date: October 23, 2015

 to:   Associate Area Counsel - Houston (Group 2)
       Large Business & International
       Natural Resources and Construction (CC:LB&I:NR:PNX)
       Attn: Katelynn M. Winkler

from: Kathleen Reed
Chief, Branch 7
Office of Associate Chief Counsel
(Income Tax & Accounting)
(CC:ITA:7)

subject: Capitalization of Software Development Costs
POSTN-124481-15

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       ISSUE

              Whether the principles and conclusions of PLR 200236028 continue to apply to
       the treatment of acquired and developed software costs?

       CONCLUSION

             The principles and conclusions of PLR 200236028 continue to apply to the
       treatment of acquired and developed software costs.

       FACTS

             In PLR 200236028 (June 4, 2002), the Internal Revenue Service addressed the
       income tax consequences on the purchase, development, and implementation of

POSTN-124481-15 2

Enterprise Resource Planning (ERP) software acquired by a taxpayer from a third party
as well as acquired computer hardware. ERP software is a database software system
that integrates different business functions such as financial accounting, sales and
distribution, materials management, and production planning. Implementation of the
ERP system generally involves various categories of costs, including (1) costs to
acquire the ERP software package from the vendor, (2) costs to install the acquired
ERP 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,
(3) software development costs, and (4) costs to train employees in the use of the new
software. The ERP software is not usable until the implementation is completed. The
Service concluded the following:

   (1) The cost of the purchased ERP software (including the sales tax) is to be

capitalized under § 263(a) of the Internal Revenue Code and amortized under § 167(f)
ratably over 36 months, beginning with the month the software is placed in service by
the taxpayer;

   (2) The employee training and related costs (maintenance, troubleshooting, and

running reports during the training; such costs did not include any reorganizational
expenditures) are deductible as current expenses under § 162. However, the pre-paid
training expenses are deductible as a current expense in the year in which incurred
under the requirements of § 461;

  (3) The separately stated computer hardware cost is to be capitalized under

§ 263(a) and depreciated under § 168 over a 5-year recovery period;

   (4) If the taxpayer is solely responsible for the creation and performance of the

software project covered by the consulting contracts, the costs of writing machine
readable code software (and its allocable portion of the costs of modeling and design of
additional software) under the taxpayer's consulting contracts are self-developed
computer software and are allowed to be deductible as current expenses pursuant to
section 5.01(1) of Rev. Proc. 2000-50, 2000-2 C.B. 601; and

   (5) The costs of option selection and implementation of templates (and its

allocable portion of the costs of modeling and design of additional software) under the
taxpayer's consulting contracts are installation/modification costs that are to be
capitalized and amortized as part of the purchased ERP software ratably over 36
months, beginning with the later of the month the purchased software is placed in
service by the taxpayer or the month the template work is available for use by the
taxpayer. The undefined miscellaneous costs under the taxpayer's consulting contracts
are also capitalized as a part of the underlying purchased ERP software and amortized
over the same 36 month period described in the preceding sentence.

   On December 19, 2002, the Service and Treasury Department issued proposed

regulations that explained how § 263(a) applies to amounts paid to acquire, create, or
POSTN-124481-15 3

enhance intangible assets (the “proposed intangible regulations”). 67 Fed. Reg. 77701.
The proposed intangible regulations did not specifically address the treatment of ERP
implementation costs. Instead, the preamble to the proposed intangible regulations
provided that the Service and Treasury Department expected that the final regulations
would address these costs and, subject to the simplifying conventions provided in the
proposed intangible regulations for employee compensation, overhead, and de minimis
transaction costs, will treat such costs in a manner consistent with the treatment
prescribed in PLR 200236028.

    On January 5, 2004, the Service and Treasury Department issued final

regulations that explained how § 263(a) applies to amounts paid to acquire, create, or
enhance intangible assets (the “final intangible regulations”). T.D. 9107, 69 Fed. Reg.

436. The final intangible regulations also did not specifically address the treatment of
     ERP implementation costs. The preamble to the final intangible regulations stated that
     issues relating to the development and implementation of computer software were more
     appropriately addressed in separate guidance, and not in the final intangible
     regulations. The preamble further provided that, while the final intangible regulations
     require a taxpayer to capitalize an amount paid to another party to acquire computer
     software from that party in a purchase or similar transaction (see § 1.263(a)-4(c) of the
     Income Tax Regulations), nothing in the final intangible regulations was intended to
     affect the determination of whether computer software is acquired from another party in
     a purchase or similar transaction, or whether computer software is developed or
     otherwise self-created (including amounts paid to implement ERP software). The
     preamble indicated that the issue of the treatment of ERP implementation costs was
     more appropriately addressed in separate guidance dedicated exclusively to computer
     software issues and, until such separate guidance was issued, that taxpayers may
     continue to rely on Rev. Proc. 2000-50. The preamble to the final intangible regulations
     did not cite to PLR 200236028. To date, no separate guidance has been issued.

LAW AND ANALYSIS

 Some taxpayers are taking the position that the conclusions set forth in PLR

200236028 no longer apply following the promulgation of § 1.263(a)-4. We disagree.

   Section 162(a) provides, in part, that there shall be allowed as a deduction all the

ordinary and necessary expenses paid or incurred during the taxable year in carrying on
any trade or business.

   However, section 263(a) provides, in part, that no deduction shall be allowed for

any amount paid out for new buildings or for permanent improvements or betterments
made to increase the value of any property or estate. Section 1.263(a)-4 provides rules
for requiring the capitalization of costs associated with the acquisition or creation of an
intangible asset.
POSTN-124481-15 4

   Section 1.263(a)-4(c)(1) requires a taxpayer to capitalize amounts paid to

another party to acquire any intangible from that party in a purchase or similar
transaction. Section 1.263(a)-4(c)(1) also provides a nonexclusive list of examples of
the types of intangibles taxpayers must capitalize including, in relevant part, computer
software. Section 1.263(a)-4(c)(1)(xiv).

   Section 1.263(a)-4 did not render PLR 200236028 obsolete. The cost of the

purchased ERP software (including the sales tax) are capital expenditures pursuant to
§ 263(a) and § 1.263(a)-4(c)(1)(xiv). Because the ERP software is not usable to the
taxpayer without the option selection and implementation of templates, the costs of
option selection and implementation of templates (and its allocable portion of the costs
of modeling and design of additional software) are capitalized as part of the purchased
ERP software. See § 1.263(a)-4(g)(1).

  Some taxpayers are taking the position that Rev. Proc. 2000-50 allows the

deduction of all software costs. We disagree.

  Rev. Proc. 2000-50 provides guidelines on the treatment of the costs of computer

software. Section 2 of Rev. Proc. 2000-50 defines the term “computer software” as any
program or routine (that is, 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.

   Section 5.01 of Rev. Proc. 2000-50 provides, in part, that the cost of developing

computer software in many respects so closely resemble the kind of research and
experimental expenditures that fall within the purview of § 174 as to warrant similar
accounting treatment. Accordingly, the Service will not disturb a taxpayer's treatment of
costs paid or incurred in developing software for any particular project where 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 § 174.

   Section 6.01(2) of Rev. Proc. 2000-50 provides that with respect to the costs of

acquired computer software, the Service will not disturb the taxpayer's treatment of
costs that are separately stated if the costs are consistently treated as capital
expenditures for an intangible asset the cost of which is to be recovered by amortization
deductions ratably over a period of 36 months beginning with the month the software is
placed in service, in accordance with the rules under § 167(f)(1). See § 1.167(a)-
14(b)(1).

    Section 4 of Rev. Proc. 2000-50 provides that this revenue procedure applies to

all costs of computer software as defined in section 2 of Rev. Proc. 2000-50.
Accordingly, Rev. Proc. 2000-50 applies only to the costs for computer software as that
term is defined in section 2 of Rev. Proc. 2000-50.
POSTN-124481-15 5

   Accordingly, the principles and conclusions contained in PLR 200236028

continue to apply. However, PLR 200236028 may not be used or cited as precedent.
See § 6110(k)(3).

   This writing may contain privileged information. Any unauthorized disclosure of

this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.

  Please call (202) 317-7005 if you have any further questions.