Is there a CAS and / or FAR regulation that requires the capitalization of indirect expense related to the development of software for internal use?
If the above indirect expense is not capitalized, should the direct labor costs associated with this development of the software be excluded from the allocation base for the calculation of the contractor's overhead rate?
The Federal Accounting Standard Board's document on Accounting for Internal Use Software
may be the reference that your DCAA office is attempting to recall. Specifically, para. 16 states: "For internally developed software, capitalized cost should include the full cost (direct and indirect cost) incurred during the software development stage." However, this document provides recommendations, and is not binding.
Regarding your second question, you should consult again with DCAA office personnel for their recommendation on that matter. Whatever is decided, it's important that how the contractor treats a particular indirect expense is consistently applied to all its contracts.