Capitalizing R&E expenditures requires detail focus

The Tax Cuts and Jobs Act (TCJA) resulted in significant changes to the treatment of research or experimental (R&E) expenditures under Section 174 that will require substantial work for many companies to implement this year.

For tax years beginning after Dec. 31, 2021, taxpayers are required to capitalize and amortize all R&E expenditures that are paid or incurred in connection with their trade or business which represent costs in the experimental or laboratory sense. Specifically, costs for U.S.-based R&E activities must be amortized over five years and costs for foreign R&E activities must be amortized over 15 years; both using a midyear convention.

Although there is bipartisan support for legislation postponing this change under Section 174, Congress failed to defer or repeal the new capitalization rules in 2022. While negotiations may resume this year, any legislation would not apply to financial statements for tax years beginning after Dec. 31, 2021, and ending before legislation was enacted. Therefore, taxpayers should be addressing the impact of amortizing these costs on 2022 financial statements. Given the challenges that legislation faces, companies should all be preparing to implement the changes for tax compliance, planning and payment purposes. 

Any new Section 174 rules could result in new, and potentially significant, book-tax differences and related deferred tax assets. It also has the potential to impact effective tax rates if a valuation allowance is required for the deferred tax asset or due to the indirect effects on other calculations, including the interest expense limitation under Section 163(j), the base erosion and anti-abuse tax (BEAT), global intangible low-taxed income (GILTI), or foreign-derived intangible income (FDII). 

Identifying affected expenditures

Taxpayers historically may not have characterized all applicable R&E costs as Section 174 costs. Instead, some R&E costs that were incurred incident to the research activities may have been treated as ordinary and necessary costs deductible under Section 162. Therefore, it is important that taxpayers analyze and potentially revise their methodology for determining Section 174 costs. It may require significant work to identify all costs that may be subject to Section 174 capitalization. Taxpayers will likely need to evaluate several data sources, including:

• Historical Section 174 computations,
• The computation of qualified research expenses (QREs) under Section 41, and
• Costs characterized as ASC 730 “book” R&D expenses for financial reporting purposes.

Taxpayers may have the option of using QREs used for computing the R&D credit under Section 41 or ASC 730 book R&D expense as an appropriate starting point to compute Section 174. The QRE approach would require several steps to "convert" QREs to Section 174 costs and to determine costs incurred incident to the research. The ASC 730 approach will likely require the identification of additional Section 174 costs not captured in book R&D expense.

The discussion below provides insights into the definition of “costs” subject to Section 174 treatment. Because most taxpayers will need to reconcile costs treated as QREs under Section 41 and/or book R&D expense as defined under ASC 740 to determine Section 174 costs, this article also includes an analysis of these costs.

How are Section 174 R&E costs defined?

Under Section 174, R&E costs must be for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, software, technique, formula, or invention (collectively referred to as a “product”) that is held for sale, lease, or license, or used in the taxpayer’s trade or business. Uncertainty relates to the capability, methodology, or design of a new or improved product.

The regulations provide further guidance as to the nature of expenses that qualify under Section 174. R&E expenditures are defined as expenditures used in connection with the taxpayer’s trade or business which represent research and development (R&D) costs in the experimental or laboratory sense. The regulations define these expenditures as all such costs incident to the development or improvement of a product, process, formula, invention, computer software, or technique.

While Section 174 and the regulations do not have an exhaustive list of costs that are incurred incident to the research, Treas. Reg. Sec. 1.174-4(c) provides taxpayers with an example where the following expenditures are treated as Section 174:

• Salaries
  
• Heat, light, and power
• Drawings
• Models
• Laboratory materials
• Attorneys’ fees, and
• Depreciation on build attributable to the R&E project

In addition to the examples in the regulations, interpretive guidance has been issued over the years that provides some insight regarding what costs are subject to Section 174 treatment.

In Rev. Rul. 73-275, a taxpayer was engaged in the business of developing and manufacturing specially built automated manufacturing systems. The ruling considered whether expenses connected with a product engineering department—including salaries and overhead—met the requirements of Section 174. The IRS considered that the sole purpose of the product engineering department involved design and development activities for products manufactured and sold by the taxpayer. Ultimately, the IRS ruled that the expenses connected with the product engineering department including the overhead expenses were Section 174 eligible.

Revenue Ruling 73-20 provides another example in which overhead costs were determined to be Section 174 eligible. In Rev. Rul. 73-20, the question of overhead costs arose in the context of a joint research venture in which the taxpayer participated. Two corporations were organized to carry out the venture: one to promote and collect funds from the taxpayer and other contributors for an R&D project, and the other to build and operate the R&D project. Costs for the R&D project were funneled through the promoting corporation to the corporation operating the project. The IRS ruled that the costs incurred by the taxpayer “in connection with” the R&D project and paid to the promoting corporation were Section 174 expenditures, including those costs that related to the administrative expenses of the promoting corporation.

Additionally, Field Attorney Advice (FAA) 20154501F considered what amounts are to be included in compensation when testing for reasonableness of compensation under Section 174(e). The FAA concluded that total compensation (i.e., taxable, non-taxable, and deferred compensation) was a relevant measure for determining whether the reasonableness requirement was met.

Section 41 QRE considerations

The TCJA included a conforming amendment to Section 41 to align with Section 174. More specifically, specified research expenses must be treated as Section 174 capitalized costs in order to be considered QREs under Section 41. Therefore, taxpayers must insure QREs are included in their overall Section 174 computation. As a result, it may be more efficient for taxpayers to begin with Section 41 QREs when determining Section 174 costs.

Under Section 41, Taxpayers are permitted to include certain R&D costs as QREs for purposes of Section 41 related to activities that meet a four-part test defined under Section 41(d)(1). This includes in-house research expenses—such as wages paid to employees performing qualified services, supplies used in the conduct of qualified research, and costs for computer rental (e.g., cloud computing) used in the conduct of qualified research. This also includes contract research expenses, which are 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.

As defined in Section 3401(a), the term “wages” means all remuneration for services performed by an employee for his employer (i.e., Form W-2, Box 1 amount). For self-employed individuals and owner-employees, the term “wages” includes the earned income (i.e., net earnings) of such employee.

The term “supplies” means any tangible property other than land or improvements to land, and property of a character subject to the allowance for depreciation.

The term “contract research expenses” means 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.

In addition, qualified research does not include any of the following:

• Research after commercial production
• Adaptation of existing business components
• Duplication of existing business components
• Efficiency surveys
• Activities relating to management function or technique
• Market research, testing, or development (including advertising or promotions
• Routine data collection
• Routine or ordinary testing or inspection for quality control
• Computer software (unless otherwise qualified under the regulations)
• Foreign research
• Any research in the social sciences, arts, or humanities, or
• Funded research

Because the definition of “costs” subject to Section 174 treatment is much broader compared to Section 41 QREs, taxpayers will need to establish a methodology to “convert” wage, supply, computer rental, and contract research QREs. In addition, taxpayers will need to determine an appropriate methodology to identify and allocate costs that are incurred incident to the research.

ASC 730: ‘Book’ R&D expense

ASC 730-10-25 requires that all R&D costs be recognized as an expense as incurred. However, some costs associated with R&D activities that have an alternative future use (e.g., materials, equipment, facilities) may be capitalizable.

“Research” is the planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process.

“Development” is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants.

Under ASC 730-10-15-3, R&D consists of “those activities aimed at developing or significantly improving a product or service (referred to as product) or a process or technique (referred to as a process) whether the product or process is intended for sale or use.” Furthermore, ASC 730-10-55-1 states that the following activities typically would be considered R&D within the scope of this Topic (unless conducted for others under a contractual arrangement):

• Laboratory research aimed at discovery of new knowledge
  
• Searching for applications of new research findings or other knowledge
• Conceptual formulation and design of possible product or process alternatives
• Testing in search for or evaluation of product or process alternatives
• Modification of the formulation or design of a product or process
• Design, construction, and testing of preproduction prototypes and models
• Design of tools, jigs, molds, and dies involving new technology
• Design, construction, and operation of a pilot plant that is not of a scale economically feasible to the entity for commercial production
• Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture, and
• Design and development of tools used to facilitate R&D or components of a product or process that are undergoing R&D activities.

ASC 730-10-55-2 states that the activities provided below typically would not be considered R&D within the scope of this Topic:

• Engineering follow-through in an early phase of commercial production
• Quality control during commercial production including routine testing of products
• Trouble-shooting in connection with break-downs during commercial production
• Routine, ongoing efforts to refine, enrich, or otherwise improve upon the qualities of an existing product
• Adaptation of an existing capability to a particular requirement or customer's need as part of a continuing commercial activity
• Seasonal or other periodic design changes to existing products
• Routine design of tools, jigs, molds, and dies
• Activity, including design and construction engineering, related to the construction, relocation, rearrangement, or start-up of facilities or equipment other than the following:
  • Pilot Plants
  • Facilities or equipment whose sole use is for a particular R&D project.
• Legal work in connection with patent applications or litigation, and the sale or licensing of patents.

Other considerations

Below are additional considerations to address when implementing the required Section 174 capitalization. This is not intended to be an exhaustive list, but it should illustrate the broad impact of the TCJA rule changes and emphasize the importance of making proper determinations.

Identifying Section 174 expenditures

Taxpayers should consider developing a process for identifying and tracking Section 174 expenditures in addition to implementing appropriate internal controls. Depending on a taxpayer’s facts, it may be reasonable to begin with either expenditures under Section 41 or ASC 730 and make the necessary adjustments to arrive at Section 174.

Expenditures may need to be evaluated at multiple levels (e.g., location, department, etc.) using the available documentation when identifying all costs incident to the research. Taxpayers should carefully account for the technical nuances with each set of requirements and should appropriately document this approach. In addition, all costs incident to the research includes direct and indirect costs which may need to be allocated between Section 174 and Section 162. Taxpayers should evaluate all facts when establishing allocation methodologies. If taxpayers can implement the necessary changes to contemporaneously track these costs, this could ease the administrative burden of identifying these costs after the tax year end.

Timing of the R&E benefit

While taxpayers will still receive a benefit for the R&E costs that are paid or incurred, these costs can no longer be deducted in the current tax year. The required amortization and capitalization will create a timing difference that could impact cashflow and funding activities such as R&D. For example, if a taxpayer incurred $1 million in R&E in the 2022 tax year, the current year benefit will only be $100,000 (i.e., 100% deduction divided into 5 years multiplied by the 50% midyear convention), effectively creating a 90% reduction in benefit for 2022. This reduction would be even greater for foreign R&E costs.

Additionally, if an R&E project is abandoned, then the taxpayer must continue to capitalize and amortize those costs over the five-or 15-year period. This could create a burden on certain taxpayers who have a short product development lifecycle and taxpayers who rely on significant participation from individuals outside of the U.S. Taxpayers may be receiving revenue from an R&E project that created a product, and yet they are still required to amortize the costs related to developing that product for a longer period. With the benefit being extended over a longer recovery period, the benefit could be impaired due to the time-value of money paired with inflation—depending on the magnitude and duration.

Changes to tax planning

Taxpayers will not be able to rely on tax planning strategies that were previously available when optimizing their tax positions. This includes relying on Rev. Proc. 2000-50 for software development costs and using Section 59(e) to amortize the costs over 10 years. Taxpayers will be required to reevaluate their tax planning strategies to account for the TCJA changes, especially if they have historically relied upon Rev. Proc. 2000-50, Section 59(e), or deducting R&E expenditures under Section 174(a).

Change in accounting method

The IRS recently released guidance (Rev. Proc. 2023-11), which modifies and supersedes the recently issued automatic procedures in Rev. Proc. 2023-08 for taxpayers to change their method of accounting to comply with the new capitalization and amortization rules provided in Section 174, as revised by the TCJA.

The necessary guidance provides administrative relief and allows taxpayers to file a statement with their federal income tax return in lieu of a Form 3115, Application for Change in Accounting Method, provided that the change is made in the first taxable year that the new Section 174 guidance is effective (i.e., the first taxable year beginning after Dec. 31, 2021).

The new procedures also provide favorable transition guidance for taxpayers that have already filed a federal income tax return for a short taxable year for which the new Section 174 guidance was effective.

Impact on research credit

Since conforming provisions for Section 41(d)(1)(A) were made to align with Section 174, taxpayers must treat costs as Section 174 for them to be includible in computing the research credit under Section 41. Prior to the TCJA changes becoming law, Section 41 only required the expenditures to be eligible for treatment under Section 174; however, the taxpayer may have treated them differently under another code section such as Section 162. A significant decrease in costs being treated as Section 174 could cause taxpayers to have limited or no research credit depending on the client’s facts such as trend in qualified costs.

International tax impact

These new rules could have an impact to the computation of several international tax items including global intangible low-taxed income, foreign-derived intangible income, the base-erosion and anti-abuse tax, and foreign tax credits.

Interest deduction limitations

Taxpayers should consider the impact of this Section 174 provisions on the computation of the limitation on the interest deduction under Section 163(j).

Section 263A impact

Taxpayers have likely taken positions that certain costs centers and related costs can be excluded from the Section 263A computation because they are Section 174 costs. These determinations will need to be considered when identifying Section 174 costs under either the Section 41 QRE or book R&D expense methods.

State and local tax impact

The requirement to amortize R&E expenditures rather than fully expensing them in the year they are paid or incurred will likely increase federal taxable income. For states that leverage components of the federal income tax return, this could increase the tax liability at the state level. Additionally, while many states employ a rolling conformity with the IRC, there are states that adopt the IRC as of a static date and do not currently follow the new Section 174 rules. Taxpayers will need to include this within their analysis and implementation of the Section 174 rules and continue to monitor states for further changes.

Next steps

Taxpayers will be required to establish a methodology for identifying and tracking all R&E expenditures based on the new capitalization requirement under Section 174. This will likely be a significant undertaking for taxpayers to comply with the TCJA changes based on the broad and subjective nature of these provisions.