Taxpayers are now required to capitalize and amortize research and experimental (R&E) expenses over five or 15 years for tax years beginning in 2022 or later. This change will affect a broad range of companies, and impact financial statements and tax returns in important ways. With legislation to reverse the change still floundering, businesses should be working to identify the affected costs and assess the impacts.
What are Section 174 research and experimental expenditures?
For federal income tax purposes, R&E expenditures under Section 174 cover a broad set of costs that companies incur when engaged in the development or improvement of a product or process. Generally, these costs are incurred for activities that are intended to eliminate “uncertainty” or where there are questions as to capability, methodology, or appropriateness of design. In practice, this definition is broad and encompasses a wide-range of expenditures.
Section 174 direct costs may include:
- computer rental (cloud computing)
- third-party contractor costs directly associated with the R&E activity
Section 174 indirect costs may include:
- allowance for depreciation of property used in connection with research
- attorney fees for making and perfecting patents
What types of businesses will be affected?
A broad range of companies are likely to have Section 174 expenditures that now must be capitalized and amortized, including businesses that:
- Claim R&D credits
- Report book R&D on ASC 740
- Develop software internally
- Develop new or improved products or processes
- Have inventory subject to UNICAP rules
How will recent changes impact my financials and tax liability?
The TCJA amended Section 174 relating to the federal income tax treatment of R&E expenditures that are paid or incurred for tax years beginning after Dec. 31, 2021. While companies may have historically deducted such costs for federal income tax purposes (or employed some other alternative recovery methodology), these new rules require capitalization and prescribe cost recovery over a period of five years for domestic R&E and 15 years for foreign R&E. Additionally, under the new rules, software development costs are explicitly required to be treated as R&E expenditures and are subject to the same capitalization and recovery rules.
While there were expectations that a change in the law to restore R&E expensing was possible, Congress failed to enact a legislated deferral of this capitalization provision. While negotiations may resume this year, companies will have to assess the impact of these new rules for their financial statements. These rules will result in new, and potentially material, book-tax differences and related deferred tax assets. In certain instances, effective tax rates could be impacted, especially where there are impacts to other tax calculations. Given the challenges that legislation faces, companies should also prepare to account for this change for tax compliance, planning, and payment purposes.
How does Section 174 interact with the Research Tax Credit under Section 41?
As discussed, Section 174 encompasses a broad range of expenditures, much broader than the definition of qualified research expenses (QREs) that are identified for purposes of computing the Research Tax Credit (RTC) under Section 41. Generally, QREs are comprised only of direct research expenditures incurred such as domestic wages, supplies, computer rental (cloud computing), and third-party contractor costs. Section 174 includes not only those costs, but many other costs (e.g., R&D conducted outside of the U.S., and indirect costs, among others) which are excluded from the RTC calculation. Companies may not have tracked and identified these costs. Further, many companies will have Section 174 expenditures even if they haven’t historically claimed the RTC. Companies will need to specifically identify Section 174 costs, as they are now subject to capitalization, and will need to implement a computational and documentation approach.
What are the implementation and maintenance challenges?
Companies will be required to establish a method for identifying and tracking all R&E expenditures covered under Section 174. This will likely be a significant undertaking for companies because of the broad and subjective nature of these provisions. As discussed above, many costs not traditionally thought of as “R&E” may be subject to Section 174 capitalization. Even companies that may initially think that they have a roadmap for identifying costs, through their historic RTC computations or financial statement reporting methods (e.g., ASC 740, tracking of software development expenses, etc.), may find those starting points do not provide a comprehensive approach to account for all R&E costs subject to capitalization. Further, with limited guidance from Treasury and the IRS expected in the short term, there are several technical considerations that companies will have to consider.
Identifying these costs is just the beginning as the required capitalization and amortization of Section 174 can impact other tax computations. For example, Section 174 capitalization can impact:
- Interest expense limitation computations under Section 163(j)
- State and local tax reporting as a result of states that have not conformed with the Tax Cuts and Jobs Act
- The treatment of R&E payments between related parties (e.g., U.S. parent paying for R&E conducted on its behalf by a CFC)
- The computations under the foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) regimes
- The determination of excludible Section 174 costs for Section 263A computational purposes
As you work through your tax provision and tax return filing process it is important to consider developing an approach to comply with these new capitalization rules.
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