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Final regulations on R&E expenses retain flexibility for taxpayers, clarify definitions

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Man examining computer componentOn July 18, the IRS issued final regulations (T.D. 9680) that retain the generally favorable provisions from the proposed regulations and provide added clarity on when certain research and experimentation (R&E) expenditures can be appropriately classified as Section 174 expenses. The final regulations are effective July 21, 2014, but can apply to open tax years.

The final regulations build on the proposed regulations (REG-124148-05) that were issued in September 2013 but offer important modifications, including a softening of the shrinking-back rule. In addition, because qualification for the Section 41 R&D tax credit requires meeting the Section 174 requirements, the final rules will also affect taxpayers claiming the Section 41 R&D tax credit.   

Background

Since 1954, taxpayers have been able to elect to currently expense research expenditures under Section 174. Regulations were released in 1957 and 1994 that defined the term “research or experimental expenditures” and provided some guidance on what types of expenses could qualify for Section 174 treatment.

The prior rules, however, left some key terms undefined and provided only sparse guidance on certain key issues related to Section 174 expenses, leading to controversy between the IRS and taxpayers with regard to which expenses qualified for Section 174 expensing and ultimately the R&D tax credit.  

Definition of uncertainty

The proposed regulations held that certain R&E expenditures may be eligible for deduction under Section 174 if the expenditures were paid or incurred after production began, as long as uncertainty relating to the development or improvement of the product remained. Costs of producing a product after uncertainty is eliminated do not qualify for Section 174 treatment.

The proposed regulations provided a facts and circumstances-based approach to defining uncertainty — an approach that remains unchanged in the final regulations. The IRS and Treasury Department acknowledged that some taxpayers asked for a bright-line standard, but ultimately declined to create one, saying the definition contained in the proposed regulations was sufficient.

By declining to offer a more specific definition of uncertainty, taxpayers may be allowed reasonable flexibility to apply the rules to their own facts and circumstances. Nonetheless, the government’s approach also could work against a taxpayer, because it provides little clarity on when Section 174 treatment no longer qualifies.

Pilot model modification

The proposed regulations defined the term “pilot model” as “any representation or model of a product that is produced to evaluate and resolve uncertainty.” This definition clarified that pilot models include not only small-scale product concepts or initial models, but also fully functional prototypes that can potentially qualify for Section 174 treatment.

The proposed regulations also offered an example as to how Section 174 should apply to multiple pilot models. That example [Example 5 under Treas. Reg. Sec. 1.174-2(a)(11)] could be read that deductibility of pilot model expenses should only be allowed if each pilot model is tested for a purpose that is different from any other pilot model.

The IRS modified Example 5 in the final regulations to clarify that it is not necessary for each pilot model to be tested for a discrete purpose for the costs of multiple pilot models to qualify as Section 174 R&E expenditures.

Shrinking-back rule

Arguably the most controversial provision of the proposed regulations was the implementation of the shrinking-back rule under Treas. Reg. Sec. 1.174-2(a)(5), which generally serves to disallow deductions under Section 174 for expenses incurred to eliminate uncertainty regarding design of components of a larger product. Such a situation could arise when a taxpayer incurs expenses to eliminate uncertainty regarding the integration of an experimental component with a nonexperimental product. Practitioners have been concerned that the provision may be used broadly by IRS examiners.

While the principle of shrink-back is retained in the final regulations, the term “shrinking-back” was removed, and references to Section 41 in that regard, which also refer to a concept of shrinking back, were also removed to avoid confusion. The final regulations also modified Example 8 and added a new Example 9 under Treas. Reg. Sec. 1.174-2(a)(11).

Example 9, which is intended to demonstrate the application of Section 174 to components of a product, is likely to be helpful to taxpayers, because it discusses when modifications to an existing design can qualify for Section 174 treatment and provides a clear example that taxpayers do not necessarily have to shrink back when modifying an existing design.

The preamble to the final regulations also makes it clear that the rules are sufficiently broad to cover the costs of testing performed to eliminate uncertainty regarding integration of an experimental component with a nonexperimental product. This acknowledgement that the integration of different components can meet the 174 requirements for the product as a whole is also helpful for taxpayers.

Impact

When it issued the proposed regulations, the IRS and Treasury issued a statement that said it “will continue to clarify the tax code in a way that promotes economic growth and job creation . . . [the] proposed rules provide the tax certainty necessary to reward businesses that invest in innovation.”  

By quickly promulgating final regulations that clarify definitions and provide greater certainty for taxpayers, the government has acted on that statement. Both the proposed and final regulations indicate the IRS and Treasury intend a friendlier environment for taxpayers hoping to benefit from the incentives provided by Sections 174 and 41.  

The final regulations are of particular interest to taxpayers that incur significant supply expenses for building prototypes, including companies in the manufacturing, aerospace and defense, automotive, shipbuilding, equipment, and similar sectors. Taxpayers acquiring or developing custom equipment or machinery may also be significantly impacted by the new guidance.  


Contact
Mark Andrus
503.276.5910
mark.andrus@us.gt.com

Joe Stoddard
801.415.1065
joseph.stoddard@us.gt.com

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