Publish Date

Sep 15, 2023


Industry Insights

On September 8th, Treasury and the IRS released Notice 2023-63 (the Notice), which showcased the rules they intend to propose regarding the mandatory requirement to capitalize and amortize specified research or experimental (SRE) costs under section 174, which became effective beginning in 2022. While the guidance provides helpful clarifications on several critical issues, the Notice is fraught with curious rules and raises numerous questions. Until the proposed regulations are issued, which would apply for tax years ending after September 8, 2023, taxpayers may generally rely on the Notice for tax years beginning after December 31, 2021, if they follow the guidance in its entirety and consistently. While businesses have long been seeking clarity on section 174 rules, it is unclear how many will choose to rely on the Notice before proposed regulations are released.

This alert discusses selected items in the Notice, including the scope of SRE expenditures and the potential implications for contract research, cost sharing arrangements, and corporate transactions.


Generally, SRE expenditures that must be capitalized under section 174 include costs related to the development or improvement of a product, as well as costs “incident to” those activities. The Notice clarifies that SRE costs would include:

  • All compensation costs (e.g., includes salary, benefits, taxes, and time-off) but not severance;
  • Certain overhead costs, such as rent, utilities, insurance, and taxes;
  • Materials and supplies;
  • Cost recovery allowances for property associated with SRE activities; and
  • Patent costs.

SRE costs would not include:

  • Certain indirect costs, such as costs for payroll, human resources, and accounting, even if the personnel perform functions for research staff or related to research activities;
  • Interest on debt to finance SRE activities; and
  • Certain internet and website related costs.

A&M Insight: For certain businesses, the Notice might provide some assurance that they reasonably excluded certain indirect costs in implementing section 174. While the scope of SRE costs was generally anticipated, some costs may be larger than anticipated. For example, pharmaceutical companies and manufacturers may no longer be able to deduct costs to create and perfect their patents. Additionally, the Notice provides that SRE costs cannot be capitalized under a myriad of provisions to circumvent the mandatory capitalization and amortization rules of section 174.

In general, the rules for allocating costs to SRE activities should be well-received. The Notice allows for the use of a cause-and-effect relationship or a method that reasonably relates costs to benefits provided to the activities. Taxpayers may apply different allocation methods for different types of costs, as long as they apply the method consistently. However, it is unclear whether the IRS and Treasury view each allocation method as an accounting method, which would require rules governing how a taxpayer could change their allocation methods. Overall, the cost allocation rules appear to be fair and provide sufficient flexibility.


Another scope issue concerns software development costs. The Notice provides that SRE expenditures include costs incurred for both internal-use software and software developed for sale or licensing to others, with some exemptions (e.g., databases not in the public domain or incidental to a computer program). For the definition of computer software, the Notice generally follows existing guidance (i.e., Rev. Proc. 2000-50 and section 197 regulations), taking into consideration technological developments (e.g., code that can be accessed remotely, such as via cloud computing).

The Notice further provides that software development activities under section 174 would include planning, designing the software, building a model, writing source code and converting it to machine-readable code, and testing. However, for internal-use software, the costs for training, maintenance (including debugging programming errors), data conversion, and installation generally would be excluded. Similarly, for computer software developed for sale or licensing to others, activities such as marketing and promotion, maintenance that does not give rise to upgrades and enhancements, distribution, and customer support would not be considered software development. Also, for many companies that purchase and install software (e.g., enterprise resource planning systems), it appears that the costs for configuring the software and for planning, designing, modeling, and deployment activities would not be considered software development expenditures, although the costs for upgrades and enhancements would be in scope.

A&M Insight: While the Notice clarifies what constitutes software development activities, the guidance raises some questions and concerns. For example, the costs for identifying and developing software requirements would be capitalized, which would be inconsistent with the treatment of those costs for financial statement purposes, which could be important for taxpayers that are subject to the corporate alternative minimum tax (CAMT).

The Notice also states that the guidance for treating SRE expenditures under section 174 affects the treatment of SRE expenditures for purposes of the research credit under section 41, although the Notice is not intended to alter eligibility for the credit, including for research with respect to computer software. Nevertheless, the interplay between sections 174 and 41 remains an ongoing concern.


In addressing questions regarding contract research, the Notice provides that costs incurred by contractors on behalf of another company would be treated as section 174 expenditures if the research provider bears financial risk or has the right to use the developed research or exploit the SRE product through sale, lease, or license. The research recipient would follow the general section 174 rules for capitalizing SRE costs.

A&M Insight: The contract research rule could wreak havoc in some situations because of the broader definition of costs subject to section 174. The Notice does not apply the same language as section 41 for research credits. For example, the concept of “funding” is provided under section 41 (and is actually turned on its head) and there is reference to the term “substantial rights.” Also, there could be a mismatch in revenues and costs — revenues would be recognized in year one while the costs would be amortized over either a five-year or fifteen-year period. The question remains whether a funding rule should be adopted for section 174, similar to section 41, that would exclude costs for funded research from the capitalization and amortization requirements.

The contract research rule would create another anomaly by requiring both the research recipient and the provider to capitalize the same SRE expenditures. The Notice does not provide broad anti-duplication rules to mitigate those situations.

The Notice also addresses the treatment of SREs and other expenditures covered by cost sharing arrangements. By way of background, under the portion of the section 482 regulations dealing with qualified cost sharing arrangements (QCSAs), cost sharing transaction payments are required between controlled participants to ensure that their resulting share of intangible development costs reflects their share of the reasonably anticipated benefits from the intangible property. Under the existing cost sharing regulations, a cost sharing transaction payment adjusts the participants’ intangible development costs — it increases the payor’s costs and reduces the recipient’s costs.

To address the fact that intangible development costs covered by a QCSA may include costs other than SREs, the Notice provides that the cost sharing transaction payments would first reduce the recipient’s capitalized costs and otherwise deductible intangible development costs. The payments would be allocated proportionately between those two types of costs, and if the payments exceed the recipient’s share of costs, the excess would be treated as income.

A&M Insight: If the cost sharing arrangement netting approach applies, then it would eliminate the duplication (i.e., more than one participant having to capitalize the same SRE expenditures) discussed above. However, a QCSA may not always be the optimal choice for the participants (i.e., a different method of cost sharing may be preferred), and in that case, the netting approach would not apply.


Section 174 requires taxpayers to continue amortizing SRE costs after the property (with respect to which SRE expenditures are paid) is disposed of, retired, or abandoned, which has spurred questions on potential implications for certain asset acquisitions and other transactions. The Notice, in addressing some aspects, provides that if a corporation ceases to exist as part of an acquisitive asset reorganization or as a result of certain liquidations, the acquiring corporation would continue to amortize the unamortized SRE expenditures over the remaining amortization period. In that case, the selling corporation would not factor the unamortized amount into its calculation of gain or loss on the sale. For other transactions, the corporation could deduct the unamortized SRE expenditures in its final taxable year, subject to an anti-abuse rule.

A&M Insight: While the Notice provides guidance on actual transactions, it fails to address how the unamortized costs should be treated in deemed transactions. For example, in a section 338(h)(10) transaction, does the buyer have increased goodwill, while the sold entity’s shareholders continue to amortize the SRE costs? Similarly, how are unamortized SRE costs treated for section 382 built-in-gain and built-in-loss calculations? It is clear that subsequent guidance will be needed on how section 174 applies in a variety of corporate transactions.


While it is still unclear whether Congress will address section 174, it is important for taxpayers to understand the potential ramifications of the interim guidance because it suggests the direction that Treasury and the IRS intend to take. The guidance does not address critical issues, such as how the rules apply to partnerships, and raises even more questions. For additional discussions on the Notice, please access our Virtual Coffee Talk, “Unpacking the Latest Section 174 Guidance.” If you would like to discuss specific implications of the interim guidance or other matters affecting your business and tax planning strategies, please feel free to contact Kevin M. Jacobs or Kathleen King.

The transition to capitalizing research and experimental costs under section 174 has been fraught with increasingly complex issues without much-needed guidance to resolve them.
Managing Director Kevin M. Jacobs speaks with CFO Dive on two provisions of the 2017 Tax Cuts and Jobs Act that went into effect last year that are still catching some finance leaders off guard.
The 2017 Tax Cuts and Jobs Act made significant prospective changes to Section 174 that will end expense deductions and require the capitalization of specified research and experimental (“R&E”) expenditures.