Publish Date
Jun 01, 2023
Industry Insights
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. With the 2022 tax filing season well underway, companies are taking different implementation approaches amid significant uncertainty, while still hoping for some congressional action to delay the capitalization rules imposed by the Tax Cuts and Jobs Act (TCJA).
Under section 174, effective for taxable years beginning after December 31, 2021, taxpayers must capitalize and amortize certain costs over a five-year or fifteen-year period for domestic research and foreign research activities, respectively. The TCJA also expanded the scope of section 174 to include all software development costs. In this alert, we provide some perspectives on selected issues in applying section 174, including:
The scope of research costs under section 174 is broad because it includes costs related to the development or improvement of a product, as well as those that are “incident to” such development or improvement, which could include costs for non-research personnel, contract services, materials, and facilities (e.g., rent and utilities). The IRS has acknowledged that the scope of section 174 costs remains uncertain and is evaluating a range of options, such as:
A&M Insight: As a result of the lack of guidance, taxpayers are scouring to identify departments and cost categories with activities that directly or indirectly relate to the creation or improvement of a product or a process. Unfortunately, without guidance, determining the scope of section 174 costs is not straightforward nor are there shortcuts. On the one hand, due to the incident to component, section 174 costs may include costs that would not be eligible for the section 41 research credit (R&D credit). On the other hand, because of the section 41 “substantially all” standard, some costs that are eligible for the R&D credit may not be section 174 costs. As a result, to effectively implement section 174, businesses need to develop a comprehensive framework to identify (1) activities and costs that are primarily for research purposes and (2) the indirect costs, for which mechanisms and controls to compute allocations on a regular basis may be needed.
The determination of what constitutes section 174 expenditures is further muddied by the TCJA’s inclusion of software development within the scope of costs that must be capitalized. Pre-TCJA, taxpayers had some flexibility in determining whether to immediately expense those costs or use alternative amortization rules, relying on Rev. Proc. 2000-50 for guidance. That guidance, however, focuses primarily on the definition of computer software rather than on software development activities and costs.
A&M Insight: Technology has significantly advanced since the IRS issued the software guidance in 2000, with, among other things, the expanded capabilities and usage of smart phones and the more pervasive use of artificial intelligence. Therefore, like cryptocurrency, the guidance regarding software does not reflect the current environment and it is unclear how the old guidance should be applied in determining the scope of software development under section 174. For example, how should solutions using open-source software be treated and how should activities required to configure and test software packages (e.g., enterprise resource planning (ERP) systems) be classified. As noted above, taxpayers should be wary of simply relying on section 41 rules without further analysis because the standards are different.
The IRS has provided that the implementation of section 174 is a change in accounting method, and therefore certain procedures must be followed. Fortunately, the IRS issued simplified procedures in Rev. Proc. 2023-11 for the first taxable year beginning after December 31, 2021: in lieu of filing a Form 3115, “Application for Change in Accounting Method,” taxpayers may attach a statement to their tax returns, which includes:
A&M Insight: While the requirements under Rev. Proc. 2023-11 are relatively straight forward, questions may arise regarding the appropriate level of detail for the expenditures and whether companies should attach a statement even if they do not have any section 174 expenditures in that taxable year. Further, Rev. Proc. 2023-11 did not provide any specific guidance as to how controlled foreign corporations (CFCs) should comply with the additional regulatory requirements for CFCs to change their method of accounting, and as a result U.S. shareholders of the CFCs will need to carefully consider how to adopt the change in method for their CFCs.
Under the TCJA, because taxpayers are no longer able to immediately deduct the section 174 expenditures, conforming changes were made to the section 280C rules which were originally intended to prevent a “double benefit” — taxpayers receiving a credit and a deduction for the same research expenditure. Under the revised statute, if a taxpayer’s R&D credit exceeds the allowable research expense deductions, the taxpayer must reduce the capitalized amount or elect to reduce its R&D credit by 21% (the current maximum corporate tax rate).
A&M Insight: Pre-2022, most taxpayers that could fully deduct their section 174 expenditures elected to reduce their research credit under section 280C. Because of the new amortization requirement, taxpayers should reanalyze their decision as they may be able to obtain an unexpected benefit.
Finally, it is extremely important for taxpayers to ensure appropriate documentation of their section 174 analysis and decisions. Businesses know too well how crucial documentation is for ensuring that their R&D credit claims withstand IRS scrutiny. Taxpayers that have implemented processes and procedures for the credit may be halfway there but more work is needed to address the full scope of section 174 costs. Companies should formulate a strategy and approach for substantiating their classification of research costs and collection of data. At a minimum, documentation should identify and explain:
As October 16th approaches — the extended due date for filing 2022 tax returns for most companies — it will become less likely that any legislation (if Congress could overcome the current gridlock) would be retroactively effective. This alert highlights only some issues companies are grappling with as the list continues to grow. For example, because section 174 costs continue to be amortized regardless of whether the property with respect to which the section 174 costs were incurred is disposed of, it is unclear how to account for the costs in asset reorganizations, deemed asset acquisitions (including section 336 and 338 transactions), and change in control transactions. Additionally, there is uncertainty as to how to treat funded research for both the payor and payee, which the IRS has acknowledged. While waiting for meaningful guidance, taxpayers must determine reasonable approaches to these and other issues. For additional discussions, please access our Virtual Coffee Talk, “Managing Section 174 in Uncertain Times.” If you would like to discuss your specific challenges and concerns in navigating the capitalization rules, leveraging available tax credits, and assessing business and tax planning strategies, please feel free to contact Kevin M. Jacobs or Kathleen King.
