Key Considerations for the Changing Tax Treatment of Research and Experimental Costs

R&E costs 2

Beginning during the 2022 tax year, taxpayers are required to capitalize Internal Revenue Code (IRC) section 174 (IRC §174) research and experimentation (R&E) expenditures and amortize them over five years for domestic R&E, and 15 years if the R&E is conducted outside the US. The definition of R&E has expanded to include software developments costs. These changes are brought forth by provisions within the 2017 Tax Cuts and Jobs Act (TCJA) which removed the option for taxpayers to immediately expense R&E expenditures starting with the 2022 tax year. Many practitioners believed legislation would have extended the immediate expensing methodology given the bipartisan support for this provision. However, Congress has not yet issued an extension, and it is unclear whether Congress intends to do so before the end of 2022.

Taxpayers must determine how the change from immediately expensing to capitalizing and amortizing R&E costs impacts their estimated tax payments, tax returns, financial statements, and their overall cash management. Tax planning and tax positions taken could also have consequences outside of IRC §174. Further, the determination of what is considered an R&E cost may require coordination across business functions which can be time consuming. Companies should expect issues in the following areas:

Topic Consideration
Cash flows Lower tax shields due to the loss of immediate expensing could create a higher cash tax obligation. Cash will need to be managed for estimated payments in 2022 and should be part of an organization’s year-end planning.
Attribute planning Consider whether there will be an increase in taxable income and if it has a corresponding impact to tax attribute utilization (e.g., net operating loss, general business credits). Consider this to attribute and cash tax modeling for 2022 and thereafter.
TCJA Interaction Consider impacts to allocation and apportionment for FDII, FTC utilization, IRC §163(j) limitations, and a Company’s GILTI computation.
State and local tax Consider state tax footprint and an organization’s unique application of state conformity/decoupling of the IRC §174 capitalization. Like federal tax, there will be state cash-tax considerations.
R&D tax credit Coordination with existing amount of QRE and consideration to any IRC §280C election.
Identification of R&E activities Understand organization costs and apply available guidance to bifurcate ordinary and necessary expenditures from IRC §174 R&E expenditures. This may be a cross-functional activity within an organization.
Identification of Foreign and domestic R&E activities Identify intercompany payments and properly capitalize costs as an expense (e.g., IRC §162) or capitalized R&E. Understand impact to GILTI calculation, impact of five year and 15-year amortization rules, and potential ‘double capitalization’ issues.
Transfer Pricing Coordination with existing positions, cross border payments, and documenting both the R&E amounts and transfer pricing adjustment amount.

Taxpayers should work with their tax preparers and advisors to understand their specific facts and circumstances to avoid being surprised by amounts reported on estimated payments, tax returns, and their financial statements.

Congress Fails to Extend Immediate Expensing Option for R&E Costs

Changes to the treatment of R&E, enacted as part of TCJA, are effective for tax years beginning after December 31, 2021. Although there was advance notice for this change, many expected the option to immediately expense R&E costs to be extended by congress before the end of 2022. The proposed Build Back Better Act which passed in the House of Representatives called for a four-year extension, however, the bill stalled in the Senate. While the recently enacted Inflation Reduction Act of 2022 contained certain tax provisions such as a corporate minimum tax rate and carried interest provisions, it did not extend the option to immediately expense R&E costs.

The changes to IRC §174 require R&E expenditures to be capitalized and amortized over five years, and 15 years if conducted outside the US for tax years beginning after 2021. The five year and 15-year amortization periods for R&E activities are subject to a midyear convention. The requirement to capitalize R&E expenditures creates new challenges for taxpayers including significant impacts to estimated quarterly payments, tax provisions, annual tax return compliance, cash management and organizational planning.

Beginning in 2022, software development costs are specifically defined as an R&E expense and are required to be amortized over five years.

Identification of R&E Costs

As a result of IRC §174, organizations must now track R&E expenses separately from ordinary and necessary expenses which can be difficult due to lack of technical guidance. Since IRC §174 R&E costs and IRC §162 Ordinary and Necessary expenses both allowed for immediate tax deductions, taxpayers did not previously need to segregate R&E costs from other costs.

The Treasury Regulations (Regulations) define R&E expenditures as costs incurred in connection with a trade or business which represent research and development costs in the experimental or laboratory sense and include all costs incidental to the development or improvement of a product. A product includes any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used in a trade or business as well as held for sale, lease, or license.

The existing Regulations provide limited guidance on what is not considered an R&E expenditure. The legislative intent demonstrates that R&E classification should apply to the nature of the activity to which the cost relates to, rather than the product. For example, quality control testing (not done in connection with a product design), efficiency studies, consumer surveys, management studies, advertising, and the cost of acquiring a patent, model, production, or process are not considered R&E expenditures and their deductibility is determined under IRC §162. Absent additional guidance, we believe specified R&E expenditures will include the same types of expenses subject to pre-TCJA R&E such as:

  • Salaries for those engaged in R&E
  • Costs incurred to operate research facilities such as utilities, depreciation and rent
  • Expenditures for materials and supplies consumed in R&E
  • Software costs afforded similar R&E treatment

 

A Change in Accounting Method

The change also brings additional compliance challenges as we expect Taxpayers will be required to file a Form 3115 – Application for Change in Method of Accounting. The TCJA Committee Reports provide that the rule will be applied on a cutoff basis, and therefore, there will not be an IRC §481 adjustment relating to the method change to comply with the new regime. In addition, an accounting method change may also need to be filed on behalf of a controlled foreign corporation (CFC) to properly capitalize and amortize R&E over 15 years which adds complexity to Global Intangible Low-taxed Income (“GILTI”) calculations.

Immediate Impact of R&E Deductions

Taxpayers can expect a minimum 90% decrease in allowed expenses in its first year’s application of post TCJA IRC §174. For taxpayers with R&E performed outside the US, this decrease can be even more significant given the 15-year amortization period for non-US R&E and also potential double capitalization for R&E performed by CFCs.

R&D Credit Impact

A specified research expense must be treated as an IRC §174 capitalized cost to be considered a Qualified Research Expenditure (QRE) for R&D credit purposes under IRC §41. Prior to the effective dates of TCJA changes, IRC §41 only required that costs were eligible under IRC §174. Therefore, to the extent a taxpayer has a QRE cost, they must be sure its correctly identified as an IRC §174 cost rather than an IRC §162 ordinary and necessary expenditure.

Contract R&D

Payments made by an Intellectual Property (IP) owner to a third party for research and development or experimentation is generally considered an IRC §174 expense for the IP owner. However, the application to the service provider is unclear. If a service provider is required to treat expenditures as an IRC §174 expenditure, requiring amortization over five years, a contract R&D service provider could see a significant income tax consequence as a result of a significant timing difference.

Please contact one of our tax leaders for more information on how WilliamsMarston can assist your company with the changing tax treatment of R&E Costs:

Bruce Major
Partner – Boston
Ph: (617) 823-7553

Brian Femia
Partner – Boston
Ph: (781) 405-5506

Leah Lavigne
Partner – Boston
Ph: (978) 273-0858

Martin Moffett
Partner – Southern California
Ph: (213) 713-2604

Daniel Moyer
Partner – Boston
Ph: (617) 974-1649

The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of IRC 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.