Editor: Christine M. Turgeon, CPA
The 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 174 to require capitalization and amortization of research and experimental (R&E) expenditures and software development costs, effective for tax years beginning after 2021. Before the amendment, taxpayers had flexibility to either deduct in the current tax year or capitalize and amortize R&E expenditures and software development costs. The modifications to Sec. 174 may affect other areas of taxation, including the research credit under Sec. 41, international tax provisions, cost-sharing arrangements under Sec. 482, and accounting methods and likely will result in higher taxable income for certain taxpayers, the effect of which must be reflected in financial statements and estimated tax payments.
Historical treatment of R&E expenditures and software development costs
For tax years beginning before 2022, Sec. 174 allowed taxpayers to either deduct their R&E expenditures paid or incurred during the tax year or treat the R&E expenditures as deferred expenses that were deducted ratably over at least 60 months. R&E expenditures that were neither treated as current expenses nor deferred and amortized were required to be charged to a capital account and possibly amortized under Sec. 167. Alternatively, taxpayers that used a current expense method under Sec. 174 could elect annually under Sec. 59(e) to recover their R&E expenditures over a 10-year period.
For software development costs incurred in tax years beginning before 2022, under Rev. Proc. 2000-50, taxpayers could deduct costs paid or incurred during the tax year or treat the costs as a capital expenditure recovered through amortization deductions over a period of 60 months or amortization over a period of 36 months. Costs capitalized and amortized over a period of 36 months also were eligible for bonus depreciation under Sec. 168(k).
Treatment of R&E expenditures and software development costs after 2021
Amended Sec. 174 requires capitalization of R&E expenditures and software development costs and recovery through amortization over a five-year period (15 years for foreign research) for costs incurred in tax years beginning after 2021. The current deduction under Rev. Proc. 2000-50 and the annual election under Sec. 59(e) to recover R&E expenditures over 10 years no longer are available for Sec. 174 costs that are required to be capitalized and amortized.
Identifying Sec. 174 costs
Under prior Sec. 174, taxpayers expensing R&E expenditures had less need to distinguish these costs from expenses deductible under Sec. 162. The new capitalization and amortization regime requires taxpayers to identify and determine the proper amount of their Sec. 174 costs.
To correctly determine Sec. 174 expenditures, taxpayers must resolve a number of technical issues that currently are not addressed in regulations or other IRS and Treasury guidance, including:
- The definition or scope of R&E activities;
- How software development costs are defined (e.g., whether they include installation of acquired software);
- Whether Sec. 174 is an activity-based test, ownership-based test, or both;
- Whether Sec. 174 requires the taxpayer to be at risk for the development;
- Whether a contractor performing R&E services for a client has Sec. 174 expenditures where the contractor is not at risk and has no ownership rights in the resulting intellectual property;
- The extent to which overhead costs are considered Sec. 174 expenditures; and
- How domestic and foreign research activities are distinguished from one another for purposes of determining whether the costs are amortized over five or 15 years.
The TCJA also amended Sec. 41, the research credit, to define "qualified research" as research for which expenditures may be treated as "specified research or experimental expenditures" under Sec. 174. Accordingly, how Sec. 174 costs are defined also has implications for the research credit under Sec. 41.
A change in characterization of R&E expenditures, as well as the increase in taxable income as a result of R&E capitalization, may affect a taxpayer's Sec. 250 foreign-derived intangible income deduction, Sec. 951A global intangible low-taxed income profile, Sec. 59A base-erosion and anti-abuse tax (if the R&E expenditures are made to related foreign affiliates), and, as a positive effect, may decrease the amount of business interest disallowed under Sec. 163(j). R&E characterization and capitalization changes also may affect the allocation and apportionment of expenses under Sec. 861, including, in particular, under Regs. Sec. 1.861-8, dealing with computation of taxable income from U.S. and other sources and activities, and the allocation and apportionment rules for R&E expenditures under Regs. Sec. 1.861-17.
Issues may arise under amended Sec. 174 with respect to certain cost-sharing arrangements subject to Sec. 482, for example, between a U.S. parent that incurs U.S.-based R&E expenses and a controlled foreign corporation (CFC) that reimburses the parent for the CFC's share of the cost-shared R&E expenditures. In a typical cost-sharing arrangement, the CFC reimbursement would reduce the R&E expenditures reported by the U.S. parent such that the U.S. parent would report its income and expenses on a net basis. However, the proper treatment is uncertain if the U.S. parent must capitalize and amortize the gross amount of the R&E expenditures over five years because the cost-sharing regulations could be read to require a taxpayer to recognize income if the reimbursement received exceeds the amount of R&E expenditures that are deducted.
That is, if the gross basis of the U.S. parent's R&E expenditures is the amount amortized, then the U.S. parent may need to recognize income equal to the amount of reimbursed expenditures in year 1 that exceeds the amortization expense, causing a disparity in the amount of income and expense recognized. If, on the other hand, amortization is based on the net basis of the U.S. R&E expenditures, then the U.S. parent recognizes no reimbursement income in the transaction. It is uncertain which outcome the IRS would deem acceptable.
Accounting method issues
In addition to resolving technical issues, guidance is needed from the IRS and Treasury to provide the procedural rules to effect an accounting method change to begin capitalizing and amortizing Sec. 174 costs. The TCJA provides that the change in method of accounting from deduction to capitalization is treated as made with the IRS's consent. This change would be made on a cutoff basis for costs paid or incurred as of the first day of the year of change, and no adjustment would be made to the treatment of prior years' R&E costs. At least one case, however, has challenged the validity of similar legislative provisions allowing method changes without IRS consent (see Capital One Financial Corp., 659 F.3d 316 (4th Cir. 2011)). The IRS has removed Sec. 174 method changes from the automatic procedures but is expected to issue new procedural rules to effectuate these changes. Guidance under Sec. 174 is included in the IRS and Treasury Priority Guidance Plan for 2021-2022.
Guidance also is needed to address other areas affected by the nondeductibility of Sec. 174 costs. For example, Sec. 263A, which generally requires taxpayers to capitalize all direct and allocable indirect costs to inventory or self-constructed property, does not apply to an amount "allowable as a deduction under Sec. 174." The required capitalization and amortization of Sec. 174 costs makes it uncertain whether costs recovered as amortization are "allowable as a deduction" for this purpose.
Technical questions concerning the definition and treatment of R&E expenditures remain. The current lack of guidance from the IRS and Treasury poses a challenge to taxpayers, who must make reasonable interpretations when modeling the impact of the new rules under Sec. 174 for purposes of financial statements and estimated tax payments.
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Ms. Turgeon at 973-202-6615 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.