Since late 2017, taxpayers have been implementing the congeries of changes wrought by the most significant revisions to the Internal Revenue Code (IRC) in a generation, the Tax Cuts and Jobs Act (TCJA). The interpretation and implementation of certain provisions of the TCJA is ongoing, as the Treasury and IRS continue to draft and finalize much-needed guidance.
Nearly four years out from the enactment of the TCJA, taxpayers now need to grapple with provisions set to change or sunset, which may lead to more taxable income and compliance burdens. One of the more surprising changes relates to IRC Section 174, Research and Experimental (R&E) Expenditures. In tax years starting after December 31, 2021, taxpayers will lose the ability to immediately expense these costs, and as such, should start developing a transition plan to maximize benefits while efficiently maintaining compliance.
From Immediately Expensing to Required Capitalization
Taxpayers have been able to elect to expense or capitalize R&E expenditures since 1954. For tax years beginning after 2021, however, all U.S.-based and non-U.S.-based R&E expenditures must be capitalized and amortized over five and 15 tax years, respectively, beginning with the midpoint of the taxable year in which the expenditure is paid or incurred. The taxpayer-friendly option to elect to currently expense these items will be eliminated, but a new potential benefit will arise: taxpayers will be able to deduct an expenditure beginning with the midpoint of the taxable year in which it was paid or incurred instead of having to wait until the first month in which they realize a benefit, as is currently the case if the costs are amortized. Taxpayers that previously were expensing the R&E expenditures likely will need to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing these expenditures. However, the IRS has yet to release new procedural guidance specifically addressing how taxpayers must comply with the new rule.
The TCJA also codified the administrative guidelines and practice of treating software-development expenditures as R&E expenditures. This means that software-development expenses paid or incurred in tax years starting after 2021 will no longer be deductible under Rev. Proc. 2000-50; instead, they will have to be capitalized and amortized over five or 15 years, depending on where the development takes place. Given the difference in amortization periods, taxpayers should factor the tax advantage of developing software in the U.S. into their decision of where to locate such development.
At the time of passage, the amendment to Section 174 was one of the lower profile changes introduced. To many who did take notice, requiring capitalization of these costs seemed contrary to the original Congressional intent of Section 174, which was to (1) encourage R&E activities and (2) eliminate the uncertainty about the tax treatment of research or experimental expenditures. Given the Biden administration’s emphasis in its “Green Book” explanation of tax proposals regarding the provision of additional support to encourage R&E activities in the U.S., it remains to be seen whether this amendment will be repealed as part of future tax reform. In the meantime, as 2022 draws nearer, the probability that taxpayers will have to address this new requirement seems more likely, at least in the short term, and they should start to plan accordingly.
Planning Into the Shift and Maintaining Compliance
Taxpayers seeking to maximize the benefit of immediately deducting R&E expenditures should consider the effective date of the required amortization rule (i.e., tax years after December 31, 2021) and if possible, accelerate their R&D activities into tax years starting before January 1, 2022.
Assuming no legislative change is made between now and 2022, taxpayers will have the added compliance burden of capitalizing all R&E expenses and recovering them over five or 15-year periods. Many taxpayers likely have a strong grasp of the amounts of R&E they incur, opting to accelerate the deductions and/or including them in the calculation of the research credit under Section 41. By definition, any costs included in the research credit calculation would need to be recovered under the five-year recovery period. As such, it is not hard to foresee taxpayer calculations serving as a road map to test for compliance with the new rule. However, it is important to note that the type of expenses eligible for deduction under Section 174 are generally broader than the type of expenses eligible for the credit under Section 41. Accordingly, taxpayers may need to examine additional costs outside of the amounts included in the credit calculation to determine whether they meet the definition of R&E expenditures under Section 174. To the extent costs are expensed under Section 162 but also meet the definition of R&E, taxpayers may have unknown exposure if the costs are not identified and capitalized. After identifying these costs, taxpayers will have to track amortization and make any necessary book/tax adjustments.
Another potential area of compliance difficulty could be identifying R&E expenditures performed abroad. For example, a taxpayer with a controlled foreign corporation (CFC) subject to GILTI and incurring significant R&E expenditures may need to review the current treatment of these expenditures. If R&E was properly deducted or recovered in any alternate way, the taxpayer may have to file an accounting method change on behalf of the CFC and properly recover over 15 years. Implementing correct accounting methods for various items to determine tested income or loss for GILTI purposes can be challenging; this may present yet another complexity in that effort.
Next Steps for Companies in Light of Amended Section 174
The TCJA requirement that research expenditures eventually be capitalized and amortized over five or 15 years will have a huge impact on all companies heavily invested in those activities. As discussed above, any types of costs currently deducted as Section 174 expenses, taken towards the research credit under Section 41 and/or immediately deducted as software-development expenditures should be identified and the potential impact of this change on those amounts should be considered. Other expenses (e.g., amounts previously treated as Section 162 expenses) incurred both domestically and abroad should be reviewed to determine if they meet the definition of R&E, and the potential impact on taxable income and process around compliance should be considered and assessed. As previously noted, while many taxpayers and tax practitioners are hopeful that the requirement for capitalization will ultimately be repealed, taxpayers should start considering the compliance and planning implications if the rule remains in place.