Tax treatment of research and experimentation (R&E) expenses and software development costs remain significantly changed for 2022 and beyond… for now.
Since 1954, taxpayers have been able to either immediately deduct R&E expenditures in the year paid or incurred or elect to capitalize and amortize over a period of at least 60 months. The Tax Cuts and Jobs Act (TCJA) of 2017 amended Internal Revenue Code (IRC) Section 174 to require U.S.-based and non-US-based research and experimental (R&E) expenditures to be capitalized and amortized over a period of five or 15 years, respectively, for amounts paid in tax years starting after December 31, 2021.
Despite widespread belief amongst the tax community and bipartisan support to delay the change to IRC Sec. 174, legislation, including the House version of the Build Back Better Act and the Inflation Reduction Act of 2022, both failed to extend this change past December 31, 2021.
However, Congress is racing towards a December 16th deadline to finalize new funding levels for fiscal 2023, and omnibus spending bills are a frequent vehicle used for tax extenders. And while bipartisan support still exists in both chambers and the business community urges Congress to act, the extension of IRC Sec. 174 is wrapped up with other extender provisions such as the expanded child tax credit, which some members of Congress have commented on the pairing as being a “non-starter.”
Perkins & Co is closely following Congress’ deliberations for the possible extension of IRC Sec. 174 as we know it. Read on below to learn more about changes to the tax treatment of R&E expenditures for tax years 2022 and beyond if Congress fails to act.
What is an R&E expense?
Section 174 expenses are costs incurred in connection to a taxpayer’s trade or business that represent research and development costs in the experimental or laboratory sense (Treas. Reg. Sec. 1.174-2(a)(1)).
The term “experimental” is intended to be broad and generic and includes costs incurred for activities intended to discover information that would eliminate uncertainty about developing or improving a business component. This refers to any product, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license (Treas. Reg. Sec. 1.174-2(a)(1) and (3)).
The R&E costs now required to be capitalized and amortized would not only include salaries of employees involved in R&E activities but also indirect overhead expenses such as rent, depreciation, utilities, supplies, etc.
Taxpayers should ensure that R&E expenditures incurred starting in 2022 are properly identified to assist with tax preparation and planning. Some taxpayers may be able to leverage existing systems/tracking to identify R&E. For instance, companies may already be identifying certain types of research costs for financial reporting purposes under ASC 730, and/or calculating qualifying research expenditures for purposes of the research credit under IRC Section 41.
What’s the Impact?
For companies that have historically immediately expensed Sec. 174 R&E costs, a temporary increase to taxable income (or temporary decrease to taxable loss) will occur in 2022 but will ultimately reverse in future years.
It’s important to note that the impact of Sec. 174 changes apply more broadly than to companies claiming an R&D credit under IRC Sec. 41. Sec. 174 expenses are more generic than Qualified Research Expenses under Sec. 41. That is because all Sec. 41 credit expenses (direct expenses) must qualify as Sec. 174 expenses (direct and indirect expenses), but not all Sec. 174 expenses meet Sec. 41 credit requirements.
Other areas that could impact taxable income projections and income tax provisions for 2022 include:
- Section 250 Foreign Derived Intangible Income (FDII) deduction: FDII benefits may increase due to increased taxable income (and therefore deduction-eligible income and foreign-derived deduction-eligible income) as a result of capitalized R&E expenditures.
- Section 163(j): Increased taxable income resulting from the capitalization of R&E expenditures may reduce disallowed business interest expense under Section 163(j) in a given year.
- Section 250 Global Intangible Low-Taxed Income (GILTI) calculation: The requirement to capitalize and amortize foreign R&E expenses over 15 years may significantly impact the amount of tested income.
- Section 861 allocations: Provisions involving the allocation of R&E expenditures, including FDII, GILTI, and the foreign tax credit, should ensure that all costs identified as Section 174 amounts are allocated in accordance with the rules provided under Treas. Reg. §1.861-17.
Finally, an unfavorable change was made with respect to the disposition, retirement, or abandonment of any Sec. 174 expenditures capitalized for tax years ending after December 31, 2021. Now, no current deduction is allowed in the event of a disposition, retirement, or abandonment; rather, the taxpayer must continue amortization of Sec. 174 expenditures over the remaining life.
Changes to software development costs
Software-development expenses paid or incurred in tax years starting after December 31, 2021, will no longer be deductible under Rev. Proc. 2000-50; rather, all expenditures are now treated as R&E expenditures under IRC 174. The tax treatment of acquired or licensed software will still be governed by Rev. Proc. 2000-50, allowing for the more rapid deduction of these costs that we are accustomed to.
How does this impact the Research & Development Credit (IRC 41)?
By definition, any costs included in the research credit calculation must be recovered under the five-year recovery period. As such, taxpayers with an existing methodology in place to calculate the research credit will likely be able to use such computations as a helpful starting point for determining R&E expenditures under Section 174.
Section 41(d) originally defined “qualified research” as research with respect to which expenditures may be treated as expenses under Section 174 and was modified to include “specified research or experimental expenditures” under Section 174 as part of the definition for R&D credit purposes resulting from the TCJA updates.
Section 280C(c)(1) was also updated to state that if the amount of credit determined for the taxable year under Section 41(a)(1) exceeds the amount allowable as a deduction for a such taxable year for qualified or basic research expenses, the amount chargeable to the capital account for the taxable year for such expenses shall be reduced by the amount of such excess. The Section 280C election to reduce the R&D credit, to the excess of the credit amount minus such credit amount multiplied by the highest tax rate, is only available if the gross credit exceeds the allowable Section 174 deduction for the current year.
These updates to Section 280C(c)(1) may encourage taxpayers to elect the gross R&D credit instead of electing the reduced credit under Section 280C, as the gross credit option will generally yield a more favorable result.
Taxpayers May Be Required to File for an Accounting Method Change in 2022
Taxpayers that previously were immediately expensing R&E expenditures may 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.
Oregon conforms to the IRC as it relates to federal taxable income on a rolling basis, so the requirement to capitalize/amortize Sec. 174 expenditures also applies to Oregon. On the other hand, some states (i.e., California) do not conform to the changes of TCJA, which allows Sec. 174 expenditures to continue to be immediately expensed. Perkins & Co’s state and local (SALT) tax experts can help you identify conformity in other states.
While we await further developments through the end of the year, we encourage clients to reach out to their Perkins & Co tax advisor, who can begin performing assessments of the impacts of R&E capitalization.