- IRS announces its intent to issue proposed regulations implementing Section 174 research expense capitalization.
- A new IRS notice (2023-63) provides interim guidance to address questions that have challenged taxpayers since the law change.
- Taxpayers still hold out hope that Section 174 gets fixed by Congress, thus rendering the notice and proposed regulations moot.
Impacted by Section 174 research capitalization?
Businesses got a reminder recently that the headaches caused by the research capitalization law change under Section 174 of the Internal Revenue Code were still very much alive when the IRS issued Notice 2023-63.
The notice — while much needed to help taxpayers struggling in the new research expense capitalization landscape — threw us some curveballs with the potential to make an already unfavorable situation even worse for U.S. organizations trying to innovate and stay competitive.
What does the new guidance mean?
Before we unpack the notice’s details, it’s important to learn what an IRS notice means.
The IRS releases a notice for three primary reasons:
- To announce that Treasury and the IRS intend to issue regulations for a particular tax statute,
- To request comments from taxpayers and practitioners as to how the forthcoming regulations should be crafted, and
- To provide interim guidance taxpayers can rely upon until the new regulations are issued.
Notices do not carry the same authority as statutes or regulations. Nonetheless, they can provide guidance to help taxpayers navigate new or complex areas of tax law, though guidance set forth in a notice might differ from the eventual regulations released. It’s also possible the regulations contemplated by a notice are never actually issued for various reasons.
In the context of Section 174, interim guidance was greatly needed from the IRS to help taxpayers implement the law change. However, because there’s bipartisan support in Congress to repeal or defer the Section 174 capitalization change, it’s conceivable Notice 2023-63 will not have a long shelf life.
What’s in the notice?
The 45-page notice covers a broad range of substantive and administrative items. Below are the major issues many taxpayers have grappled with in this first year of research capitalization.
Scope of Section 174
A fundamental issue the notice addresses is the definition and scope of specified research or experimental (SRE) expenditures under Section 174 considering changes made by the Tax Cuts and Jobs Act (TCJA). The notice generally looks to existing Treasury Regulation Section 1.174-2 for applicable definitions, but also adds new examples of the types of costs that fall within Section 174’s purview, including:
- Labor costs — Includes the cost of full- and part-time employees and independent contractors that perform, directly support, or supervise SRE activities. Labor costs include all elements of compensation, such as base compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave, payroll taxes, pension costs, and employee benefits. Severance pay, however, is not included.
- Materials and supplies — Includes the costs of materials and supplies used in SRE activities, as well as tools and equipment not depreciable under Section 168.
- Cost recovery — Depreciation, amortization, and depletion allowances in connection with property used for SRE activities must be capitalized. Amounts representing the amortization of research expenditures do not have to be capitalized, however.
- Patent costs — Includes the costs of obtaining a patent, such as attorney fees.
- Overhead costs — Includes rent, utilities, taxes, repairs, and similar costs with respect to facilities and equipment used for SRE activities.
- Travel costs — Costs for travel relating to SRE activities are capitalizable.
The guidance also notes some costs explicitly excluded from Section 174, such as:
- Costs paid by general and administrative departments that only indirectly support SRE activities (e.g., human resources, finance, accounting)
- Interest on debt to finance SRE activities
- Web hosting
- Costs to register a trademark or internet domain
The examples of included and excluded costs provided are generally consistent with the approach most practitioners have taken to date given the guidance already in existence under Section 174.
Allocating SRE expenditures
When it comes to allocating costs to SRE activities, the notice generally takes a cause-and-effect approach where the inquiry focuses on the relationship between a particular cost and how it benefits an SRE activity. Additionally, the allocation method for one type of cost may differ from the method used for another type of cost, although the method must be consistent within a particular cost type.
For tax year 2022, many taxpayers have specifically identified direct SRE costs while using one of two methods/ratios to allocate indirect costs (e.g., rent, depreciation):
- Direct SRE labor costs over total labor costs
- Square footage of a facility dedicated to SRE activities over total square footage of the facility.
The notice appears to sanction both approaches.
Treatment of software development
The inclusion of software development under new Section 174 was a major change impacting a broad range of businesses. The notice has provided some clarification on software capitalization.
The definition of software set forth is fairly broad and includes system software, programming software, application software, and embedded software. However, the notice importantly makes a distinction between new software functionality versus maintenance activities.
Specifically, Section 174 capitalization applies only to costs for software upgrades and enhancements. It does not apply to maintenance after the software is placed in service (in the case of software used internally by the taxpayer) or is ready for sale to a customer (in the case of software held out for sale, lease, or license).
This means companies must be able to differentiate between these two broad categories of activities. A reasonable method to allocate capitalizable and non-capitalizable activities and costs will be crucial for companies with software development spend.
One of the most challenging areas for organizations trying to implement Section 174 capitalization has been the proper treatment of research being performed under contract, both for contractors and customers. Unfortunately, the notice’s interim guidance is not taxpayer friendly in some important ways.
The notice addresses contract research both from the customer’s standpoint (or “research recipient”) and the contractor’s standpoint (or “research provider”). The treatment of costs paid by a research recipient continues to be governed by existing Section 174 regulations. These rules were originally drafted decades ago with full expensing in mind, and generally provide that costs paid to another person for research are subject to Section 174 if made at the research recipient’s order and risk.
Existing regulations under Section 174, however, are largely silent on costs paid by research providers — which has been a major source of confusion for taxpayers —and the notice takes a very expansive view of costs requiring capitalization in this area.
In particular, the notice says a research provider must be at financial risk of loss under an agreement in order for capitalization to apply but goes on to say the financial risk element is irrelevant if the provider has a right to use or exploit any SRE product in its trade or business without having to obtain prior approval from the research recipient.
In other words, the right to use the SRE product is the real determinative factor in the analysis.
Many practitioners expected the funded research issue to be governed by rules like the research tax credit under Section 41, which require both rights to the research and financial risk. Removing the financial risk prong of the analysis is a surprising move by the IRS and has the potential to significantly hurt research contractors. Additionally, the notice’s framework may result in situations where both the research recipient and provider are capitalizing costs under the same contract.
The proposed approach is concerning to research contractors operating under agreements and grants with governmental and nonprofit entities. Many small businesses funded by these sources could now be faced with capitalizing nearly all their research spend. This is viewed by many as a highly punitive result with the potential to put small companies out of business and discourage innovation.
The IRS, however, has requested comments in the notice as to whether the Section 174 funding rules should be modeled after research credit funding principles. This is expected to generate many comments from taxpayers, their advisors, and industry groups — with most commentators strongly advocating for the two-pronged “rights and risk” framework.
Dispositions of SRE property
New Section 174(d) was added by the TCJA. While brief, the subsection has caused no shortage of uncertainty. The new provision reads:
If any property with respect to which specified research or experimental expenditures are paid or incurred is disposed, retired, or abandoned during the period during which such expenditures are allowed as an amortization deduction under this section, no deduction shall be allowed with respect to such expenditures on account of such disposition, retirement, or abandonment and such amortization deduction shall continue with respect to such expenditures.
There have been many questions about the treatment of unamortized SRE costs considering various sale and disposition transactions a taxpayer may experience. The notice addresses several of these questions, but several remain:
- Section 381 transactions — If a corporation ceases to exist for federal income tax purposes in a transaction falling under Section 381(a), the acquiring corporation must continue amortizing the predecessor corporation’s unamortized SRE expenditures over the remainder of the applicable period (i.e., the five- or 15-year period required under Section 174).
- Other corporate transactions — If a corporation ceases to exist in a transaction where Section 381 does not apply (e.g., a dissolution), the corporation is allowed to deduct the full amount of unamortized SRE expenditures in its final taxable year.
- Sale of assets — The notice makes clear the sale of SRE property does not accelerate the deductibility of unamortized costs nor do such costs factor into the computation of gain or loss under Section 1001. The same treatment would apply for applicable asset acquisitions under Section 1060 and asset sale elections under Section 338(h)(10).
The notice’s failure to allow unamortized SRE costs in gain and loss computations is somewhat of a surprise since it’s a departure from pre-TCJA principles. Additionally, the notice does not address (but does request comments for) the treatment of unamortized SRE costs in the context of various partnership transactions, including contributions, distributions, mergers, and liquidations.
Until guidance is received relating to partnerships, taxpayers will be left guessing as to the proper treatment, which creates a degree of risk due to the complexities of partnership taxation, tiered structures, and IRS partnership audit rules.
Long-term contracts under Section 460
The interplay and priority between the percentage-of-completion method (PCM) for long-term contracts under Section 460 and capitalization under Section 174 have been vexing issues since the TCJA changes. The PCM generally requires taxpayers to deduct allocable contract costs as incurred and recognize revenue on that contract based on the ratio of current year allocable costs over total estimated costs of the contract.
Under current regulations, allocable contract costs include research expenses (other than independent research and development expenses). Therefore, as these expenses are incurred, they increase the completed portion of a contract and the percentage of the contract price to be reported. Since Section 174 now disallows a current deduction for the SRE costs, a mismatch inconsistent with PCM principles is created between the contract price and allocable costs.
To remedy the mismatch, the notice proposes amending the Section 460 regulations to provide that costs allocable to a long-term contract under the PCM include amortization of SRE expenditures rather than the capitalized amount of the expenditures. Such amortization is then treated as incurred for determining the percentage of contract completion as deducted. However, the notice requests comments whether this approach should be adopted in the proposed regulations.
The proposed rule would allow taxpayers using PCM to potentially defer a portion of income for at least one year (i.e., only 10% of the allocable 2022 SRE costs are included in the 2022 PCM calculation rather than 100%). But taxpayers would also be required to report remaining contract revenue in the year following the year of completion, regardless of SRE costs that remain unamortized.
The IRS anticipates the forthcoming proposed regulations will be effective for taxable years ending after September 8, 2023 (the issuance date of Notice 2023-63). Taxpayers may, however, generally rely on the notice for taxable years beginning after December 31, 2021.
The IRS also advised taxpayers it intends to issue automatic accounting method change procedures to comply with the notice, including procedures for taxpayers that already changed their accounting methods to comply with new Section 174 but whose methods do not fully comply with the notice.
How we can help
CLA’s research and development (R&D) tax team can help your organization navigate and implement the new Section 174 capitalization rules, which can be done on a standalone basis, or seamlessly as part of a research tax credit study.
Contact your CLA professional to learn how we can help your organization comply with these new rules.