In 2017, Pub. L. No. 115-97 (commonly referred to as Tax Cuts and Jobs Act) was enacted. A marquee feature of that tax act was the reduction of corporate tax rates from as high as 35% to 21%. In order to pay for the large reduction in rates, Congress also passed other less advertised changes and, in some cases, delayed the effective date.
Revised Internal Revenue Code Section 174 (Section 174) Requires Capitalization and Amortization of Research and Software Development Costs.
The effect of one such unfavorable change was to significantly delay the tax benefit/timing of certain deductions associated with research and software development (R&D) expenditures. The effective date of this highly unpopular change was scheduled several years in advance of enactment of the Tax Cuts and Jobs Act. For calendar year taxpayers, the effective date was 1/1/2022. As mentioned below, the revised Section 174 requires certain R&D costs incurred for 2022 and beyond to be capitalized and amortized, where the old Section 174 allowed for immediate write-off.
At the time of enactment, many informed tax practitioners expected this new provision to be repealed or further delayed before it ever became effective. Unfortunately, neither occurred and the law became effective as originally scheduled. For many research-based or software development companies, this rule had the potential to cause a serious cash flow challenge. Many companies who expected to report big losses for 2022 actually reported taxable income. Unless the income was sheltered by net operating loss deductions or research credits, some companies had an unexpected tax liability to fund.
The fact the law became effective as scheduled also presented a significant challenge to tax return preparers. No interpretive guidance was issued in advance of the effective date. Many questions regarding which costs are affected by the change and how to allocate affected in-direct costs were unanswered at the time most returns for 2022 were prepared. Implementing the revised law also included a mandatory accounting method change, i.e., capitalizing all affected expenditures and then amortizing the capitalized costs over a “5 year” or a “15 year” schedule, for U.S. domestic costs and foreign based costs respectively. Since the law prescribed a “half-year convention” in the first year of the schedule, only 10% of the costs capitalized in 2022 were allowed as amortization for U.S. based costs (one-half of a 20% per year straight-line amortization schedule). This means the final 10% is not allowed until the sixth year of the scheduled amortization. Similar rules exist for foreign based research and development costs, except the amortization period requires 16 years.
The revised law also prevents the write-off of the unamortized costs when the property is disposed of. In general, the amortization must continue as scheduled following a disposition of the property with few exceptions. This aspect represents an unwelcome departure from general disposition rules in a taxable sale transaction.
September 2023 – The IRS Finally Issues Guidance
On September 8, 2023, the IRS issued Notice 2023-63 (the Notice). It provides interim guidance with respect to Section 174 capitalization and anticipates soon-to-be-issued proposed regulations. The IRS states in the Notice that these proposed regulations will apply for tax years ending after September 8, 2023. Presumably, the guidance in those regulations will follow the Notice. However, the guidance may also be relied upon for prior years (2022 and pre-issuance 2023).
Please note that the following discussion only briefly highlights selected portions of the Notice. A complete review of the Notice is required before implementing its provisions. We strongly suggest the reader consult an informed tax practitioner regarding these provisions before making decisions affected by Section 174 or the Notice.
The rules related to capitalization under Section 174 use the term “specified research or experimental” expenditures (SRE expenditures). I abbreviate that term to “SRE” in my comments below. Please note that the revised Section 174 (see the Background discussion above) also covers software development costs as discussed below:
Allocation Method (In-Direct R&D Costs)
The Notice mentions using a “cause and effect relationship” approach when allocating direct and in-direct costs, that is, an allocation method should be based on how a particular expenditure affects the SRE activity. For example, allocation of rent to an SRE activity might look to the ratio of square footage used (this approach is an example in the Notice). The new guidance also explains that using different methods for different expenditures is acceptable. However, the method chosen for a particular type of expenditure must be used on a consistent basis (year-to-year).
General and Administrative Costs
When determining which costs must be capitalized, many question arise about general and administrative costs that may indirectly affect SRE activities, e.g., how should they be allocated to SRE activities?
The Notice is clear that general and administrative costs that only indirectly support research/development activity are not required to be capitalized. The Notice mentions payroll, accounting, and human resource personnel, and acknowledges that, for example, even though some accounting staff may account for research costs, the wages paid to the accounting staff are not required to be allocated to SRE activities.
Interest on Debt to Finance SRE Activities
The Notice provides that interest on debt that is used to finance SRE activity is not required to be capitalized.
Costs incurred for web hosting that involve the payment of a specified, periodic fee to an ISP in return for hosting a web site are not required to be capitalized. That creates the question regarding costs paid to a hosting service for hosting research activity. Are they required to be capitalized?
The language used in the Notice seems drafted to be very limited with respect to hosting, accordingly, it’s reasonable to presume that fees for hosting a research network used for software development or research are subject to capitalization (until further clarity is provided).
Domain Names and Trademarks
Costs to register a domain name or trademark are not subject to capitalization per the Notice.
Previously, Rev. Proc. 2000-50 prescribed the treatment of certain software costs. Consistent with the revised Section 174, the Notice provides that Section 174 applies to software development activity and provides helpful definitions (see Section 5 of the Notice). It discusses what the IRS considers software development (i.e., subject to capitalization) for this purpose and states that the Rev. Proc. is obsolete now.
These rules make it clear that development costs related to implementation of purchased software, including configuration of pre-coded parameters to make it compatible with a taxpayer’s business, are not activities that constitute software development for this purpose.
Certain Costs Associated with Software Developed by the Taxpayer for Internal Use
Some costs associated with implementation of internal use software such as training employees and maintenance costs are mentioned as examples of costs that are not software development costs (i.e., not subject to capitalization).
Write-Off of Unamortized Costs Prohibited When the Related Property is Disposed of
Section 174 prohibits claiming a deduction for unamortized Section 174 costs/unamortized SREs when the developed property for which these costs were incurred is disposed/sold/abandoned. The Notice confirms this treatment (see Section 7 of the Notice). It states that even if a corporation later goes out of existence the remaining costs must continue to be amortized. Unamortized costs associated with property that is sold in a taxable transaction can only be written off in the final tax year of the corporation. (The Notice only speaks to corporate treatment).
An exception to this rule is in the case of a transaction described in Section 381(a) (tax free reorganizations, etc.). The Notice also states the if property is transferred by a corporation in a Section 351 transaction, the transferor must continue to amortize the remaining SREs.
Transfers of Property To and From Partnerships
The Notice guidance is clear that the rules mentioned above do not apply to property transferred to and from partnerships. Presumably guidance on unamortized SRE costs associated with partnership transactions is to be provided in the future.
Amortization of Property
Guidance related to short year amortization of capitalized costs, including how to amortize in the year the property (related to the SREs) is transferred to another corporation, is also provided in the Notice.
Long Term Contract Accounting
The Notice also addresses how Section 174 applies to Long Term Contract accounting under Section 460. See Section 8 of the Notice.
Cost Sharing Transactions
Section 9 of the Notice speaks to a proposed revision of a regulation under Section 482 that addresses cost sharing transactions.
Research Performed Under Contract
As acknowledged in the Notice, Section 174 doesn’t provide guidance on how costs associated with providing research or software development services as a contractor (contracted R&D services offered to a third party) should be treated. The Notice provides intuitive definitions of a “research provider” and a “research recipient.” It also provides a definition of a “SRE product,” which includes “any pilot model, process, formula, invention, technique, patent, computer software, or similar property (or component thereof) that is subject to protection under the applicable domestic or foreign law.”
“Financial risk” is defined as “the risk that the research provider may suffer a financial loss related to the failure of the research to produce the desired SRE product.” An example in the Notice involves a research provider that contracts to develop a SRE product for a third party (per the third parties order), makes no performance guarantee with respect to the SRE product, and is paid a fixed sum plus an amount equivalent to its actual expenditures (i.e., costs plus the fixed sum). The research provider has no right to use or otherwise exploit “the resulting SRE product.” The example concludes that the research provider has no financial risk in this situation.
Based on the forementioned definitions, the Notice provides that if the research provider bears financial risk under the terms of the contract, then costs paid or incurred by the research provider are subject to capitalization.
The Notice further provides that even if the research provider does not bear financial risk, if the research provider has “a right to use any resulting SRE product in its business or otherwise exploit any resulting SRE product through sale, lease or license” then costs incurred by the research provider are subject to capitalization. An exception to this rule exists “if such right is available to the research provider only upon obtaining approval from another party to the research arrangement” (not related to the research provider).
Effective Date for Reliance on the Provisions of the Notice
The Notice anticipates the issuance of proposed regulations that will include rules consistent with those prescribed in the Notice. Such regulations would apply for taxable years ending after September 8, 2023. A taxpayer may choose to rely on the rules described in the Notice for expenditures incurred in taxable years beginning after December 31, 2021, provided the taxpayer relies on all of the rules in the Notice and applies them “in a consistent manner.” The exception is for the unamortized SREs associated with property contributed to, distributed from or transferred from a partnership.
If you have questions regarding the Notice, reach out to a Clark Nuber professional who will be happy to provide guidance.
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