The Tax Cuts and Jobs Act passed in 2017 was one of the more significant pieces of legislation in some time. Four years removed from its enactment, taxpayers continue to grapple with provisions that are set to change or sunset—one of which being the sunsetting of the ability to expense research and experimentation (R&E) costs in the year these costs are paid or incurred.
Effective for tax years beginning after December 31, 2021, taxpayers are required to capitalize and amortize U.S.-based R&E expenses over a period of five years and non-U.S. R&E expenses over 15 years. Software development costs are specifically included as R&E expenses under Internal Revenue Code (IRC) Section 174(c)(3) and subject to the same mandatory amortization period of either five years or 15 years. Taxpayers cannot recover research and expenditure costs before the end of the amortization period even if sold or abandoned.
Prior to this change, taxpayers had the option to adopt a tax method of accounting to currently deduct these costs under IRC §174(a), capitalize and amortize these costs over no less than 60 months starting with benefit onset under IRC §174(b), or charge these costs to a capital account under Treasury Regulation §1.174-1. In addition, taxpayers were able to make an election under IRC §59(e) to amortize R&E expenditures over 10 years. Similarly, for software development costs, taxpayers had the option to currently expense these costs as incurred, amortize them over 36 months from the date the software was placed into service, or amortize over not less than 60 months from the development completion date.
The House version of the Build Back Better Act, passed by the House of Representatives in November 2021 and now stalled, delayed the effective date of these changes until tax years beginning after December 31, 2025. While this specific provision enjoyed bipartisan support and many believed this provision would become law providing a technical fix to the mandatory §174 capitalization, the fate and path forward of the Build Back Better Act toward enactment is highly uncertain as of the date of this publication. Thus, taxpayers are left to deal with the original effective date and the mandatory requirement to now capitalize and amortize R&E expenses.
The mandatory capitalization of R&E expenses is an issue that is going to impact, at a minimum, every business that either claims the research credit under IRC §41 or performs research activity. Is your business ready?
Key Observations & Takeaways
- Capitalization and amortization of R&E expenses begin with the midpoint of the tax year in which the expenses are paid or incurred. Thus, the amortization period is actually six years for U.S.-based R&E expenses and 16 years for non-U.S. expenses.
- All software development costs, regardless of internal or external use, are now governed by the new amortization rule.
- The challenge for taxpayers in complying with this new rule change lies in the fact that the activities and costs that fall within the definitional scope of §174 are much broader than that for research credit purposes under §41. Section 174 includes all activities and costs incident to the elimination of uncertainty concerning the development or improvement of a product. While research credit-eligible activities include direct research, support, and supervision and exclude activities like foreign research, funded research, reverse engineering, indirect support, and supervision, §174 may include these activities. Similarly, on the cost side, while credit-eligible costs only include wages, supplies, contract research, and computer lease costs, §174 is much broader and can include an allocable portion of overhead costs, e.g., rent and utilities, cost recovery, patent fees, foreign research costs, and all software development costs, as examples. Thus, a business’s §174 costs could be potentially much larger than its credit-eligible costs for the research credit.
- In addition, when claiming the credit, many businesses often make what is called the “280C” election under IRC §280C(c)(3)(C) to claim the reduced research credit. While this is often a facts and circumstances determination for companies as to whether it is beneficial to elect the reduced credit, theoretically, a company may not want to make the reduced credit election because the §41 costs are added back by way of the required capitalization of §174 expenses. This is going to require further analysis and modeling.
Why Is This Change So Significant?
The mandatory §174 capitalization rule has the potential to materially impact the following:
- Cash flow planning and cash taxes – Federal and state estimated tax payments and cash taxes for 2022 and beyond.
- Financial statement impact and considerations within Accounting Standards Codification (ASC) 740.
- Consideration of state tax conformity issues.
- Accounting method change considerations – The capitalization requirement is treated as a change in accounting method on a cutoff basis for amounts paid or incurred as of the first day of the year of change requiring taxpayers to file a Form 3115, Application for Change in Accounting Method.
- International tax provisions – Allocation of R&E costs for §250 foreign-derived intangible income deduction, foreign tax credit calculation, and IC-DISC purposes as well as interaction with §59A BEAT provisions and GILTI for controlled foreign corporations incurring significant R&E costs.
- Implications for increased adjusted taxable income under §163(j), potentially limiting the amount of disallowed interest in a given period.
- Timing differences between the deduction for generally accepted accounting principles versus tax – Need to track the amortization of these costs and make the necessary book/tax adjustments.
- Classification of expenses as §162, ordinary and necessary business expenses, versus §174 – Taxpayers may have previously deducted credit-eligible costs as ordinary and necessary business expenses. These costs should be reviewed to determine if they meet the definition of R&E under §174.
- Software development – Buy or build, onshore or offshore?
Planning for Change Now
The mandatory §174 capitalization rules went into effect on January 1, 2022, and could potentially have a material impact on businesses performing R&E activities and those that claim the research credit. To the extent a business has not begun to plan, model, and evaluate the impact of these new rules on taxable income, cash taxes, estimated tax payments, tax rate, related international provisions, or state tax posture or develop a process to efficiently capture and allocate these costs, now is the time! Taxpayers need to be prepared to provide documentation to the IRS substantiating the computation of their §174 costs. Ultimately, this is going to result in greater compliance efforts and additional analysis outside of the typical research credit analysis. Taxpayers must have a clear plan in place to identify and track §174 expenses going forward.
The mandatory §174 capitalization rules and the R&D tax credit are complex to analyze, calculate, and document. BKD’s national team of R&D tax credit professionals can help you evaluate the impact of the changes to §174 as well as assist in implementing the accounting method change of capitalizing and amortizing §174 expenses for tax years beginning after December 31, 2021.
If you have any questions about whether your business qualifies for the R&D tax credit or are interested in learning more about the R&D tax credit and BKD’s services, please reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.