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On March 11, 2022, Congress passed the Omnibus spending bill (H.R. 2471, the Consolidated Appropriations Act, 2022) which did not include a repeal or a delay of the previously enacted changes to Internal Revenue Code (IRC) Section 174 . Despite significant bipartisan support, as well as support from many industry lobbying groups, the requirement to capitalize Section 174 research and experimental expenditures remains in place.

There are several other potential vehicles for rolling back the requirement to capitalize Sec. 174 expenditures, including[1]:

  • Building a Better America
  • United States Innovation and Competition Act of 2021
  • Post mid-term election legislation

With the Section 174 changes in effect and an uncertain path to repeal or roll back of the effective date to capitalize Section 174 costs, taxpayers must continue to evaluate the federal, state and international impact of the changes.

Key Changes to Section 174

The Tax Cuts & Jobs Act, enacted on December 22, 2017, made changes for tax years beginning after December 31, 2021. Under this newly effective provision, taxpayers are required to capitalize and amortize research & experimental (R&E) expenditures over five years for research performed within the U.S. and 15 years for research performed outside the U.S. Amortization deductions begin with the midpoint in the year in which the costs were incurred. Additionally, software development costs were specifically included in the definition of a Section 174 expenditure, and therefore must be capitalized and amortized over five (or 15) years. Finally, a taxpayer cannot recover costs earlier than the end of the required amortization period.

This is a significant shift from the prior Section 174, which allowed taxpayers to:

  • Elect to deduct R&E expenditures under Section 174(a);
  • Elect to capitalize and amortize under a period no less than 60 months, starting with the month in which the taxpayer first realizes benefits from such expenditures under Section 174(b);
  • Capitalize and amortize such expenditures over 10 years under Section 59(e)(2);
  • Have the option to currently expense software development 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 changes to Section 174 will impact any taxpayer currently engaged in activities in the research or experimental sense, or software development, regardless of whether the expenditures were historically treated as Section 174 and either deducted or capitalized and amortized. The new Section 174 requirement results in a deferral of previously deductible expenditures under Section 174(a). This applies to taxpayers regardless of whether they've historically claimed the R&D tax credit. Therefore, for taxpayers who have never claimed the Credit for Increasing Research Activities, or "R&D tax credit" under Section 41, now is an optimal time to evaluate credit eligible activities, because generally, to be considered a qualified research expenditure for the R&D tax credit, an expense must be eligible for Section 174 treatment.

Additional Considerations

Tracking of Section 174 costs: R&E expenditures, as defined in section 174, means expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense.[2] Generally, the term includes all costs incident to the development or improvement of a product, including direct costs such as labor, materials used in the development process, third party consultants and attorney fees to secure a patent. This also includes indirect expenses such as lab depreciation, utilities and supporting departments. Taxpayers should evaluate their ability to track the type of expenditures and sourcing of location of research to identify if activities are Section 174 expenditures.

Estimated Payments

Generally, flow-through entities may rely on the safe harbor of 2021 taxes when computing 2022 estimated payments. However, flow-through entities should consider the tax impact of capitalizing Section 174 costs for cash flow planning purposes.

The requirement to capitalize Section 174 costs could have a significant impact on the estimated tax payments of large C-corporations (defined as a corporation having taxable income of $1 million or more during any of the three immediately preceding tax years[3]).

All taxpayers with R&E expenditures should evaluate the impact on estimated tax payments and model the cash flow implications.

International Impact
  • Section 250 Deduction for Foreign Derived Intangible Income (FDII). The Section 250 deduction is largely based on a mechanical formula that mainly considers a taxpayer's taxable income in a taxable year. Because the new Section 174 rules likely impact a taxpayer's US taxable income, taxpayers reliant on a Section 250 deduction may see potentially beneficial changes in deduction eligible income (DEI). The new Section 174 rules likely also have a considerable impact with respect to allocating and apportioning R&E expenses to be allocated and apportioned to foreign derived deduction eligible income (FDDEI) and DEI under the rules of Reg. 1.861-17.
  • Section 250 Deduction for Global Intangible Low-Taxed Income (GILTI). The effect of these rules impacting FDII deductions as a result of changes to taxable income may also have the indirect effect of impacting the GILTI deduction for certain taxpayers with controlled foreign corporations (CFCs) based on the carrot and the stick paradigm set forth in the legislative history of the Tax Cuts and Jobs Act.
  • Foreign Tax Credit (FTC) Expense Apportionment. The changes to Section 174 may have a considerable impact to FTC computations depending on the client's facts. For example, a lower amount of Section 174 deduction in a given year may result in less research and development expenditures being allocated and apportioned to gross intangible income. This may have the effect of lowering potential FTC limitation in the General, Passive and Branch baskets depending on the client's facts. Thus, certain taxpayers with FTC carryforwards in these respective FTC baskets may enjoy larger FTC limitations in future years.
  • GILTI and the GILTI High Tax Exclusion under Reg. 1.951A-2(c)(7): The requirement to capitalize and amortize R&E expenses throughout 15 years may have a significant impact on the tested income calculated for each CFC and potential for taxpayers to claim the GILTI High Tax Exclusion in such tax year. For example, if a CFC has R&E expenses that have been capitalized for US federal income tax purposes but are deductible for foreign income tax purposes, there is a potential mismatch effect where less foreign income taxes are paid in a taxable year with respect to a larger amount of tested income simply due to differences in US and foreign jurisdictional tax law. As a result, taxpayers may see this mismatch effect directly influence a taxpayer's GILTI high tax exclusion ratios necessary to claim the GILTI High Tax Exclusion. Taxpayers should consider whether adopting an accounting method change may be a favorable outcome after modeling the net U.S. tax effect on GILTI.
  • Section 163(j) Limitation: The impact to taxable income due to the changes in deductible R&E expenses is likely to impact the Section 163(j) adjusted taxable income limitation for both US entities as well as foreign entities. Taxpayers should consider whether these new rules have the effect of reducing disallowed business interest expense deductibility under section 163(j) and what is the net US tax impact after considering the changes to the Section 163(j) limitation in conjunction with other provisions – i.e., GILTI, FDII, and FTCs.
  • Due to the interplay of multiple provisions, it is uncertain whether the net effect of these provisions results in favorable repercussions to taxpayers. DHG recommends taxpayers consult with their tax advisors and model the impact of these new rules with respect to each of these provisions noted above to determine how these new rules impact their US federal income tax liability.
State Impact

From a state tax perspective, it is important to consider the manner in which each state conforms to the IRC and whether any have specifically decoupled from or failed to adopt these new requirements.

DHG has multi-functional teams to assist you with analyzing the federal, state and international impact of these new requirements, as well as managing your cash flows related to computing estimated tax payments. For more information on how Section 174 changes may impact your company and to discuss how DHG can help with modeling the impact of Section 174, please contact your DHG advisor or the contacts below.

 

References

 

[1] https://www.taxnotes.com/tax-notes-today-federal/legislation-and-lawmaking/dems-feared-tax-provisions-would-clutter-huge-omnibus/2022/03/10/7d8bb

[2] Treas. Reg. 1.174-2

[3] Section 6655(g)(2)

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