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Companies face the loss of a major tax break on research and experimental ("R&E") costs for 2022, absent Congressional action. Since 1954, Internal Revenue Code section 174 has allowed taxpayers to immediately deduct R&E costs. Effective January 1, 2022, the Tax Cuts and Jobs Act of 2017 ("TCJA") amended section 174 to eliminate the deduction of R&E costs.

Instead, costs for R&E activities in the U.S. now must be capitalized and amortized over five years (over fifteen years in the case of foreign research expenditures), beginning at the midpoint of the tax year the expenditures are paid or incurred. Even in the event of disposition, retirement, or abandonment of property, the taxpayer must continue to amortize R&E costs over the remaining life, rather than currently deduct the unamortized basis.

On December 12, 2022, the IRS issued procedures on how to implement the radically new section 174 capitalization rules under Rev. Proc. 2023-8. The administrative guidance will be integral for businesses filing returns for the 2022 tax year.

Method in Practice

The amendments to section 174 are treated as a change in a taxpayer's method of accounting. Generally, taxpayers are required to obtain IRS consent before changing a method of accounting used for federal income tax purposes.

However, Rev. Proc. 2023-8 provides an automatic change in method of accounting for R&E costs under section 174. In lieu of Form 3115: Application for Change in Accounting Method, a taxpayer may comply by filing a statement with its original tax return for the first year the amendment is effective. A transition rule is available for 2022 tax returns filed on or before January 9, 2023. The change applies on a cut-off basis, with no adjustments for prior tax years' costs.

Rev. Proc. 2023-8 also clarifies the change in accounting method does not apply to acquired, leased, or licensed computer software under Rev. Proc. 2000-50. Unlike software acquisition costs, however, the new capitalization rules do apply to a taxpayer's software development expenditures paid or incurred after January 1, 2022, no longer deductible under Rev. Proc. 2000-50.

Modeling the Effects

Unless modified by tax extender legislation in the coming weeks, businesses may need to consider the far-reaching implications of capitalizing R&E costs for the 2022 tax year onward, such as:

• Research and Development (R&D) Tax Credit: R&E expenses are expansively defined to include both direct and indirect business costs in connection with R&D in the experimental sense. A portion of direct R&E expenses under section 174 may represent qualified research expenditures eligible for the R&D tax credit under section 41. In prior years, classification either as section 174 expenses or as ordinary and necessary business expenses under section 162 did not necessarily raise concern, as there was no difference in timing (with a limited exception for AMT). Classifying these expenses now becomes a critical issue under the amended section 174, particularly for taxpayers considering R&D tax credit claims and potential IRS scrutiny.
• Qualified Small Business Stock (QSBS) Status: Eligible shareholders in a C corporation may exclude capital gain recognized on the sale of QSBS held for over five years. Among the requirements under section 1202, the corporation's assets must not have exceeded $50 million through the date of issuance. The $50 million test is based on cash and the aggregate adjusted basis of other property held in the corporation. Because the tax basis of the corporation's assets impacts the threshold, capitalizing R&E costs otherwise deducted under prior law may disqualify corporations from issuing QSBS at an earlier point in funding rounds.
• Cash Flow and Tax Attributes: In the year of change, 90% of a taxpayer's current R&E activities in the U.S. are not currently deductible under a half-year convention of amortization with a five-year period (and even less in the case of foreign activities). Taxpayers that did not previously account for an increase to taxable income on quarterly estimated payments may face a greater tax liability or greater use of net operating loss carryforwards and tax credits, as available.
• ASC 740: Currently deducting R&E expenses for tax purposes under prior law aligned with expensing such costs on financial statements for book purposes. As there is no corresponding change to financial accounting under U.S. GAAP, the temporary book-to-tax difference results in a deferred tax asset to report.
• International Tax Impact: The new R&E capitalization requirements also carries through to the computation of various international tax items, including global intangible low-taxed income, foreign-derived intangible income, the base-erosion and anti-abuse tax, and foreign tax credits.

While businesses and industry groups have urged Congress to reverse the TCJA amendment to section 174, the new capitalization rules for R&E costs are currently in effect for tax years starting January 1, 2022 and later. Absent a further change in law, taxpayers should be positioned to track and identify all R&E expenditures, as well as determine the collateral effects of the method change. 

For questions about the tax treatment of research costs, please contact Nancy Dollar or the Hanson Bridgett Tax Group.

 

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