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Section 174 of the Internal Revenue Code (IRC) underwent significant changes in recent years, with the Tax Cuts and Jobs Act (TCJA) requiring mandatory capitalization and amortization of Section 174 “research and expenditure” costs for tax years beginning on or after Jan. 1, 2022. Prior to the TCJA, taxpayers had the option to immediately expense their R&E expenditures (the default option), choose to ratably deduct R&E expenditures over a 60-month period, or make an annual election under Section 59(e) to amortize R&E costs over a 10-year period. This new change in accounting method will affect a broad range of companies, and impact financial statements and tax returns in important ways.
Congress on a bipartisan basis – in both houses – recognizes that the amortization provision is a disaster. Senators Hassan (D-NH) and Young (R-IN) introduced legislation to repeal amortization in the Senate recently and Congressmen Estes (R-KS) and Larson (D-CT) introduced similar legislation in the House. Both bills have a host of cosponsors, but with legislation to reverse the change still in limbo, businesses should be working to identify the affected costs and assess the impacts.
How you should approach the new Section 174 amortization provision:
For federal income tax purposes, R&E expenditures under Section 174 cover a broad set of costs that companies incur when engaged in the development or improvement of a product or process. Generally, these costs are incurred for activities that are intended to eliminate “uncertainty” or where there are questions as to capability, methodology, or appropriateness of design. In practice, this definition is broad and encompasses a wide-range of expenditures, much broader than the definition of qualified research expenses (QREs) that are identified for purposes of computing the Research & Development Tax Credit (R&D Credit) under Section 41.
Generally, QREs are comprised only of direct research expenditures incurred such as domestic wages, supplies, computer rental (cloud computing), and third-party contractor costs. Section 174 includes not only those costs, but many other costs (e.g., R&D conducted outside of the U.S., and indirect costs, among others) which are excluded from the R&D Credit calculation. Companies may not have tracked and identified these costs. Further, many companies will have Section 174 expenditures even if they haven’t historically claimed the R&D Credit. Companies will need to specifically identify Section 174 costs, as they are now subject to capitalization, and will need to implement a computational and documentation approach.
Companies will be required to establish a method for identifying and tracking all R&E expenditures covered under Section 174. This will likely be a significant undertaking for companies because of the broad and subjective nature of these provisions. As discussed above, many costs not traditionally thought of as “R&E” may be subject to Section 174 capitalization. Even companies that may initially think that they have a roadmap for identifying costs, through their historic R&D Credit computations or financial statement reporting methods (e.g., ASC 730, tracking of software development expenses, etc.), may find those starting points do not provide a comprehensive approach to account for all R&E costs subject to capitalization. Further, with limited guidance from Treasury and the IRS expected in the short term, there are several technical considerations that companies will have to consider.
Identifying these costs is just the beginning as the required capitalization and amortization of Section 174 can impact other tax computations. For example, Section 174 capitalization can impact:
Interest expense limitation computations under Section 163(j)
State and local tax reporting as a result of states that have not conformed with the Tax Cuts and Jobs Act
The treatment of R&E payments between related parties (e.g., U.S. parent paying for R&E conducted on its behalf by a CFC)
The computations under the foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) regimes
The determination of excludible Section 174 costs for Section 263A computational purposes
As you work through your tax provision and tax return filing process it is important to consider developing an approach to comply with these new capitalization rules.
Why you should “capitalize” on the R&D Tax Credit:
We’ve found in practice that the R&D tax credit is especially important for many small and medium businesses because the credit serves essentially as a means of financing growth and expansion of these businesses that qualify. Recall – even though there is now amortization – the R&D tax credit is still available both at the federal level and most states have a state R&D tax credit as well. Businesses that are subject to the new Section 174 amortization provision should carefully consider the R&D Tax Credit which can help to offset the increased costs of capitalization and can provide a significant tax benefit to businesses that engage in R&D activities.
The R&D Tax Credit provides an incentive for companies to increase their innovation and improvement activities. The credit is available to both public and private companies and is not industry specific. Per Internal Revenue Code Section 41, for research expenditures to qualify for the credit, they must meet four requirements:
1. Qualified Business Component
First, the code requires that the research activity tie directly to a new or improved business component that is held for sale, lease, or license by the taxpayer or used by the company in its trade or business. A business component could be any product, process, software, technique, formula, or invention, and the purpose of the research must be to increase the function, reliability, quality, or performance of that business component. An improvement does not have to be significant; small incremental improvements can qualify if they meet the other requirements for qualified research. The tax code doesn’t define thresholds for research project size or scope.
2. Technological in Nature
Second, research expenditures must be technological in nature, i.e., they must fundamentally rely on the principles of hard science including, but not limited to, physical science, chemistry, biology, engineering, or computer science. It’s not necessary for the taxpayer to seek knowledge that “exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering.” In other words, the research does not have to involve the discovery of information that is new to the world or even to the industry; it only needs to be innovative or new to the taxpayer.
3. Eliminating Uncertainty
Third, qualified research activities must be undertaken for the purpose of eliminating technical uncertainties. Even if there is no doubt the objective of the research project can be achieved, expenditures could still qualify provided that at the onset of the project there is uncertainty regarding the capability, methodology, or appropriate design of the business component. It’s important to note that the research need not be successful to qualify for the credit.
4. Process of Experimentation
Finally, the code requires that a process of experimentation be used to eliminate the uncertainty in order to qualify for the credit. For purposes of the credit, experimentation means a process where one or more alternatives were identified as possibilities to eliminate uncertainty, and those alternatives were evaluated, discussed, designed, modeled, developed, and/or tested. The process of experimentation could involve a systematic method of trial and error and generally should be capable of evaluating more than one alternative.
The four-part test outlines what types of activities and expenses qualify for the R&D federal tax credit. Though there are some exclusions listed in the code, many activities that a company undertakes to improve and grow its business will qualify. It’s important to remember that the credit is available to U.S. companies across many industries, projects need not be successful to qualify, and many states also offer tax credits for research expenditures.
Key Takeaways:
Businesses that are subject to the new Section 174 amortization provision should carefully consider the impact on their tax liability and may want to consult with a tax advisor to discuss the best way to comply with the new rules and minimize the impact. As such, these changes have made it more important than ever for businesses to consider the R&D Tax Credit. Our team of experienced tax credit specialists can help you understand the R&D Tax Credit, capture the qualifying expenses, and potentially reap significant tax savings. Get in touch with a member of our team today to get your company the credit it deserves.
The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.