The Internal Revenue Service recently issued much anticipated guidance on the amortization and capitalization of research and development expenditures after Congress failed to delay the feared requirement from the Tax Cuts and Jobs Act of 2017, but corporate tax professionals would like to see more clarity.
The IRS released Notice 2023-63 in September, providing interim guidance on the capitalization and amortization of specific research or experimental expenditures incurred in taxable years beginning after Dec. 31, 2021, under Section 174 of the Tax Code as amended by the TCJA. The notice announced that the Treasury Department and the IRS intend to issue forthcoming proposed regulations to address the capitalization and amortization of the expenditures, the treatment of them under Section 460, and the application of Section 482 to cost-sharing arrangements involving the expenditures.
Samuel Corum/Bloomberg
The long-awaited guidance outlines some provisions that are expected to be included in the forthcoming proposed regulations, while the interim guidance answers many questions but leaves others unaddressed, according to tax experts.
“This notice was highly anticipated,” said Sophia Shah, federal tax consulting services senior manager at Top 100 Firm Crowe LLP, based in New York. “It’s clear that the IRS and the Treasury are being responsive to all the uncertainty on identifying and allocating the Section 174 research and experimentation costs, and how nuanced it can be based on a business’ profile. We finally have some guidance in our hands, but it’s gotten us even more eager for more guidance. Taxpayers have such diverse facts and circumstances, maybe based on their entity structure or their global footprint and the size of their company and the types of industries that they serve. They all share this common goal of seeking answers to ensure compliance with the law.”
This is the second round of guidance tax professionals have received from the IRS and the Treasury. The first round, in Revenue Procedure 2023-8, arrived not long after Congress failed to delay the TCJA requirement for amortization and capitalization of R&D expenses instead of immediately writing them off, in its year-end consolidated appropriations package last December, but it was related more to the method change of adopting Section 174.
“I think the timing on the first guidance in December was fantastic because it helped a lot of taxpayers heading into year-end planning for compliance and tax planning,” said Matt Paparella, a partner in the tax group at Crowe.
However, the latest notice, which appeared Sept. 8, is not as well timed. “In a perfect world, this timing is not necessarily ideal as we head into deadlines,” he added. “We have already filed tax returns for clients.”
He acknowledged that much of the guidance aligned with many of the assumptions being made by taxpayers or practitioners this past year, but it’s by no means perfect, as more guidance is still needed. Timing is crucial as it could have a negative impact when immediate compliance deadlines are approaching. To be sure, there is some leeway, as companies can wait until the regulations are proposed and finalized — but they can’t keep writing off their R&D expenses immediately anymore.
“I’m sure they wish they could still continue to write it off,” said Shah. “This is the new regime. This is the new Section 174 law where you’re required to capitalize and amortize these expenses. But in how you identify and allocate the cost, there is still very much of a gray area. This guidance helps answer a lot of those questions and uncertainties on what actually is a Section 174 cost and what are some additional considerations for how you allocate those costs to capitalize and amortize them.”
The guidance helps companies determine what is or is not considered R&D and provides more clarity on definitions.
“There’s really not that avenue to say, well, we can keep following the old 174 regime,” said Paparella. “It’s clear that we need to capitalize and amortize. But a lot of the ambiguity and headaches for taxpayers over the last year, prior to this guidance, has been assumptions on what the general definitions meant. The amortization scheme was there. It was required. It was more like how do we define it? How tightly or loosely do we define this? This guidance at least helps taxpayers start to dial this in more. Hopefully, with additional guidance, we continue to refine that. It was a bit of a figure-it-out-for-yourself approach previously, because the guidance was just R&D with some very general definitions. At least this helps us move in the right direction to put a little more clarity on what’s in and what’s out.”
The guidance contains a number of different provisions spelling out various details in areas such as:
- Midpoint amortization;
- The identification and allocation of costs;
- Software development;
- Research performed under a contract;
- The disposition, retirement or abandonment of property;
- Long-term contracts under Section 460; and,
- Cost-sharing regulations.
“The guidance hit on a lot of burning questions that taxpayers had,” said Shah. “A notable area with a lot of questions has been contract research between a research provider and a research recipient, and how it either aligns or diverges from case law. The guidance was extremely appreciated, but the implications specifically on that right-to-use provision for the research provider could have significant and widespread consequences for those who perform R&D on behalf of a business. A lot of it aligns with expectations, but this provision about that right to use could have severe impacts for a lot of taxpayers, or it could have none for certain taxpayers who don’t engage in contract research.”
The IRS is asking for comments and feedback that will indicate what the reactions will be and what additional changes and guidance are desired.
Technology questions
The rules related to software development should also provide more clarity to companies and their tax advisors.
“I really appreciated the detailed descriptions and the updated and refreshed definition of software development,” said Shah. “Before, it’s been really hard to understand what is truly software development, and how an upgrade versus a maintenance activity is treated. I think taxpayers are really going to like the differentiation between what is includable and what is excludable explicitly mentioned in the notice, but I think there are certain areas that are still extremely gray. At what point is it considered bug fixing versus new development and new features? They explicitly mentioned security patches and data conversion activities. It’s gotten a lot more descriptive, and there are going to be even more questions. What I do think is very noteworthy is the notice itself explicitly states that Revenue Procedure 2000-50 is obsolete now.”
One of the biggest challenges has been for taxpayers who are not in the business of selling software, but are at least involved somehow with software, Paparella noted.
“At what point do you draw that line? I think the guidance is helpful, but not fully informative as you look at purchases of software and upgrades of software,” he said. “It adds more clarity, but just naturally the business of software creates some headaches. Taxpayers will continue to want guidance to understand at what point they can draw the line as they invest in software rather than are in the business of software.”
Software developers will also find the guidance helpful. “For companies that are in the business of software, it has been historically challenging to claim R&D credits on software, so I think this additional guidance provides some help from a 174 perspective, but the interplay between the credit and 174 will still be germane to technology companies,” said Paparella. “There are different definitions, but still aligned though, so they’re not disproportionately different.”
The additional guidance on the Section 174 credit may influence a credit that could be otherwise claimed by companies through Section 41, the credit for increasing research activities. “The more advantageous credit they get, I think that’s going to be interesting to see how taxpayers can interpret that favorably or unfavorably going forward,” said Paparella.
The IRS may need to issue more guidance to clarify what actually rises to the level of software development. “If you’re in a certain industry, in this day and age, there’s probably some level of software development going on,” said Shah. “Maybe it’s performed on behalf of the company, or it’s the internally developed software going on in the business. But additional guidance related to what is an includible or executable activity from a R&D perspective will be extremely helpful.”
Not so different, after all
The guidance provided in the notice on incidental costs could be helpful to some companies. “The previous 174, the way it was written, generally defined costs incidental to research and gave a few examples in the regulations,” said Paparella. “From a cost accounting and quantification standpoint, it still continues to be a challenge, even with the new guidance. However, it provides a bit more specificity in terms of what type of costs they’re anticipating, as costs incident to research, and also provides at least some example guidance on how to quantify those types of costs.”
Many tax practitioners were already using an approach that is similar to what turned out to be in the guidance. “The silver lining with that is from our experience, and what we’ve seen from a lot of our peers in the industry, is how practitioners and taxpayers have defined incidental costs has aligned pretty well with this new guidance,” said Paparella. “There weren’t any substantial new items that I saw. However, incidental costs will always be a challenge. Every company accounts for costs differently from a project or departmental or top level per sector perspective. Trying to quantify that reasonably and accurately to satisfy the IRS will always be a challenge because in the R&D space, it’s a lot easier to quantify people’s time and contractors and R&D supplies. As you move further away from those core costs, it just creates challenges. But the good thing is at least we have more guidance to point to as to how it may be quantified by a taxpayer to align with the new guidance.”
The guidance at least provides some flexibility, and more guidance is on the way eventually.
“One of my big takeaways from what is a specified research expenditure is there appears to be greater flexibility to reasonably allocate the costs,” said Shah. “As long as the allocation methods are applied consistently for each type of cost, using a reasonable method leaves a lot of options for computing it for taxpayers. Of course, there are still some more questions on what this means in terms of allocating the book-to-tax differences impacted by Section 174, which are not mentioned in the notice. But hopefully, we’ll get some more guidance in the proposed regulations.”
Companies are hoping to see some specific safe harbors and simplified approaches in future guidance, especially for smaller businesses. “One thing that I would like to see in terms of proposed regulations or additional clarity on is, just due to the complexity of the law and the guidance itself, we see a lot of businesses looking for some type of safe harbor or a bright-line test,” said Shah. “Whether that’s for smaller businesses or startups, due to financial statement R&D being utilized, they’re just ultimately hoping for a more streamlined approach to identifying and allocating these costs. There’s just been this common sentiment about whether there will be some sort of avenue for a more simplified approach, and if anything like that will be available if you meet certain requirements.”
Paparella noted there’s a similar approach under Section 41 for the credit that allows companies to use GAAP R&D accounting as a starting point for their credits. However, companies are still hoping to see more changes from Congress, although that appears unlikely right now, as the immediate write-off of R&D costs has traditionally helped encourage innovation and inventiveness here in the U.S. Instead they will have to hope for more leeway from the IRS and the Treasury Department in how they interpret the law.
“It’s delaying the deductions of these costs that are incentivized otherwise to be spent in the United States, so it is a challenge there from a policy perspective,” said Paparella. “Anything they can do at a minimum, if the law does not otherwise change, to ease the administrative burden on taxpayers I think would be substantial, especially for small taxpayers. But even on the flipside, large taxpayers may have good accounting records, but still the breadth of data here is a lot to work through to comply with this as they further and further define this guidance.”
The question of delaying the R&D amortization requirement came up last December during negotiations between Democrats and Republicans in Congress over passing the year-end tax extenders in the consolidated appropriations package, but the two sides could not agree on extending the tax break in exchange for extending the expanded Child Tax Credit. Given the ongoing level of dysfunction in the House, which is currently struggling to elect a Speaker, any chance of a retroactive change from Congress in the near term seems unlikely.
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