The IRS provided guidance in Notice 2023-63 on several issues related to new requirements to capitalize research expenditures for tax years beginning after December 31, 2021. While Congress continues to debate repeal of this mandate, the Notice can be used to implement current rules.
Key takeaways include:Previously, “research expenditures,” as defined under section 174 of the Internal Revenue Code, could be expensed as a reduction to taxable income by their full amount in the current year. This option to immediately deduct qualified research expenses has been available since 1954, but the Tax Cuts and Jobs Act (“TCJA”) changed the rules. The TCJA also requires capitalization of research expenses for tax years beginning after December 31, 2021. These capitalized expenses are then amortized over five years for activities conducted in the U.S. and its possessions, or over fifteen years for foreign activities.
Additionally, all software development costs were added to the definition of section 174 costs to be capitalized, among other changes that impact businesses conducting research activities.
Specified Research Expenditure (SRE) activities are defined as software development activities (as provided in the Notice) or research or experimental activities described in Reg. §1.174-2. Included in these costs are those incident to the development of a product. The Notice provides a non-exhaustive list of examples that would be considered incident to SRE activities that includes:
Also provided is a listing of costs not permitted or required to be treated as SRE expenditures:
Costs that are included as related to an SRE activity must be allocated on the basis of a relationship that reasonably relates the costs to the benefits provided to the SRE activities. The allocation method used for one type of cost may be different than the allocation method used for another type of cost. However, the allocation method used for each type of cost must be applied on a consistent basis. Notice 2023-63 provides examples.
Many in the industry have expressed concern over the TCJA addition that requires software development costs to be treated as capitalized research expenditures. In particular, it was unclear what expenses should be included. The Notice provides clarity in determining which expenses require capitalization under section 174 and also those that can be excluded.
Software development costs that require capitalization and amortization under section 174 include:
Activities discussed above that relate to upgrades and enhancements to purchased computer software also require capitalization under section 174. However, purchase and installation of such software is not a section 174 expenditure.
Software-related costs that do not require capitalization and amortization under section 174 include:
The TCJA also changed the treatment of unamortized research expenditures when projects are abandoned, disposed, or retired. Rather than being able to write off the related expenses at that time, new section 174(d) requires that the amortization deductions continue.
An exception is provided in the Notice where a business ceases to exist and section 381(a) does not apply – in this case only a deduction equal to the unamortized SRE expenditures may be taken in the final tax year. Otherwise, where section 381(a) does apply, the acquiring corporation will continue to amortize the SRE expenditures.
TCJA mandatory capitalization of SREs no longer aligns with the goals of section 460 percentage of completion (“PCM”) accounting method for long-term contracts. As such, the Service is proposing to amend the section 460 regulations to provide that the costs allocable to a long-term contract accounted for using the PCM include amortization of SRE expenditures, rather than capitalized amounts, and that such amortization is treated as incurred for the purposes of determining the percentage of contract completion as deducted.
Businesses may rely upon guidance provided in the Notice prior to the issuance of proposed regulations that are anticipated to include consistent information.
Congress continues to mull repealing or postponing mandatory Section 174 research expense capitalization, potentially retroactively to the 2022 tax year. However, despite bipartisan congressional effort and strong industry support, politics continues to prevent crossing the finish line. We will keep you updated as developments occur.
Please reach out to your RubinBrown representative with questions or concerns.
Published: 12/13/2023
Readers should not act upon information presented without individual professional consultation.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.