Key Takeaways

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:

• There is no change in how the Section 41 research credit is calculated. However, incidental research costs like overhead may be required to be capitalized under Section 174, some of which are outside the eligible costs captured in a research credit study.
• Certain indirect costs may be excluded from capitalization.
• The Notice provides a non-exhaustive list of what software development costs require capitalization, as well as activities that do not.
• Research providers under contract must capitalize costs if the provider bears financial risk under contract terms or if they have the right to use or sell/license any resulting research product.
• Businesses that cease to exist may write off unamortized research costs in their final tax year.
• The Service proposes to amend percentage-of-completion regulations to account for research expenditure capitalization and amortization.

Background

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.

Allocation of Specified Research Expenditures

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:

• Labor costs (generally included in research credit calculations)
• Materials and supplies costs (generally included in research credit calculations)
• Cost recovery allowances (not included in research credit calculations)
• Patent costs (may be partially included in research credit calculations)
• Certain operation and management costs such as rent, utilities, insurance, taxes, maintenance, and similar overhead costs (not included in research credit calculations)
• Travel (not included in research credit calculations)

Also provided is a listing of costs not permitted or required to be treated as SRE expenditures:

• General and administrative costs that only indirectly support or benefit SRE activities (ex: payroll personnel that prepare salary checks of research personnel and accountants who account for research expenses)
• Interest on debt to finance SRE activities
• Costs listed in Reg. §1.174-2(a)(6)(i)-(vii)
• Amortization of SRE expenditures
• Costs defined in the Notice that are not software development related

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.

Software Development Activities

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:

• Planning the development of computer software (or the upgrades and enhancements to such software), including identification and documentation of the software requirements.
• Designing the computer software (or the upgrades and enhancements to such software).
• Building a model of the computer software (or the upgrades and enhancements to such software).
• Writing source code and converting it to machine-readable code.
• Testing the computer software (or the upgrades and enhancements to such software) and making necessary modifications to address defects identified during testing, but only up until the point in time that:
  • In the case of computer software developed for use by the taxpayer in its trade or business, the computer software is placed in service; and
  • In the case of computer software developed for sale or licensing to others, technological feasibility has been established, product masters(s) have been produced, and the computer software is ready for sale or licensing to others.
• In the case of computer software developed for sale or licensing to others (or the upgrades and enhancements to such software), production of the product master(s).

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:

• Computer software developed by a taxpayer for use in its trade or business – this includes training, maintenance, data conversion, and installation activities.
• Activities occurring after the development of computer software developed for sale or licensing to others – this includes marketing, maintenance, fixing bugs, distribution, and customer support.
• Costs to input content into a website.
• Costs for website hosting that involve the payment of a specified, periodic fee to an internet service provider in return for hosting a website on its server(s) connected to the internet.
• Costs to register an internet domain name or trademark.

Contract Research

The Notice also provides guidance for research performed under contract. Those providing research must treat costs as subject to section 174 capitalization and amortization if the provider bears financial risk under contract terms. Additionally, a research provider must also capitalize costs if they have the right to use any resulting SRE product in their trade or business or exploit a resulting SRE product through sale, lease, or license. If the provider must obtain approval from an unrelated party outside of the research arrangement, they will not be considered to have SREs for these purposes.

Property Dispositions

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.

Long-Term Contracts

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.

Outlook

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.

Related: Focus on Taxation: Impacts of Mandatory Research Expense Capitalization

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.}}