FAQ: Capitalization and amortization of R&D costs under new section 174 rules
ARTICLE | April 27, 2023
Authored by RSM US LLP
The required capitalization and amortization of research and development costs under the new section 174 rules are proving problematic, costly, and confusing for many middle market companies—especially those in industries and sectors heavily engaged in R&D and software development, such as life sciences and technology.
To help you better understand how the new rules affect your business, here are answers to frequently asked questions about the changes to section 174 and their ramifications for a wide range of tax and accounting issues.
Basics of the new tax treatment of R&D expenses under section 174
Q: What changed, exactly, in the required tax treatment of R&D expenses?
A: For tax years beginning after Dec. 31, 2021, taxpayers must capitalize and amortize all R&D expenditures paid or incurred in connection with their trade or business. The straight-line recovery periods are five years and 15 years for domestic and foreign-incurred R&D, respectively.
Previously, taxpayers could immediately deduct R&D expenses from their taxable income. The unfavorable change was enacted as part of the Tax Cuts and Jobs Act of 2017. At the time TCJA was enacted, many hoped that Congress would revisit this change to the tax treatment of R&D expenses before it took effect. However, without legislation to reinstate immediate deductibility, the requirement to capitalize and amortize R&D expenses is the law.
It’s worth noting that the TCJA change to section 174 did not affect the section 41 rules for claiming an R&D tax credit. The determination of qualified research expenditures has not changed.
Q: Why is this new requirement so significant and difficult to implement?
A: The difficulty stems from the need to identify R&D activities conducted and allocate relevant costs. A business cannot tie this to a specific cost on its general ledger. In addition, taxpayers now must layer on software development considerations that historically may not have been viewed as an R&D activity.
Before this change, because deducting expenses under section 174 provided favorable treatment to costs that the business might otherwise capitalize, businesses that did not look for qualifying costs were not creating additional tax exposure. Now, they have to find those costs because they are required to capitalize and amortize them over the appropriate period. This process puts more of a burden on taxpayers.
Another set of major challenges results from how interconnected section 174 is with other tax issues. The new requirement cannot be addressed in a vacuum; taxpayers likely will experience ancillary effects.
Before this change, businesses wanted to pursue qualifying R&D activities because they could deduct their costs and get out-of-code sections that otherwise would require capitalization of those costs. Other rules were written with the understanding that section 174 allowed for immediate deductibility. Now that section 174 is unfavorable, it’s difficult to reconcile those other rules because the intent is skewed from what it was.
Q: What industries are most affected by this change?
A: When many people think of R&D, they think of experts wearing goggles and white coats in a laboratory. That isn’t wrong, of course, but R&D activities covered by section 174 reach beyond obviously affected industries such as life sciences and technology. They likely affect taxpayers across all industries, including, for example, manufacturing, government contracting, and some financial institutions.
Beyond those, think about software development. There are professional services and law firms that develop internal-use software. There are architects, engineers, and various types of manufacturers that are just working to improve a product.
In other words, this affects every industry.
Q: Does my business have to comply with the change to section 174?
A: Yes. Section 174 is not elective and will apply to any taxpayer engaged in R&D activities.
Q: Can my business get out of the new section 174 requirement if it chooses not to claim an R&D tax credit under section 41?
A: No, claiming credits under section 41 is irrelevant in determining whether an expenditure is an R&D expense subject to the new requirement to capitalize and amortize them.
Q: Do the new section 174 rules affect other sections of the tax code?
A: Yes, they affect several other code sections. Taxpayers will need to understand how the new section 174 rules may affect certain calculations under other code sections. Given these ancillary effects, taxpayers may need to prioritize the new section 174 requirement when preparing their taxes.
Q: Is capitalizing and amortizing R&D expenses a method of accounting?
A: Yes. The change from deducting to capitalizing and amortizing these costs is a change in method of accounting that will generally follow normal accounting method change procedures (e.g., filing a Form 3115); however, for the first required year of capitalization, a taxpayer can include a white paper statement with their tax return in lieu of filing a Form 3115.
Q: Are there any silver linings in the change to section 174?
A: Taxpayers may have previously passed on claiming an R&D tax credit because they were not in a taxable income position (to benefit from the credit) or because a prior credit estimate was deemed immaterial to the company. Now that taxpayers are required to capitalize and amortize R&D expenses, they may want to consider engaging a tax advisor to assist in gathering the documentation and data necessary to compute a credit claim.
While this is additional work, the taxpayer may have already performed the lion’s share to determine R&D expenses and may be able to gather tax credit data in real-time and use the credit to offset some of the potential increase to taxable income.
Additionally, this change may favorably affect some internationally active businesses as it relates to, for example, the foreign-derived intangible income (FDII) deduction. For more details, please see the questions below about international tax topics.
Identification and treatment of R&D expenses
Q: How do I determine what constitutes an R&D expense?
A: R&D expenses are not specific types of costs. Instead, they are determined by the activity a taxpayer undertakes. R&D expenses are present if a taxpayer develops a new or improved product or service or develops software.
Taxpayers developing a new or improved product or service must be uncertain whether the intended functionality or capability can be developed or about the appropriate design needed to achieve the intended functionality or capability. In this circumstance, the taxpayer undergoes a process of experimentation that is technological in nature to resolve the uncertainty.
Typical project expenditures subject to capitalization include:
- Researchers’ wages, including nontaxable benefits
- Contract research expenditures (100% versus 65%)
- Direct research supervisor wages for researchers
- Cost of supplies
- Overhead expenses, including rent, utilities, and depreciation
- Depreciation on equipment directly used or allocated to an R&D activity
- Costs attributable to a pilot model
- Expenditures for software development
Q: How is it determined what activities give rise to R&D expenses?
A: In the absence of specific guidance, taxpayers must use a reasonable approach to interpreting the law.
The law provides the instruction of Congress to defer the recovery of R&D expenses over five or 15 years. There is nothing to suggest that Congress intended to change the definition of R&D expenses aside from including software development costs. Because of this, until the IRS issues further guidance, it is reasonable to continue to rely on guidance under section 174 as it existed before amendments by the TCJA.
Q: How do I determine if my business has R&D expenses?
A: While not every business will have R&D expenses, many do, especially if it produces goods or incurs expenses related to software development (i.e., websites, mobile applications, enterprise resource planning systems, etc.). Generally, businesses with engineering departments, R&D departments, or those that report R&D expenses in their financial statements have significant R&D expenses.
Q: How do costs covered under section 174 differ from those that qualify for the R&D tax credit?
A: Section 174 covers a broader range of activities and costs than those that qualify for the R&D tax credit under section 41. Generally, costs that qualify for the R&D credit will also be treated as section 174 costs; however, the inverse is not true.
For example, wages that qualify for the R&D tax credit are limited to Box 1 wages (or self-employment earnings in the case of a sole proprietorship). But section 174 qualifying wages include additional wage amounts, such as nontaxable benefits and retirement contributions. There is a so-called “substantially all” rule for the R&D credit where taxpayers may claim 100% of Box 1 wages for employees that spend 80% or more of their time performing qualifying activities—this does not exist for section 174.
When it comes to payments made to third parties to perform contract research, only 65% of eligible contract research expenses are included toward the R&D credit, whereas 100% may be eligible for inclusion as a section 174 cost. Additionally, section 174 costs include allocable overhead costs, such as rent and utilities, as well as the depreciation of equipment used in the R&D process, and patent legal expenses that aren’t included in qualifying R&D tax credit costs.
It’s important to note that all computer software development costs are now considered section 174 costs. For R&D credit purposes, there is a higher threshold for software development initiatives to be eligible for the credit in the case of software developed by the taxpayer for internal use. There is no such threshold for section 174, so taxpayers may notice a much higher section 174 cost compared to what is claimed for R&D credit purposes for software development initiatives.
Q: If my business has never claimed an R&D tax credit, might we still have R&D expenses?
A: It’s possible. Some taxpayers forgo taking the R&D credit for various business reasons but still have R&D expenses. Also, expenditures paid or incurred in software development are considered R&D expenses and may not be captured in an R&D credit study.
Q: What method should my business use to allocate our indirect costs?
A: Generally and without IRS guidance, there is no right or wrong way, although costs should be allocated based on a reasonable methodology. Many practitioners deem reasonable methodologies to include allocations based on employee headcount or square footage (similar to section 263A methodologies). Alternatives that best align with a business’s facts and circumstances can also be used.
Q: My company performs contract research for other taxpayers on a cost-plus basis. How will those costs be treated?
A: In the absence of specific guidance addressing this issue, RSM’s view is that companies that provide contract research services and do not retain risks or rights to the underlying research are service providers and would have section 162 expenses, not section 174 expenses.
Any agreements should be reviewed to determine whether the risks and rights retained by each party give rise to section 174 expenses.
Q: My business engages third parties to perform research. Does that constitute section 174 expenses?
A: In the absence of specific guidance addressing this issue, RSM’s view is that a company that engages a third party to perform research on the company’s behalf has section 174 expenses if the company maintains the risks and rights to the underlying research.
Any agreements should be reviewed to determine whether the risks and rights retained by each party give rise to section 174 expenses.
Q: My company reimburses the costs incurred by a subsidiary/parent for research expenses. Do both entities have section 174 expenses?
A: With cost reimbursements, the taxpayer receiving reimbursement may not have an expense to capitalize. A rights/risk analysis of the work performed is likely required first to see which party should be treated as incurring section 174 expenses.
Q: Can my business use its generally accepted accounting principles (GAAP) or ASC 730 numbers as a proxy for its R&D expenses?
A: No, not without a book safe harbor provided by the IRS or Treasury Department. In addition, the GAAP research numbers may not include software development costs. However, knowing the total amount of research costs capitalized for book purposes may provide a starting point for determining the scope of activities to include in the tax R&D expense analysis.
Q: Are taxpayers required to capitalize section 174 expenses for book purposes also?
A: No, the taxpayer’s financial statement treatment will still be governed by the appropriate financial accounting standard (GAAP, etc.). Section 174 applies to tax treatment only.
Q: What if my business abandons or scraps a section 174 project before related costs have been fully amortized?
A: Regardless of the abandonment of the underlying property, capitalized R&D expenses costs will continue to be amortized over the respective 5- or 15-year period.
Q: How does the inclusion of software development in section 174 differ from prior years?
A: Software development is now statutorily defined in section 174 as an R&D expenditure.
Many taxpayers find that they have R&D activities buried throughout their trial balance, or they did not look at software development because they are not software developers, per se, but do, in fact, have software development activities. Those activities may include software development and would be R&D now. For example, a taxpayer may be a grocery store that develops a mobile app, a website functionality to enable sales, or internal accounting systems for delivering goods or services.
Q: Now that software development is an R&D activity, is there a bright-line definition of what constitutes software development?
A: Unfortunately, there is no bright-line definition of software development. Through published guidance and case law, software development costs generally consist of costs incurred to write additional machine-readable code that allows a software program to function in a desired way.
If a third party is used to write the additional code, a benefits and burdens analysis should be performed to determine whether the costs are development costs or acquisition costs.
Q: What areas of software development may not be deemed section 174 costs?
A: It is a gray area, but acquiring someone else’s R&D or software, lease, or software license is likely not covered under section 174. There may be positions to take the configuration of existing functionality within a software package as excluded from section 174.
Q: What determines if software is in an R&D state or an implementation stage?
A: The underlying activity is the determining factor. It is very common to segregate or bifurcate the phases of implementation, and taxpayers may find certain development or customization activities are taking place throughout. Activities such as configuring existing functionality may not give rise to R& D.
Q: Are software subscriptions and implementation service fees for new ERP software and services or other business and technology applications still subject to Rev. Proc. 2000-50?
A: Rev. Proc. 2000-50 will still govern the treatment of acquired, leased, or licensed software (effectively recovered over the license term in a SaaS environment). However, it is common to see further development or customization activities above the minimum license—these costs may be subject to section 174 as software development expenditures.
Q: Are the majority of costs for software as a service (SaaS) technology companies now required to be capitalized?
A: Generally, on the development side of the business, yes. Ongoing maintenance and customer support are generally still deductible as incurred.
State and local tax
Q: How does state conformity affect section 174?
A: Generally, state conformity to the federal tax code must be reviewed state-by-state. While some states automatically conform to changes to the code for state income tax purposes (called rolling conformity states), many others have fixed-date conformity or only conform to specifically enumerated provisions.
Accordingly, it is critical to understand whether the state conforms to the TCJA changes made to section 174. Most, but not all, states have updated their conformity dates or specific conformity provisions to incorporate changes made by TCJA or otherwise conform to the provisions through rolling conformity to the code.
Q: Have any states decoupled from section 174?
A: As an example, at least one state, Tennessee, has enacted specific legislation to decouple from the federal capitalization requirements under section 174 and allow state-level current expensing. Other states may propose or enact legislation to decouple from the federal capitalization rules during the 2023 or 2024 legislative sessions.
Q: Is the state treatment identical for pass-through entities as for corporations?
A: Some states have differing conformity rules for corporations and pass-through entities, creating a disconnect between proper state treatment of expenses under section 174 for differing entity types. Pass-through entities should consider these differences, especially because conformity to section 174 is often addressed in a corporate context.
Q: Are there any concerns about state-level R&D credit computations?
A: Some state R&D computations reference federal section 174 rather than section 41. As taxpayers analyze section 174 expenses for federal purposes, it may be beneficial to reclassify some costs as deductible under a different federal code section, where possible, to preserve current deductibility for federal purposes. Such a reclassification could have a negative impact on the state R&D credit for jurisdictions that reference section 174 as the basis for the state-level credit computation. This is a nuanced and state-specific analysis.
Q: How could potential federal changes impact the states?
A: The timing of federal legislation is a key factor for fixed-date or selective conformity states. With most state legislatures out of session by the beginning of summer, there is a distinct possibility that some states will not be able to respond to federal legislation timely. Changes to federal provisions, effective in 2023 or earlier, may not be conformed to by many states until 2024 state sessions or later.
Q: Does the new requirement under section 174 apply to my business’s foreign operations?
A: Yes, with a key difference: section 174 costs incurred in R&D activities that take place outside of the United States must be amortized over 15 years rather than five. This difference in the law is meant to provide a clear incentive to perform such activities in the United States. In practice, this may or may not tip the scale against valuable foreign-country incentives, but it will certainly take a bite out of those cash flows.
Q: Does this affect my business’s foreign tax, U.S. tax, or both?
A: These capitalization rules apply to section 174 expenses incurred in any foreign operations whenever that income is being computed or reported on a U.S. tax basis. That is, nothing is changing for local country tax or statutory accounting purposes. These rules must be applied where your foreign activities meet your U.S. tax reporting and taxable income. For example, computation of global intangible low-taxed income (GILTI), Subpart F, foreign tax credits, foreign-derived intangible income (FDII), and base erosion and anti-abuse tax (BEAT); reporting on Forms 5471, 8858, 1118, 8991, etc.
Q: How will this affect my organization’s U.S. tax liability on foreign operations?
A: It will always depend on the specific facts and circumstances, but in general, we expect the following:
- If a taxpayer is subject to GILTI: The capitalization of R&D expenses at the foreign subsidiary level will increase GILTI income on the U.S. parent’s return. It may also alter the applicability of the GILTI high-tax exception election (HTE), bringing other foreign subsidiary profits into the GILTI inclusion that may have been excludable in prior years. Because GILTI is accounted for as a period cost for ASC 740 purposes by most taxpayers, this may increase the taxpayer’s effective tax rate.
- Subpart F income would be similarly affected.
- R&D expenses incurred by foreign branches in the local country would be subject to a 15-year amortization through the U.S. parent’s return, increasing U.S. taxable income from the branch operation without a corresponding increase to available foreign tax credits in the branch basket.
Q: Is there any good news on the international front?
A: The capitalization of section 174 costs could favorably affect taxpayers in the following areas:
- Foreign tax credit limitation: Special rules regarding the apportionment of R&D expenses generally exert downward pressure on taxpayers’ ability to claim foreign tax credits. The limitation on R&D deductions to a relatively small amount of amortization may have the side effect of releasing pressure on foreign tax credit limitations and increasing credit claims.
- FDII: Where section 174 capitalization increases U.S. taxable income, this may increase the FDII deduction proportionally, which is a favorable, permanent book-tax difference, and, therefore, may result in a reduction to a taxpayer’s effective tax rate.
- BEAT: In general, increased regular taxable income will make a BEAT liability less likely. Further, taxpayers who make base erosion payments for R&D will see reduced base erosion tax benefits in the near term as deductions for those expenses are limited and deferred through capitalization and amortization. This may help some taxpayers pass the 3% test for BEAT applicability or, barring that, reduce the BEAT tax base.
Legislative processes, administrative guidance, and advocacy
Q: What happened to congressional action regarding required capitalization?
A: While there is broad bipartisan support to repeal or defer the required capitalization of R&D expenses, Congress did not come to an agreement to do so before the 117th Congress adjourned at the end of 2022.
A bill to reinstate full and immediate deductibility was introduced in the Senate on March 16, 2023, and is co-sponsored by seven Republicans, five Democrats, and one independent. However, despite that example of bipartisan support, RSM’s tax policy team believes it is very unlikely that the 118th Congress will make any changes to section 174 because the two parties have different political priorities.
Further, retroactivity in future legislation is uncertain. Ultimately, taxpayers must proceed with the current state of the law and capitalize and amortize their R&D expenses.
Q: As capitalization is the law, what guidance have the IRS and Treasury issued?
A: The IRS released a revenue procedure with the procedures and terms and conditions for a taxpayer to change its method of accounting for R&D expenses. Substantive guidance has not yet been issued as of late March 2023, and we do not expect additional guidance in this area until late spring or summer of 2023 at the earliest.
Q: What can my organization do to advocate reinstating the immediate deductibility of R&D expenses?
A: Taxpayers eager to share their thoughts directly with policymakers can communicate with their local congressional representatives. RSM’s tax policy team members have found that congressional staffers appreciate hearing from taxpayers and businesses to better understand the real-world ramifications of their actions or lack thereof.
This article was written by RSM US LLP and originally appeared on 2023-04-25.
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