Internal Revenue Service Guidance on Capitalization and Amortization of R&E Expenditures Under Section 174

As previously reported, the Internal Revenue Service (IRS) recently issued Notice 2023-63 to provide interim guidance on the capitalization and amortization of specified research and experimental (SRE) expenditures under Internal Revenue Code Section 174.

Overview

The Tax Cuts and Jobs Act (TCJA) amended Section 174 to require taxpayers to capitalize and amortize SRE expenditures over five years for domestic research expenses or 15 years for foreign research expenses. The TCJA also requires software development costs to be treated as SRE expenditures. In addition, the TCJA added new Section 174(d), which provides no deduction of SRE expenditures is allowed upon the disposition, retirement, or abandonment of property with respect to which SRE expenditures are paid or incurred, and that amortization of such SRE expenditures should continue. These amendments apply to SRE expenditures paid or incurred in taxable years beginning after December 31, 2021.

Procedures for taxpayers to obtain automatic consent to change their method of accounting in the first or second year of required adoption will be forthcoming. Taxpayers that must comply with Section 174 may implement the rules of the Notice by following the guidance in Revenue Procedure 2023-24. The Treasury Department and the IRS issued Revenue Procedure 2023-8 to provide procedures for taxpayers to obtain automatic consent to change methods of Revenue Procedure 2023-24, implementing the requirement imposed by the TCJA that a taxpayer must make this change in method of accounting on a cutoff basis if the change was made during the taxpayer’s first taxable year beginning after December 31, 2021. Procedures are included for treatment required during short taxable years as well.

Identification of SREs

SRE expenditures are defined as research and experimental expenses paid or incurred in connection with a taxpayer’s business that either:

• Satisfy the requirements under Regulation 1.174-2 to be research or experimental expenditures, or
• Are paid or incurred in connection with the development of computer software, as defined in the Notice.

SRE activities are defined as:

• Research or experimental activities in a laboratory sense that are intended to discover information that would eliminate uncertainty concerning the development or improvement or appropriate design of a product or a component or subcomponent of a product, as detailed in Regulation 1.174-2, or
• Software development activities, as described in this Notice.

The Notice provides sufficient detail characterizing costs that are treated as SRE expenses and those expenses not considered SRE expenses. Examples of expenses treated as SRE expenses include the following:

• Labor costs of employees and independent contractors who perform, supervise, or directly support SRE activities. Labor costs include basic compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan.
• Costs of materials and supplies, including tools and equipment not depreciable under Section 168, which are used or consumed in the performance of SRE activities or in the direct support of SRE activities.
• Cost recovery allowances, including depreciation, amortization, or depletion allowances, with respect to property used in the performance of SRE activities or in the direct support of SRE activities, including property placed in service in a taxable year that begins on or before December 31, 2021.
• Patent costs, including attorney fees.
• Operation and management costs, rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs with respect to facilities, equipment, and other assets used in the performance of SRE activities or in the direct support of SRE activities.
• Travel costs for the performance of SRE activities or the direct support of SRE activities.

The following costs are specifically excluded from treatment as SREs:

• General and administrative service department costs, payroll, accounting, HR.
• Interest on debt to finance SRE activities.
• Costs incurred for activities determined not to be computer software development costs:
  • Computer software developed by a taxpayer for use in its trade or business.
  • Computer software developed for sale or licensing to others where the activities occur after such software (or upgrades and enhancements to such software) is ready for sale or licensing to others.
• Costs to input content into a website or host a website.
• Costs to register an internet domain name or trademark.
• Costs listed in Section 1.174-2(a)(6)(i)-(vii), relating to costs such as quality control, efficiency surveys, management studies, etc., in connection with literary or historical projects.
• Amortization of SRE expenditures.
• Amortization of research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2022.

To determine total SRE expenditures for a taxable year, taxpayers must allocate costs, including the types of costs described within this Notice, to SRE activities on a reasonable basis that includes a cause-and-effect relationship between the costs and the SRE activities or another relationship that 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, but the allocation must be applied consistently for each type of cost.

Software Development

Guidance is provided to determine which activities constitute qualifying software development. The Notice defines computer software consistent with Regulation 1.197 and further defines “upgrades and enhancements” to include modifications to existing computer software that result in additional functionality (enabling the software to perform tasks that it was previously incapable of performing) or materially increase speed or efficiency of the software. It should be noted, however, that the purchase and installation of purchased computer software, including the configuration of pre-coded parameters to make such software compatible with the business and reengineering the business to make it compatible with the purchased software, and any planning, designing, modeling, testing, or deployment activities with respect to the purchase and installation of such software, are not activities that constitute software development for purposes of Section 174. 

Contract Research

The Notice also provides clarity in determining whether costs paid or incurred for research performed under contract are SRE expenditures under Section 174. The following terms are defined in the Notice:

• Research Provider: The term “research provider” means the party that contracts with a research recipient to:

  a) perform research services for the research recipient with respect to an SRE product, or
  b) develop an SRE product that the research recipient acquires from the research provider.

• Research Recipient: The term “research recipient” means the party that contracts with the research provider to:

  a) perform research services for the research recipient with respect to an SRE product, or
  b) develop an SRE product that the research recipient acquires from the research provider.

The research provider must bear financial risk under the terms of the contract with the research recipient, for the costs paid or incurred by the research provider, that are incident to the SRE performed by the research provider under the contract, to be considered SRE expenditures.

Under long-term contracts, computing income on a percentage of completion basis applying Section 460, allocable SRE expenditures are included in the numerator without a corresponding deduction for the costs. The Notice states IRS intention to propose regulations to limit the inclusion of SRE expenditures in the percentage of completion calculation by including amortization of SRE expenditures and treat amortization as incurred for purposes of the calculation.

Additional Items of Interest

• The Notice provides several examples of the anticipated revisions to the treatment of SRE expenses in cost-sharing agreements under Section 482. The Notice would treat cost-sharing transaction payments under a cost-sharing arrangement as a reduction of the Section 174 SRE expenditures chargeable to capital account.
• The IRS intends to issue guidance to provide procedures for taxpayers to obtain automatic consent to change methods of accounting in a taxpayer’s second year to comply with this Notice.
• The Treasury Department and the IRS request comments on issues arising from the interim guidance set forth in this Notice to be submitted prior to November 24, 2023.

To gain clarity and confidence in implementing these required SRE changes, please reach out to one of our Ryan tax professionals below.

TECHNICAL INFORMATION CONTACTS:

Ian Boccaccio
Principal
Ryan
469.399.4545
ian.boccaccio@ryan.com

Violet Goodheart
Director
Ryan
469.399.4772
violet.goodheart@ryan.com

The material presented in this communication is intended to provide general information only and should solely be seen as broad guidance and not directed to the particular facts or circumstances of any individual who may read this publication. No liability is accepted for acts or omissions taken in reliance upon the content of this piece. Before taking (or not taking) any action, readers should seek professional advice specific to their situation from Ryan, LLC or other tax professionals. For additional information about this topic, please contact us at info@ryan.com.