In mid-September, the IRS issued Notice 2023-63 (PDF) to provide interim guidance that helps taxpayers clarify how to calculate Section 174 capitalization and amortization of specified research or experimental (SRE) expenses as amended by the Tax Cuts and Jobs Act (TCJA).
Before TCJA, Section 174 gave taxpayers a choice between deducting R&E expenses in the year they were incurred, capitalizing and amortizing expenses over a period not less than five years, or charging R&E expenses to a capital account.
The TCJA amended Section 174 to require taxpayers to charge SRE expenditures to a capital account. The expenditures must be amortized over five years for domestic expenses and 15 years for foreign expenses. The new guidance makes clarifications to topics including:
- The scope of SRE expenses under Section 174
- Software development expenses
- Research under contract
- Disposed or abandoned property
- And more …
Taxpayers are not required to implement the guidance but can rely on it if they adopt all the rules outlined in the notice. Fortunately, much of this guidance aligns with what the accounting industry and the team at Sensiba were expecting and planning for.
Defining Specified Research or Experimental Expenditures
The notice defines key terms to help taxpayers identify and allocate SRE expenditures for taxable years starting after December 31, 2021. Under the notice, SRE activities include experimental initiatives related to the development or improvement of a product or component. The notice adds software development activities (discussed below) to the SRE activity criteria.
SRE expenses in connection with the taxpayer’s trade or business must be paid or incurred by the taxpayer during the taxable year.
The notice provides examples of costs that would be considered incidental to SRE activities, such as labor, materials and supplies, patents, and certain operational and management costs incidental to the direct SRE costs.
It similarly provides examples of costs that would not qualify as SRE, including a taxpayer’s general and administrative expenses (such as payroll, HR, and other functions), interest on debt to finance SRE initiatives, SRE expenses capitalized in prior years, and other similar costs. SRE costs must be allocated using a cause-and-effect relationship between costs and SRE activities. For example, a taxpayer may allocate a percentage of facility expenses to SRE based on a ratio of the square footage within a facility in which SRE activities are conducted to the facility’s total square footage.
Software Development Activities
Under the notice, the definition of “computer software” has been expanded to include cloud computing as well as software updates and enhancements. Activities treated as software development for SRE purposes include:
- Planning and designing software
- Writing and testing code
- Developing product masters
Activities that would not qualify as software development include employee training, post-deployment maintenance, data conversion and formatting, and other similar expenses.
Research Under Contract
The notice clarifies the role and responsibilities of a contracted research provider (the organization performing SRE activities) and the research recipient (the organization hiring a provider) as well as an SRE product and how SRE expenses can be attributed to specific parties.
To the extent a research provider bears financial risk under a contract, its paid or incurred costs incidental to SRE activities should be attributed to the provider. Similarly, if the provider has the right to use a resulting product or to sell or license a product to another party, its costs are considered SRE expenditures.
Disposed or Abandoned Property
Unfortunately for taxpayers, if there are unamortized SRE expenditures resulting from property that has been disposed of, abandoned, or retired, the organization must continue to amortize those expenditures over the applicable period (despite the abandonment).
Similarly, if a taxpayer is acquired by another organization, the acquiring corporation must continue to amortize the taxpayer’s unamortized SRE expenditures over the applicable period.
However, if a corporation ceases to exist without being acquired, it can take a deduction equal to its unamortized SRE expenditures in its final taxable year.
IRS Request for Comments
In its draft notice, the IRS has asked taxpayers to submit comments in response to various Section 174 provisions and questions outlined in the notice. Written comments should be submitted by November 24, 2023.
To learn more about the most recent IRS guidance on Section 174 application, contact us.