After much anticipation, the U.S. Department of the Treasury (Treasury) and the IRS have finally provided insight into what taxpayers should expect to see in proposed regulations addressing the capitalization and amortization regime that applies to specified research or experimental (SRE) expenditures under section 174. Notice 2023-63 announces that Treasury and the IRS intend to issue proposed regulations addressing (1) the capitalization and amortization of SRE expenditures (including how to identify and allocate SRE expenditures and the rules that apply to software development costs (SDCs) and contract research arrangements), (2) the treatment of SRE expenditures under section 460, and (3) the way in which section 482 applies to cost sharing arrangements involving SRE expenditures. The Notice does not address—but does request comments on—a variety of related issues, including how section 280C applies when a taxpayer claims a section 41 research credit and the way in which section 174's disposition rules apply to partnership transactions. Taxpayers may rely on the Notice before Treasury and the IRS issue proposed regulations but are not required to do so. Comments on the Notice are due by November 24, 2023.
Scope and Basic Rules
Before 2022, taxpayers could generally currently deduct research or experimental expenditures and SDCs. However, the Tax Cuts and Jobs Act of 2017 (TCJA) amended section 174, for tax years beginning after December 31, 2021, to require taxpayers to capitalize SREs and amortize them over five years for domestic research and 15 years for foreign research.
The Notice answers basic mechanical questions on how section 174's capitalization and amortization regime operates. For example, the Notice clarifies that the five-year amortization period for domestic research means 60 months and the 15-year amortization period for foreign research means 180 months. The place where the research activity is performed determines whether the related SRE expenditures are domestic or foreign. For this purpose, "domestic" means the U.S., Puerto Rico, and any U.S. territory or possession, while "foreign" means everywhere else.
Taxpayers must allocate costs to SRE activities, which consist of (1) activities in the experimental or laboratory sense intended to discover information that would eliminate uncertainty concerning the development, improvement, or appropriate design of a product (or component or subcomponent thereof) (i.e., Treas. Reg. § 1.174-2 activities) and (2) software development activities as defined in the Notice (which include planning the development of computer software, designing computer software, building a model of computer software, writing source code, and certain testing). This allocation must occur on the basis of a "cause-and-effect" relationship, such as allocating labor costs based on time spent on SRE activities as a percentage of total time. While the allocation method may differ from one type of cost to another, a taxpayer must use an allocation method consistently for each type of cost.
Once a taxpayer allocates costs to SRE activities, they must determine which of these costs are SRE expenditures subject to section 174. The Notice provides that SRE expenditures include (but are not limited to): labor costs (including stock-based compensation), materials and supplies costs, cost recovery allowances (including property placed in service before 2022), patent costs, travel costs, and certain overhead costs (e.g., rent, utilities, insurances, and taxes with respect to facilities used to perform or support SRE activities). The Notice also identifies certain costs that are per se excluded from being SRE expenditures, including costs incurred by general and administrative service departments that only indirectly support or benefit SRE activities (e.g., payroll or HR personnel), costs listed in Treas. Reg. § 1.174-2(a)(6) (e.g., consumer surveys and advertising), amortization of SRE expenditures, and interest on debt to finance SRE activities.
Contract Research
The Notice addresses contract-research arrangements and proposes a broad rule providing that a research provider incurs SRE expenditures if the research provider either (1) bears financial risk under the contract or (2) has a right to use any resulting "SRE product" or otherwise exploit any such SRE product in the research provider's business without having to obtain prior approval from an unrelated counterparty. The term "SRE product" means any pilot model, process, formula, invention, technique, patent, computer software, or similar property subject to protection under domestic or foreign law but excludes "mere know-how" obtained in the course of performance. Taxpayers are encouraged to submit comments, with the Notice specifically requesting feedback on whether special methods are needed for government research contracts and whether the section 174 contract research rules should parallel the funded research rules for the section 41 research credit.
Long-Term Contracts Subject to the Section 460 Percentage of Completion Method
The Notice announces that Treasury and the IRS intend to revise existing regulations under section 460 to address how the percentage of completion (PCM) method applies to long-term contracts when allocable contract costs include SRE expenditures. Current regulations provide that the portion of the contract price a taxpayer must report in a tax year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs. Treasury and the IRS intend to issue proposed regulations providing that costs allocable to a long-term contract accounted for using the PCM include amortization of SRE expenditures rather that the capitalized amount of such SRE expenditures. Thus, SRE expenditures would enter the numerator of the PCM completion factor as such SRE expenditures are amortized under section 174. Regarding the denominator of the completion factor, the Notice requests comments on whether estimated total allocable contract costs should include all SRE expenditures that directly benefit or are incurred by reason of the performance of the long-term contract or only the portion of the SRE expenditures expected to be amortized during the contract's term.
Cost Sharing Arrangements
The Notice also announces that Treasury and the IRS intend to revise existing regulations under section 482 to address cost sharing arrangements (CSAs) involving SRE expenditures. Existing regulations under section 482 provide that a cost sharing transaction (CST) payment reduces the recipient's deductible intangible development costs (IDCs) and constitutes income to the extent the CST payment exceeds the recipient's deductible IDCs. Capitalizing SRE expenditures under section 174 would reduce a CSA participant's deductible IDCs, thereby increasing the likelihood that the CSA participant would recognize income upon receiving a CST payment. The Notice announces an intention to issue proposed regulations that revise the existing section 482 regulations to provide that a CST payment reduces the recipient's deductible and capitalizable IDCs proportionately and constitutes income to the extent the CST payment exceeds the sum of the foregoing.
Applicability Date
The Notice is not currently binding, though a taxpayer can rely on the Notice before Treasury and the IRS issue proposed regulations provided the taxpayer applies the Notice consistently and in its entirety. We expect a robust comment process on the Notice and eventually, a notice of proposed rulemaking containing proposed regulations reflecting or addressing comments that Treasury and the IRS received on the Notice. After a second comment process, Treasury and the IRS would proceed to issue a Treasury Decision containing final regulations. The Notice announces an intention that any such final regulations apply to tax years ending after September 8, 2023 (the date Treasury and the IRS issued the advance release of the Notice). Of course, the Notice and any future proposed regulations or final regulations could be mooted by legislation that retroactively restores current deductibility of SRE expenditures.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
We operate a free-to-view policy, asking only that you register in order to read all of our content. Please login or register to view the rest of this article.