IRS Releases Long Awaited Guidance on R&E Amortization
The IRS has released some long-awaited guidance (Notice 2023-63) to clarify the treatment of specified research and experimental expenditures (SRE) under Section 174. This guidance is specified as interim guidance, providing taxpayers with a small amount of guidance just days before the September 15 deadline. Those who are filing on extension or have been granted extensions for various catastrophic environmental conditions, or who regularly file on October 15 may find this guidance more useful as they will have a little more time to digest it.
The much-anticipated interim guidance, which taxpayers have the option of relying on immediately, addresses several issues, including:
- The definition of software development
- The treatment of research performed under contract
- The identification and allocation of SRE expenditures
- The interaction of Section 174 with long-term contracts under Section 460
- Cost sharing arrangements under Section 482
- Certain dispositions
The Treasury Department and the IRS intend to propose rules that will align with this interim guidance that would apply for taxable years ending after Sept. 8, 2023. Until then, taxpayers can rely on the interim guidance but are not yet required to implement the guidance provided. Taxpayers cannot rely only on certain sections while taking differing positions on other sections in the notice.
What is this guidance for?
The Tax Cuts and Jobs Act amended Section 174, removing the option to expense SRE expenditures and now require taxpayers to capitalize and amortize these expenses over a period of 5 years for domestic research and 15 years for foreign research, beginning with the midpoint of the taxable year in which the expenses are paid or incurred. This amendment also requires software development costs to be treated as SRE expenditures.
The amendments to Section 174 are applicable to SRE expenditures paid or incurred in taxable years beginning after Dec. 31, 2021. As provided by the TCJA, a change to implement the new Section 174 rules is a change in method of accounting that is applied on a cut-off basis.
- Identification and Allocation of SRE Expenditures
The notice provides a description of SRE expenditures in section 4.02(2) and (3). This defines SRE expenditures to include expenditures that satisfy the requirements under the Treas. Reg. Sec. 1.174-2 or are incurred in connection with the development of any computer software – regardless of whether the software expenditures satisfy the Treas. Reg. Sec. 1.174-2 requirements.
The notice also includes examples of the types of costs that are considered incident to SRE activities, including but not limited to:
- Labor costs
- Materials and supplies costs
- Cost recovery allowances
- Patent costs
- Certain operation and management costs (generally facility and equipment costs such as rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs)
- Travel costs
The notice also includes a list of costs that are not permitted or required to be treated as SRE expenditures. These include general and administrative costs, interest on debt to finance SRE activities, and amortization of amounts capitalized under Section 174 in prior years
- Software Development
The notice also provides a few key definitions in Section 5.02(1) as it relates to software development. The definition of computer software is generally an expanded/updated definition of the ones found in Section 2 of Rev. Proc. 2000-50 and Treas. Reg. Sec. 1.197-2(c)(4)(iv). It includes cloud computing, updates, and enhancements. Upgrades and enhancements generally mean 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.
Section 5.03 of the notice provides a non-exhaustive list of activities that are treated as software development for Section 174 purposes:
- Planning the development of computer software
- Designing the computer software or upgrades and enhancements
- Building a model of the computer software
- Writing source code and converting to machine-readable code
- Certain testing of the computer software until it is placed in service or ready for sale or licensing
- Production of the product master(s) (for computer software developed for sale or licensing to others)
Work spent on general maintenance after software is placed in service (including debugging, denoising, and diagnosing the software), data conversion, and installation activities are generally not considered to be software development.
- Research Performed Under Contract
Many have questioned how research under contract impacts amortization. The notice indicates that Research Recipients (i.e. the party that contracts a research provider) can reference Treas. Reg. Secs. 1.174-2(a)(10) and (b)(3) to determine if the costs paid are SRE expenditures.
For Research Providers, costs incurred are SRE expenditures if:
- The research provider bears financial risk (i.e., risk that the research provider may suffer financial loss related to the failure of the research), or
- The research provider has a right to use any resulting SRE product in its trade or business or otherwise exploit any resulting SRE product through sale, lease, or license.
When addressing long-term contracts, a percentage-of-completion (PCM) method should be used to account for income. Under the PCM, the portion of the contract price a taxpayer recognizes as revenue in a tax year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs. The regulations further provide that taxpayers deduct allocable contract costs as they are incurred and, as provided by Treas. Reg. Sec. 1.460-4(b)(2)(iv), an increase in the percentage of the contract price to be reported is matched by deduction of the incurred costs that cause the increase. The government stated in the notice that “the current Section 460 regulations provide that incurred research or experimental expenses increase the percentage of the contract price required to be reported, although Section 174(a) prevents a corresponding current deduction of incurred SRE expenditures.”
The notice provides further information on short taxable years, cost sharing, and the retirement or abandonment of property related to SRE.
The IRS is requesting any comments or questions requiring further guidance or clarification to ensure the provided information covers all bases.
While this notice does provide some helpful clarity in the forthcoming proposed regulations, the timing of the notice’s release was truly not ideal. Many taxpayers have already filed their returns for their first taxable year beginning after December 31, 2021. Those that have yet to file are left with little time to analyze the guidance and potentially change their accounting methods. Regardless, if taxpayers adhere to the guidance, the notice requires the implementation of all rules. There is no cherry picking here.
Taxpayers that do not intend to implement the guidance provided in Notice 2023-63 for their 2022 tax return should begin to evaluate how their 2022 computations and positions align with the guidance in the notice to ensure they are better prepared to implement the guidance in the anticipated proposed regulations, which the notice says is expected to be applicable for the first taxable year beginning after Sept. 8, 2023. However, proposed regulations are generally not applicable until finalized, so it’s unclear whether the government meant to refer to the final regulations. The notice contains a long list of areas in which the government specifically is requesting comments, so the government may make some changes to these proposed rules based on those comments.
Are you developing new technology for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.
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