Amortization of Specified Research and Experimental Under Section 174

IRS takes a reasonable approach for expenditures under section 174

The IRS released Notice 2023-63, which provides some clarification pertaining to Section 174's specified research or experimental ("SRE") expenditures and implies that the IRS would issue proposed regulations giving more guidance 'compatible with the provisions indicated in' the Notice. At a fundamental level, the Notice describes what costs are includible in SRE expenditures, what costs the IRS considers excludible from SRE expenditures, what activities constitute software development, and how to recover the SRE expenditures. According to the Notice, the proposed regulations are expected to apply to taxable years ending after September 8, 2023. Taxpayers may rely on the Notice for SRE expenditures paid or incurred in taxable years beginning after December 31, 2021, if they rely on all of the regulations in the Notice and apply them consistently.

Overview

Internal Revenue Service (IRS) has released interim guidance, notice 2023-63, that announce that the IRS and Department of Treasury intend to issue proposed regulations on the following items.:

• Capitalization and amortization of Specified Research or Experimental (SRE) expenditures under Section 174

• Treatment of SRE expenditures under Section 460

• Cost Sharing Arrangements involving SRE Expenditures under Section 482

Prior law under Section 174 allowed taxpayers to deduct SRE expenditures, whereas the TCJA amended Section 174 removes this option and instead requires the taxpayers to capital and amortize specified research and experimental expenditures (SRE) over five years for domestic research expenses or 15 years for foreign research expenses. The TCJA requires software development costs to be treated as SRE expenditures and provides provisions that 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. Therefore, the amortization of such SRE expenditures should continue. The amended Section 174 applies to SRE expenditures paid or incurred in taxable years beginning after December 31, 2021.

In accordance with the notice, Section 174(b) as amended by TCJA defines SRE expenditures and activities as follows with respect to any taxable year beginning after December 31, 2021:

2. Expenditures that are paid or incurred in connection with a taxpayer’s trade or business that –

• Meets the requirements under Treas. Reg. Section 1.174-2 to be research or experimental expenditures or

• Costs incident to the development of any computer software

2. Activities that –

• 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 or

• Software development activities, as described in this Notice.

Identification and allocation of SRE expenditures

The notice provides types of the costs that are considered incident to SRE activities or paid or incurred in connection with software development activities includes but not limited to the following:

• Labour costs

• Materials and supplies costs

• Cost recovery allowances

• Patent costs

• Certain operation and management costs such as 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

The following costs are not treated as SRE expenditures:

• General and administrative service department costs, payroll, accounting, HR.

• Interest on debt to finance SRE activities.

• Costs paid or incurred for activities determined not to be computer software development costs.

• 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 notice states that 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.

Disposition, retirement, or abandonment of property

Any property in relation to SRE expenditures if disposed, retired or abandoned during the applicable Section 174 amortization period –

• Requires the amortization deductions for such SRE expenditures continue over the period.

• Upon sale of the property, the taxpayer does not take into account its unamortized SRE expenditure as basis for the purposes of gain or loss computation.

• If the corporation ceases to exist for federal income tax purposes in a transaction under Section 381(a), the acquiring entity will continue to amortize the transferor’s unamortized SRE expenditures over the remainder of Section 174 amortization period beginning the month of the transfer.

• If the corporation ceases to exist, for transactions not described in Section 381(a), the corporation will be allowed a deduction of the unamortized SRE expenditures in its final taxable year unless any anti-abuse exception applies.

Software Development

The IRS and Treasury Department intend to propose rules in proposed regulations with is forthcoming consistent with the interim guidance provided in the Notice which provides taxpayers with clarity in determining whether certain activities constitute 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.

Activities treated as software development –

• Planning the development of computer software

• Designing the computer software or upgrades and enhancements

• Building a model of the computer software or upgrades and enhancements

• Writing source code and converting to machine-readable code

• Testing of the computer software until it is placed in service or ready for sale or licensing

• Production of the product master(s)

Other activities –

1. Upgrades and enhancements to purchased computer software are treated as software development.

2. Activities not treated as software development:

• Computer software developed by a taxpayer for use in its trade or business.

• Computer software developed for sale or licensing to others.

Research Performed under Contract

The Notice provides with clarity in determining whether costs paid or incurred for research performed under contract are SRE expenditures under Section 174.

The Notice defines the following terms -

• Research Provider: The party that contracts with a research recipient to perform research services for the research recipient with respect to an SRE product or develop an SRE product that the research recipient acquires from the research provider.

• Research Recipient: The party that contracts with the research provider to perform research services for the research recipient with respect to an SRE product or develop an SRE product that the research recipient acquires from the research provider.

• SRE Product: Any pilot model, procoss, formula, invention, technique, patent, computer software or similar property that is subject to protection under applicable domestic or foreign law.

Treatment of the costs paid or incurred –

• Research Provider: If bears the financial risk under the terms of the contract with the research recipient, then the costs paid or incurred by the research provider that are connected to the SRE activities performed by the research provider under the contract are SRE expenditures.

• Research Recipient: If the performance of the services is by research recipient’s order and risk then such costs would be treated as SRE expenditures.

Treatment of SRE expenditures under Section 460

The IRS and Treasury Department anticipate to issue proposed regulations that would amend the existing Section 460 regulations to provide that the costs allocable to a long-term contract accounted for using the percentage completion method include the amortization of SRE expenditures under Section 174(a)(2)(B) rather than the capitalized amount of such expenditures, and that such amortization is treated as incurred for purposes of determining the percentage of contract completion as deducted.

Cost Sharing Under Section 482

Generally, the notice would treat Cost Sharing Transaction (CST) payments under a Cost Sharing Arrangement (CSA) as a reduction of the Section 174 SRE expenditures that are chargeable to capital account.

Under the current law, CST Payments between controlled participants in a CSA are made to ensure that each controlled participant’s share of Intangible Development Costs (IDC) is in proportion to its share of Reasonably Anticipated Benefits from exploitation of the developed intangibles (RAB share), CST payments generally reduce deductible IDCs borne by the controlled participant to which the CST payments are owed. CST payments more than such deductible IDCs are treated as in consideration for the use of land and tangible property furnished for purposes of the CSA by the controlled participant to which the CST Payment is owed.

The IRS and Treasury Department anticipate issuing proposed regulations that would revise the rules that would provide that the CST payments owned to a controlled participant reduce:

• The amount of the category of IDCs borne directly by that participant that are required to be charged to the capital account.

• The amount of the category of IDCs borne directly by the participant that are deductible.

Change in method of Accounting

• TCJA requires taxpayers to apply the provisions of Section 174 as a change in method of accounting for purposes of Section 481 applied on a cutoff basis to SRE expenditures paid or incurred in taxable years beginning after December 31, 2021. Therefore, no adjustment under Section 481(a) is permitted or required with respect to research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2022.

• Currently, IRS and Treasury Department provides procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with Section 174 if the taxpayer makes this change on a cutoff basis if the change was made during the taxpayer’s first taxable year beginning after December 31, 2021. If the taxpayer makes the change for the taxable year subsequent to the taxpayer’s first taxable year beginning after December 31, 2021, is required to make that change with a modified S.481(a) adjustment that takes into account only SRE expenditures paid or incurred in taxable years beginning after December 31, 2021.

Recommended Action Items for Taxpayers

The Notice 2023-63 provides clarity into the proposed regulations that is forthcoming from IRS with regards to capitalization and amortization of SRE expenditures. Taxpayers should assess their 2022 SRE expenditures to implement the guidance in the proposed regulations anticipated to be applicable for the first taxable year beginning after September 8, 2023.

Please do not hesitate to reach out to our US corporate tax professionals here at Trowbridge for any questions or concerns.