The IRS has released interim guidance (Notice 2023-63) to clarify the treatment of specified research and experimental expenditures (SRE) under Section 174, which must be capitalized and amortized under the Tax Cuts and Jobs Act (TCJA). The release provides the first substantive guidance for complying with the new rules after the IRS initially focused on procedural guidance for implementation.
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
Taxpayers are not yet required to implement the guidance provided in the notice, but can rely on the interim guidance if they implement all the rules. Taxpayers cannot rely only on certain sections while taking differing positions on other sections in the notice. The IRS intends to propose regulations consistent with the guidance that would apply for taxable years ending after Sept. 8, 2023.
The IRS also intends to issue procedures for taxpayers to obtain automatic consent to change their method of accounting to comply with this notice, including procedures for taxpayers that have already changed their methods of accounting to comply with Section 174. Taxpayers that have not yet changed their method to comply with Section 174 may implement the rules of the notice by following the guidance in Section 7.02 of Rev. Proc. 2023-24 to change their methods of accounting under Section 174 (see our prior story for more information on implementing the rules).
Background
The TCJA amended Section 174 by removing the option to expense SRE expenditures, instead requiring taxpayers to capitalize and amortize SRE expenditures over a period of five years (attributable to domestic research) or 15 years (attributable to foreign research), beginning with the midpoint of the taxable year in which the expenses are paid or incurred. 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 such SRE expenditures are paid or incurred, and instead that amortization of such SRE expenditures should continue.
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.
Proposed guidance
The guidance provided in Notice 2023-63 addresses several key technical aspects of the capitalization and amortization requirements of Section 174, including:
- Identification and allocation of SRE expenditures
- Software development
- Research performed under contract
- Application to long-term contracts under Section 460
- Cost sharing under Section 482
- Short taxable years
- Disposition, retirement or abandonment of property
Identification and allocation of SRE expenditures
Section 4 of the notice defines terms that are essential to the identification and allocation of SRE expenditures for taxable years beginning after Dec. 31, 2021. Generally, all terms used in the notice have the same meaning as those found in the existing Treas. Reg. Sec. 1.174-2, with certain modifications. In accordance with the notice:
- “SRE expenditures” are research or experimental expenditures which are paid or incurred by the taxpayer in connection with the taxpayer’s trade or business, that:
- satisfy the requirements under Treas. Reg. Sec. 1.174-2 to be research or experimental expenditures, or
- are paid or incurred in connection with the development of any computer software as described in the notice.
- “SRE activities” are:
- software development activities as described in the notice, or
- research or experimental activities in the experimental or laboratory sense 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 (see Treas. Reg. Sec. 1.174-2).
Grant Thornton Insight
The notice provides taxpayers with helpful clarification that, although the term “specified” in Section 174(a) currently is not included in Treas. Reg. Sec. 1.174-2, the definitions in Treas. Reg. Sec. 1.174-2 are still applicable (except for the modifications to include software development).
In accordance with the above definitions, SRE expenditures include all costs incident to SRE activities. The notice provides examples of the types of costs that are considered incident to SRE activities to the extent in the direct support of 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. Most notably, costs paid or incurred by general and administrative (G&A) services departments or functions that only indirectly support or benefit SRE activities (e.g., payroll, HR, accounting, etc.), interest on debt to finance SRE activities, and amortization of amounts capitalized under Section 174 in prior years, are not SRE expenditures according to the notice.
Grant Thornton Insight
The explicit exclusion of costs paid or incurred by G&A service departments from costs incident to SRE activities is generally a welcome interpretation that costs “incident to” SRE activities are not aligned with the broader capitalization requirements in Section 263A and the regulations thereunder. This is consistent with the legislative history of Section 263A, in which Congress chose to not subject these types of intangible intellectual properties to the uniform capitalization rules. However, the prohibition of optionally capitalizing the costs in the list, particularly the exclusion of G&A service costs and interest on debt to finance SRE activities from SRE expenditures is concerning for taxpayers that may have capitalized such costs for book purposes. It is not uncommon for taxpayers to allocate a portion of certain G&A service costs to R&D departments. Additionally, book may capitalize interest to certain types of software development. A book safe harbor that allowed optional capitalization would prevent the additional burden of having to identify and remove such costs.
For purposes of determining SRE expenditures attributable to foreign research, the notice provides that taxpayers must look to where the SRE activities are performed. The definition of foreign research aligns with the definition under the R&D credit under Section 41 and means any research conducted outside the U.S., the Commonwealth of Puerto Rico, or any territory or other possession of the U.S.
The notice also provides rules for allocating SRE expenditures. In accordance with Section 4.03(3) of the notice, taxpayers must allocate costs to SRE activities on the basis of a cause-and-effect relationship between the costs and the SRE activities or another relationship that reasonably relates the costs to the benefit provided by the SRE activities. Although the notice states that the allocation method used for one type of cost may differ from the allocation method used for another type of cost, the method used for each type of cost must be applied on a consistent basis.
Grant Thornton Insight
The requirement to apply the allocation method used for each type of cost on a consistent basis will likely be burdensome for many taxpayers because taxpayers will have to allocate book/tax differences in the same manner as the underlying expense. It appears, for example, to require specific tracing of the way in which book allocated depreciation for each asset in order to allocate the book/tax difference for each asset in the same manner as book. Taxpayers may currently allocate book/tax differences such as depreciation based on reasonable factors rather than specific tracing of every asset.
Additionally, it raises a question of whether a change in a taxpayer’s book allocation method among departments will require the taxpayer to file an accounting method change. It is common for taxpayers when determining how much operation and management costs to capitalize for Section 174 to follow the book allocation of costs to departments under the presumption that book is using reasonable relationships. Under this approach, a change in the way a type of cost is allocated for book purposes may require the taxpayer to file an accounting method change.
As described above, taxpayers that wish to follow the guidance provided in the notice must implement all the rules in the notice. Therefore, taxpayers must carefully consider whether the identification and allocation rules create substantial burden before deciding to implement the rules of the notice.
Under Section 4.04 of the notice, SRE expenditures must be treated consistently for purposes of all provisions under Subtitle A of the Code. For example, SRE expenditures may not be treated as ordinary and necessary under Section 162 or capitalized under Sections 195, 263(a), 263A or 471.
Grant Thornton Insight
Presumably, even though the notice does not specifically state it, other provisions could require or permit the capitalization of the amortization of Section 174 SRE expenditures. For example, Treas. Reg. Sec. 1.263A-1(k)(1) provides taxpayer with an optional provision to capitalize certain costs under Section 263A. The notice provides a special rule for the treatment of the amortization under Section 460.
The IRS has requested comments on whether additional guidance is necessary, including whether simplified methods or safe harbors should be provided for identifying and allocating expenditures to SRE activities.
Software development
Notice 2023-63 includes several key definitions in Section 5.02(1) as it relates to software development for purposes of the notice:
- 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). For example, 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)
Examples of activities that do not constitute software development include employee training, maintenance after the computer software is placed in service (e.g., corrective maintenance to debug, diagnose, and fix programming errors), data conversion activities, and installation of the computer software.
Grant Thornton Insight
The examples of software development included in the notice are very helpful. Be aware that, due to the continuous nature of the software development life cycle, it is critical for taxpayers that perform testing of computer software to carefully analyze the nature of their activities to distinguish quality control testing from non-quality control testing. This is particularly important because quality control testing is not a SRE activity under Treas. Reg. Sec. 1.174-2(a)(6).
Under the notice, activities that are treated as software development for purchased software are generally limited to upgrades and enhancements. Other activities, including the purchase and installation of the computer software (e.g., configuration of pre-coded parameters to make such software compatible with the business or re-engineering the business to make it compatible with the purchase software) do not constitute software development.
Grant Thornton Insight
The guidance provided in the notice generally aligns with the guidance in a 2002 private letter ruling (PLR 200236028) in which the IRS ruled that, with respect to purchased Enterprise Resource Planning (ERP) software, the costs of option selection and implementation of templates (and its allocable portion of the costs of modeling and design) are installation/modification costs. In accordance with the PLR, such amounts are required to be capitalized as part of the purchased ERP software under Section 263(a). Therefore, taxpayers must be aware that, although installation activities may not be required to be capitalized as SRE expenditures, they may be required to be capitalized under Section 263(a).
The IRS has requested comments on the definition of computer software, including if there is a more appropriate definition under the Financial Accounting Standards Board Accounting Standards Codifications (ASCs) or an industry standard definition.
Research performed under contract
For purposes of the guidance provided with respect to research performed under contract, the notice provides the following definitions:
- A “research provider” is the party that contracts with a research recipient to:
- o Perform research services with respect to an SRE product, or
- o Develop an SRE product acquired by the research recipient.
- A “research recipient” is the party that contracts with the research provider.
- An “SRE product” is any pilot model, process, formula, invention, technique, patent, computer software, or similar property (or component thereof) that is subject to protection under applicable domestic or foreign law. Notably, a SRE product does not include mere know-how gained through the performance of research services.
Research recipient
The notice cross-references the requirements of Treas. Reg. Secs. 1.174-2(a)(10) and (b)(3) for determining if the costs paid or incurred by the research recipient are SRE expenditures. Accordingly, the performance of the services must be at the research recipient’s order and risk for such costs to be SRE expenditures.
Research provider
The notice provides that costs incurred by the research provider in performing research activities 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.
A research provider is not treated as having a right to use the SRE product in its trade or business if such right is available only upon obtaining approval from another party that is not related (within the meaning of Section 267 or Section 707).
Grant Thornton Insight
This has been a significant area of uncertainty for research providers, who didn’t necessarily care whether their deductions prior to the TCJA amendments were under the former Section 174 or Section 162. Interestingly, the notice provides that a research provider only need financial risk for its costs incurred in performing the research to be capitalizable SRE expenditures, even though a long line of case law requires a taxpayer to have the rights to exploit the results of the research in its trade or business to have Section 174 expenditures. It is unclear whether the government believes that if the research provider has financial risk, it means the research provider owned the SRE product and exploited the SRE product through sale to the research recipient (regardless of whether the agreement is a “work for hire” arrangement), or whether government intends to override case law with respect to research providers.
The IRS has requested comments regarding any special rules that may be needed for service or manufacturing production contracts with the government (including Section 460 long-term contracts), and if there are other factors that should be considered in determining whether a party to a research contract has SRE expenditures.
Application to long-term contracts under Section 460
Section 8.03 of Notice 2023-63 provides that costs allocable to a long-term contract accounted for using the PCM include the amortization deduction associated with SRE expenditures, rather than the total amount of SRE expenditures incurred during the tax year (i.e. the amount charged to capital account).
Generally, Section 460(a) requires use of the percentage-of-completion method (PCM) to account for income from a long-term contract. 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.”
Grant Thornton Insight
This result makes sense when compared to the treatment of other depreciable/amortizable assets under Section 460, for which only the current year depreciation (without regard to bonus depreciation) or amortization is included in the numerator rather than the entire incurred expenditure that is charged to capital account. Although this guidance provides helpful clarification with respect to determining the numerator of the PCM ratio, it is still unclear how taxpayers should determine the denominator of the PCM ratio and the lookback calculation.
The IRS has requested comments on how to compute estimated total allocable contract costs (i.e., the denominator of the PCM ratio). For example, does this include all SRE expenditures that directly benefit or are incurred by reason of the performance of the long-term contract or, alternatively, only that portion of the SRE expenditures expected to be amortized during the term of the contract?
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 current Treas. Reg. Sec. 1.482-7(j)(3)(i), 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 in excess of 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.
Section 9.03 of Notice 2023-63 anticipates proposed regulations will amend Treas. Reg. Sec. 1.482-7(j)(3)(i) with rules providing that CST payments owed 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
Short taxable years
Section 3 of Notice 2023-63 provides taxpayers clarity regarding the application of these rules for short taxable years. Generally, the midpoint of the taxable year means the first day of the seventh month of the taxable year in which the SRE expenditures are paid or incurred. The amortization deduction for a short taxable year is based on the number of months in the short taxable year.
Disposition, retirement, or abandonment of property
In accordance with Section 174(d), if any property related to SRE expenditures is disposed, retired, or abandoned during the period when the expenditures are allowed as an amortization deduction, no deduction shall be allowed with respect to such expenditures on account of the disposition, retirement, or abandonment, and the amortization deduction shall continue with respect to such expenditures. Additional clarification is provided in the notice, including the application in several corporate transactions:
Sale of property
Generally, if any property with respect to which SRE expenditures are paid or incurred is disposed of, retired, or abandoned during the applicable Section 174 amortization period, the taxpayer does not take into account its unamortized SRE expenditures as basis in the computation of gain or loss under Section 1001, as part of a Section 165 loss, or otherwise. Instead, the taxpayer disposing, retiring, or abandoning such property continues to amortize such expenditures under Section 174 over the remainder of the applicable Section 174 amortization period. The guidance provided above is applicable to property transferred in taxable asset acquisitions under Section 1060(c) and property transferred in a Section 351 exchange, except for a limited exception below.
Section 381(a) transactions
Section 7.04 of Notice 2023-63 provides that if a corporation ceases to exist for federal income tax purposes in a transaction or series of transactions under Section 381(a), the acquiring corporation will continue to amortize the distributor or transferor’s unamortized SRE expenditures over the remainder of applicable Section 174 amortization period beginning with the month of transfer.
Other transactions in which a corporation ceases to exist
For transactions not described in Section 381(a), if a corporation ceases to exist, the corporation is allowed a deduction equal to the unamortized SRE expenditures in its final taxable year, limited by an anti-abuse exception. Notably, Section 10 of the notice expressly prohibits taxpayers from relying on the guidance above for SRE expenditures paid or incurred with respect to property that is contributed to, distributed from, or transferred from a partnership.
Grant Thornton Insight
The guidance in the notice with respect to transactions in which the trade or business ceases to exist is a welcome interpretation of the statute and addresses some of the uncertainties under the new provision. However, it is concerning that, in instances where a taxpayer actually sells the property in a transaction to which Section 1001 applies, the taxpayer is generally not entitled to recovery of its basis in the Section 174 amounts in the year of sale. This raises uncertainty particularly for C corporations regarding the reporting requirements and whether the character of the amortization deductions must be separately tracked depending on the nature of the character of the sale, potentially creating burdensome tracking systems. For example, are the future amortization deductions potentially required to be reported each year on the Form 4797, Sales of Business Property, if the gain was reported there, while normally amortization of retained property would be reported on the Form 4562, Depreciation and Amortization?
Next steps
Notice 2023-63 provides helpful clarity into forthcoming proposed regulations from the IRS regarding key aspects of the Section 174 capitalization and amortization requirements elevated by the TCJA amendments. However, the timing of the notice’s release is not ideal, as many taxpayers have already filed their tax return for their first taxable year beginning after Dec. 31, 2021. Taxpayers that have not yet filed their 2022 tax return and wish to change their method of accounting under Section 174 by wholly adhering to the notice have little time to analyze the guidance and make any necessary changes to their Section 174 computations. Taxpayers should be aware that adhering to the guidance in the notice requires implementation of all rules, and some of these rules could present challenges and additional burdens in the Section 174 analysis that could be difficult to address in time for filing.
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.
For more information, contact:
Dennis St. Martin
Senior Manager
Washington, D.C.
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