Calendar-year taxpayers are faced with the reality that research and experimental, or R&E, expenditures, are no longer deductible but must be capitalized and amortized under IRC Section 174 as amended by the 2017 Tax Cuts and Jobs Act (TCJA). While everyone knew this change was coming for tax years after 2021, many held out hope that the mandatory capitalization would be repealed or at least postponed. In the fall of 2021, the House passed the Build Back Better Act, which sought to delay the mandatory capitalization of R&E expenditures for another four years. But the bill has not received enough support in the Senate and has stalled.
Tax departments now need to consider the impact of the mandatory capitalization of R&E expenditures in their first-quarter tax provisions and their first-quarter estimated tax payments. Tax practitioners have pointed out a number of technical issues that have not yet been addressed by Treasury or IRS guidance. This article will highlight some of the practical challenges taxpayers face in complying with Section 174 in early 2022. The technical issues will not be discussed here, but see this article that highlights some of those technical issues.
To properly comply with Section 174, taxpayers must be able to identify all R&E expenditures, which Treasury Regulations broadly define as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” Further, R&E expenditures include “all costs incidental to the development or improvement of a product.” Practitioners point out that Treasury or the IRS should provide more guidance on the definition or scope of Section 174 costs—and the definition of software development costs—as the current language can be interpreted very broadly.
Historically, taxpayers may be more familiar with IRC Section 41, better known as R&D tax credits, than with Section 174 because R&D tax credits can significantly reduce a taxpayer’s cash taxes. For the same reason, R&D tax credits have been more controversial between taxpayers and the IRS, so more guidance and case law have been developed in this area. Generally, R&D tax credits are computed based on a taxpayer’s qualified research expenses, or QREs. QREs are Section 174 costs that meet additional requirements collectively known as the four-part test. Taxpayers who have claimed the R&D tax credits in prior tax years should consider using their QREs as a starting point for determining R&E expenditures.
Let’s illustrate with a hypothetical taxpayer: a manufacturer in the technology industry. Some of its product costs are QREs and eligible for R&D tax credits. Most of its QREs are expensed as costs of goods sold for accounting purposes and, therefore, its taxable income is expected to increase significantly as a result of mandatory capitalization of R&E expenditures.
The in-house tax team starts this exercise by gathering a list of current projects from the company’s project costing system and projected costs. Next, the tax team attempts to identify which projects may contain Section 174 costs, using the prior year’s R&D tax credit study as a guide. The tax team also considers whether any projects not meeting the four-part test under Section 41 may still meet the broad definition of R&E expenditures under Section 174. It is important to bear in mind this exercise will be a cross-functional effort, not only involving accounting and finance personnel but also the engineers, technical, and perhaps management personnel who can provide insights into the research and experimental activities.
Once the tax team has determined the list of projects that meet the requirements of Section 174, it needs to consider what types of costs should be included. While Section 41 limits the types of expenditures—e.g., certain wages, supplies, and computer leasing costs—to be included in QREs, Section 174 is much broader and includes indirect costs. For example, QREs generally only include wages for certain personnel—namely, in-house employees directly working on research and those who directly supervise these employees and those who directly support these employees. However, Section 174 costs may include wages for management personnel incurred “in connection with” research or development activities or for support costs such as legal fees for a patent application. The tax team needs to look beyond the project costs ledger to identify additional indirect costs such as general and administrative costs. Last but not least, the tax team should also take into account any research and development expenses under Accounting Standards Codification (ASC 730) to the extent not already included in the project costs analysis.
Indeed, the tax team for our hypothetical taxpayer will be kept fairly busy trying to quantify its Section 174 costs, assessing the impact on its expected tax liabilities—including, for example, impact on Section 163(j), GILTI, FTC, and possibly the base erosion and anti-abuse tax (BEAT)— and perhaps even consider possible planning strategies.
If I was granted three wishes for changes with respect to Section 174, assuming it is not repealed or delayed, they would be:
- First, quarterly estimates should be computed without IRC Section 174 costs because it is impossible to accurately estimate the R&D expenditures so early in the year when many projects may have just started or are in progress. Taxpayers tend to perform their R&D tax credit analyses—which can cover Section 174 costs—much later in the year, and they can recapture the benefit of underpaying the quarterly estimates by the tax return extension due date.
- Second, we need Treasury and/or IRS guidance soon. Specifically, it would ease compliance burden immensely if there were a safe harbor to deem a taxpayer’s Section 174 costs as a percentage—equal to at least 100%—of its QREs. This would help taxpayers who claim the R&D tax credits, who are the taxpayers most likely affected by Section 174. Treasury and the IRS should engage with taxpayers and practitioners to determine an appropriate percentage.
- Third, the mandatory capitalization section should not apply in computing GILTI, as there’s no policy reason for preventing a CFC’s GILTI income from qualifying for the high-taxed exclusion because Section 174 artificially inflates its U.S. taxable income, but its foreign tax liability has not changed.
A recent benchmark survey cited keeping up with legislative and other tax law changes and planning and modeling around these changes as the top challenges for tax departments. If Congress can act quickly to repeal or delay the effective date of Section 174, this will be one change welcomed by tax departments overloaded by the changes from the last few years.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Betty Mak is a senior tax manager with Maxar Technologies (Maxar), a provider of comprehensive space solutions and secure, precise, geospatial intelligence, based in Westminster, Colo. Mak, who is a U.S. (New Hampshire) and Canadian CPA, is also a member of Tax Executives Institute (TEI)’s Federal Tax Committee and the First Vice President of TEI’s Vancouver Chapter.
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