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Capitalizing RE and increased interest disallowance effective
January 2022
In brief
Section 174 allowed taxpayers to currently deduct ‘research or experimental’ (R&E) expenditures. Taxpayers alternatively could elect to treat R&E as deferred expenses that are deducted ratably over at least 60 months or as capital expenditures that are amortizable over a useful life, if determinable. Taxpayers choosing to deduct R&E expenditures also could annually elect under Section 59(e) to recover the costs over a 10-year period.
Similarly, Rev. Proc. 2000-50 provided that software development costs could be deducted currently, capitalized and amortized over five years, or capitalized and amortized over three years (with or without bonus depreciation).
The 2017 tax reform act amended Section 174, effective for amounts paid or incurred in tax years beginning after December 31, 2021, to eliminate these options and require taxpayers to charge their R&E expenditures and software development costs (collectively, R&E expenditures) to a capital account. Capitalized costs are required to be amortized over five years (15 years for expenditures attributable to foreign research). Because taxpayers may claim the Section 41 R&E credit only for costs that are eligible to be treated as R&E expenditures under Section 174, it is expected that any amounts treated as qualified research expenditures for purposes of the R&E credit also will be capitalized under amended Section 174.
Legislation currently is under consideration in the Senate that would reinstate on a temporary basis the previous Section 174 treatment of R&E expenditures. The House-passed ‘Build Back Better’ reconciliation bill would defer for four years the effective date of the 2017 capitalization and amortization requirement. If enacted, taxpayers with R&E expenses paid or incurred in tax years beginning before 2026 would continue to have the earlier options.
Observation: Congress could provide temporary Section 174 relief as part of action on the Build Back Better bill or in another legislative vehicle. Allowing taxpayers to currently deduct R&E expenditures has broad bipartisan support because it is seen as encouraging research activities and having broad economic benefits. There are freestanding bills in both the House and Senate to repeal the change to Section 174 that would require capitalization.
A change to the Section 163(j) interest deduction limitation also has gone into effect in 2022. For tax years beginning after 2021, taxable income no longer is adjusted for depreciation, amortization, and depletion in arriving at adjusted taxable income (ATI), resulting in lower ATI and potentially a greater interest disallowance. The House-passed Build Back Better bill does not propose to delay or eliminate this change to the computation of ATI.
For consideration: With the delay in Senate action on the Build Back Better bill, the changes to Section 174 and Section 163(j) have become effective for tax years beginning in 2022. Taxpayers should consider the impact of these changes on their first quarter 2022 financial reporting and estimated tax payments and on cash taxes, R&E credits, Section 861 allocation and apportionment of R&E expenditures, state income taxes, and other tax matters.
If the effective date of the Section 174 change is not amended by statute, taxpayers with R&E expenditures may want to evaluate what costs are required to be treated as Section 174 costs rather than taken into account under another provision. Taxpayers also may want to consider the impact of any modification to what is classified as Section 174 costs on the taxpayer’s research credit calculation and other impacted areas.
In detail
Section 174
The new requirement to capitalize and amortize all R&E expenditures will require taxpayers to determine the proper amount of their Section 174 costs. Many taxpayers may treat the expenditures characterized as R&E on their financial statements as their Section 174 costs assuming there is no difference between a current deduction under Section 174 and a current deduction under Section 162.
However, among other consequences, improperly characterizing a cost as a Section 174 expenditure could impact a taxpayer’s inventoriable costs under Section 263A (because engineering and design costs are inventoriable unless they are Section 174 costs), Section 59(e) elections (because Section 174 costs are eligible to be capitalized under Section 59(e)), and apportionment under Section 861 regulations (because Section 174 expenditures have special rules). As a result, it is important to properly characterize Section 174 expenditures whether or not there is a requirement to capitalize those costs.
To properly determine Section 174 expenditures, taxpayers must consider numerous technical issues that currently are not addressed in regulations or other IRS and Treasury guidance. Some of these issues are:
- What is the definition or scope of R&E activities? Section 174 specifically excludes costs related to acquiring land or other property for R&E activities and costs for mineral exploration, and now specifically includes software development costs, but otherwise does not define R&E expenditures.
- Is the characterization of a Section 174 expenditure an activity-based test, an ownership-based test, or both?
- How should indirect costs be treated?
- How are domestic and foreign research activities and the resulting intellectual property distinguished for purposes of determining whether the costs are amortized over five or 15 years?
- How are R&E costs treated when a contractor performs R&E services for a client and the contractor is not at risk and has no ownership rights in the resulting IP? Are the contractor’s costs subject to Section 174?
- How does R&E capitalization impact the rules under Reg.1.861-8 (dealing with computation of taxable income from US and other sources and activities), Reg.1.861-17 (dealing with allocation and apportionment of R&E expenditures), and the cost-sharing regulations under Section 482?
- How should R&E capitalization be treated under UNICAP? Section 263A provides that the UNICAP rules do not apply to amounts “allowable as a deduction” under Section 174. Is Section 174 amortization a production cost subject to UNICAP, or does the Section 263A exclusion apply to the ‘deduction’ for amortization?
- How are software development costs defined? For example, do they include installation of acquired software?
- What is the character of Section 174 amortization for other federal tax purposes?
- What procedures must be followed to implement the method change to required capitalization?
The IRS and Treasury have included on their Priority Guidance Plan for 2021-2022 issuing “guidance addressing amortization” of R&E expenditures under Section 174, which is expected to address the procedural rules to effect an accounting method change and some of these technical issues.
Section 163(j)
Section 163(j) limits a taxpayer’s deduction for business interest to the sum of (1) business interest income, (2) 30% of ATI, and (3) floor plan financing interest. ATI is taxable income with certain adjustments. For tax years beginning before 2022, deductions for depreciation, amortization, and depletion, including amounts capitalized to inventory under Section 263A and recovered through cost of goods sold, are disregarded in computing ATI. Thus, taxpayers may increase ATI and reduce disallowed interest by capitalizing costs recovered as depreciation or amortization.
For tax years beginning after 2021, depreciation, amortization, and depletion no longer will be added back to taxable income in computing ATI, potentially resulting in a greater business interest disallowance for many taxpayers. However, capitalized interest will continue to be excluded from the disallowance. Thus, taxpayers may continue to reduce the amount of disallowed interest by properly capitalizing interest under Section 263(a) or Section 263A, or electively under Section 266.
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