IRS provides automatic method change for RE expenditures: PwC

IRS provides automatic method change for RE expenditures

December 2022

In brief

The 2017 tax reform act amended Section 174, effective for amounts paid or incurred in tax years beginning after December 31, 2021, to require taxpayers to charge research and experimental (R&E) expenditures, including software development costs (collectively, Section 174 costs), to a capital account. Section 174 costs are required to be amortized over five years (15 years for expenditures attributable to foreign research).

Previously, for R&E expenditures taxpayers could either (1) currently deduct the expenditures, (2) treat the expenditures as deferred expenses deducted ratably over at least 60 months or as capital expenditures amortizable over a useful life, if determinable, or (3) annually elect under Section 59(e) to recover the expenditures over a 10-year period.

Although software development costs were not explicitly included in the Section 174 definition of R&E expenditures, Rev. Proc. 2000-50 provided that software development costs in many respects so closely resemble the kind of R&E expenditures that fall within the purview of Section 174 as to warrant similar accounting method treatment. Accordingly, under Rev Proc 2000-50, taxpayers could either (1) currently deduct the expenditures in accordance with rules similar to Section 174(a) or (2) capitalize the expenditures and recover them ratably, in accordance with rules similar to those provided by Section 174(b), over a period of 36 or 60 months.

Legislation that would reinstate the previous treatment of R&E and software development costs has had bipartisan support in Congress, but to date has not been enacted. In the interim, the IRS amended the automatic method change revenue procedure to limit use of the automatic procedures for R&E expenditures under Section 174 and software development costs under Rev. Proc. 2000-50 to method changes for expenditures under the statute as in effect before 2022.

The IRS has now issued Rev. Proc. 2023-8, providing for taxpayers to change their method of accounting for Section 174 costs for tax years beginning after December 31, 2021, using the automatic procedures.

For consideration: Taxpayers that must change their method of accounting for Section 174 costs now make the change when filing their 2022 federal income tax return using the automatic procedures. Until the IRS and Treasury issue additional guidance, however, taxpayers will need to consider and resolve a number of technical issues in implementing this change. For additional information on technical issues arising from Section 174 capitalization, please see the PwC Insight Capitalization of R&E expenditures and increased interest disallowance are effective for 2022.

In detail

Rev. Proc. 2023-8 provides an automatic change in method of accounting for taxpayers to comply with amended Section 174 to capitalize and amortize their Section 174 costs. Thus, the method change applies to expenditures paid or incurred in tax years beginning after 2021. Rev. Proc. 2023-8 expressly does not apply to changes in the treatment of R&E expenditures under Section 174 or to changes in the treatment of computer software under Rev. Proc. 2000-50 in tax years beginning before 2022.

Rev. Proc. 2023-8 allows taxpayers to make the change for the first tax year beginning after 2021 by filing a statement providing certain specified information with their federal income tax returns in lieu of filing Form 3115. The requirement to file a duplicate copy is waived.

The change for the first tax year beginning after 2021 is made on a cut-off basis, and the limitation on using the automatic procedures to change a method of accounting for an item more than once in five tax years is waived.

Under a transition rule for tax returns filed on or before January 9, 2023, for a tax year beginning after 2021, taxpayers are deemed to satisfy the method change procedures if they (1) properly capitalized and amortized Section 174 costs in accordance with amended Section 174 and (2) reported the Section 174 costs on Part VI of Form 4562, Depreciation and Amortization, filed with the return.

Taxpayers must file a Form 3115 for tax years later than the first tax year beginning after 2021 and include an attachment providing certain additional information. The change is made with a modified Section 481(a) adjustment that takes into account only Section 174 costs paid or incurred in tax years beginning after 2021.

Rev. Proc. 2023-8 denies audit protection for expenditures paid or incurred before 2022 and states that no inference should be drawn about the treatment of R&E expenditures paid or incurred, and method changes made, under former Section 174. The background section explains that the IRS may change the characterization or classification of expenditures as Section 174 R&E expenditures in these tax years to apply Section 174 to the proper amount of expenditures paid or incurred in each tax year beginning after 2021.

Observation: The definition of Section 174 costs, as distinguished from ordinary business expenses deductible under Section 162, is a key issue that is anticipated to be addressed in forthcoming IRS and Treasury technical guidance.