Research and experimentation is fundamental for innovation, allowing companies to pursue cutting-edge solutions in a competitive market. It is also expensive. To reduce the cost and encourage research and experimentation, Congress currently offers a choice between two tax benefits. These research and experimentation (R&E) tax incentives—sometimes referred to as research and development incentives—sweeten the pot for companies developing new products or processes by providing a tax credit equal to 20 percent of eligible costs or the ability to immediately deduct all of those expenses in the year they were paid or incurred.
However, some of this benefit will be reduced if Congress and the President do not prevent a change mandated by the 2017 tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA).
A Closer Look at the R&E Tax Changes
Companies that choose the tax credit are generally not able to deduct all of the eligible costs. There is a deduction “haircut” equal to the amount of the credit, usually leaving 80 percent of the eligible costs as deductible. Regardless of the choice between a partial or a full deduction of eligible costs, companies can choose the timing of those deductions. Instead of an immediate deduction, research companies may currently treat most R&E expenditures as deferred expenses and amortize the costs for 60 months or more, or for a period that ranges from 36 to 60 months for software costs. These alternative amortization options currently allow taxpayers more flexibility to match the deduction to years in which the taxpayer’s research investment begins to generate income.
The TCJA provision eliminates this flexibility.
Starting Jan. 1, 2022, companies will be required to capitalize and amortize R&E expenses over a five year period for research performed in the U.S. and over a 15 year period for research conducted outside the U.S. Amortization begins with the midpoint of the tax year in which the expenses were paid or incurred. For research performed in the U.S., only 10 percent of the deductible costs can be claimed in the first year due to the midpoint rule.
The adjustment is meant to incentivize long-term R&E projects and increase federal revenue (according to estimates by the Joint Committee on Taxation, current projections for the change expect it to bring in around $120 billion of federal revenue in the first 10 years). But the change may also inflate the cost of investing in research and diminish a company’s cash flow.
Measuring the Impact of the Changes
The transition to amortizing R&E costs over five or 15 years will dramatically affect most U.S. companies that focus on research, especially when it comes to budgeting, forecasting, and calculating the bigger financial picture. For many organizations, R&E co-development and collaboration frequently occur, which can also complicate the timing of revenue recognition for R&E funding and the related R&E tax deduction. Additionally, the TCJA requirement to capitalize and amortize R&E costs does not distinguish between successful and failed research or experimentation attempts, so companies may be forced to maintain deferred costs for failed attempts that will never correlate with future years of income production.
Software development costs—such as design, coding, and testing—paid or incurred in connection with R&E are also subject to the provision. The cost of software licenses used in conjunction with research and experimentation is included as well. For example, if a company invests in a three-year software license to develop a new product, it will be required to amortize that cost over five or 15 years. Under current IRS guidelines, taxpayers may capitalize and amortize software development costs over 36 months or 60 months or expense them immediately. With the changes, that choice will no longer be available, with costs having to be capitalized and amortized over a five to 15 year period.
Companies should also note:
- The new provision should not negatively impact the R&E tax credit.
- R&E expenses can be excluded from inventory capitalization required for tax purposes.
- The provision may impact Base Erosion and Anti-Abuse Tax, Global Intangible Low-Taxed Income, and Foreign-Derived Intangible Income calculations.
Critics Fighting Back
Research and development experts argue the TCJA change will negatively impact the nation’s innovation and the workforce. In a 2019 study, the R&E Coalition estimated the provision’s economic impact would be widespread.
The study determined that the requirement to amortize certain R&E expenditures may:
- Reduce R&E spending by $4.1 billion annually in the first five years
- Reduce roughly 23,000 jobs in the first five years
- Reduce U.S. R&E-related labor income by $3.3 billion annually in the first five years
Many lawmakers view the tax code change to be detrimental to the future of R&E and have taken measures to prevent it from going into effect. A bipartisan group of Senators recently introduced the American Innovation and Jobs Act, eliminating the TCJA provision and allowing companies to continue immediately deducting R&E expenses. Earlier this year, the House of Representatives introduced a similar bill.
The timing of eliminating this change is vital. If Congress does not act before the provision goes into effect on Jan. 1, 2022, benefits from a repeal may be significantly mitigated. First, businesses will have to enter the year using projections that include the change, which will likely blunt the impact of repeal as businesses frequently plan research and development expenditures well into the future. Second, any retroactive change may require significant effort from businesses to return to the current law method. By Jan. 1, 2022, many businesses will likely have already changed their accounting methods to comply with this new provision, and a retroactive repeal will require them to change back. Further guidance from the IRS may be necessary as it is not entirely clear how taxpayers would revert to the current law method.
Eliminating immediate expensing also creates additional difficulties for taxpayers. Currently, taxpayers are not required to identify incidental costs attributable to research expenditures, such as electricity bills, because they are all immediately deductible. With the provision, a taxpayer will be required to identify these costs and amortize them over the applicable five or 15 year period. For example, if a manufacturing business devotes part of its electricity usage and part of its water usage towards developing a new product, it will then be required to determine which portion of those costs are attributable to the development in order to properly capitalize and amortize those costs over the required period.
Next Steps to Consider
Although eliminating the five-year R&E amortization requirements has widespread appeal with Congress, it is uncertain whether action will be taken. Therefore, it is imperative companies plan for these changes now. Working with a tax advisor specializing in the nuances of the R&E tax credit and application can help your organization evaluate and understand how the provision will impact operations.
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