On Sept. 8, 2023, the IRS issued advance guidance, Notice 2023-63, concerning the scope of research and experimentation (R&E) expenditures subject to the new Section 174 cost capitalization rules. These new capitalization and amortization rules apply to taxable years beginning after Dec. 31, 2021, affecting tax returns about to be filed and, in many cases, those already filed. The IRS grants taxpayers the choice to rely on its advance guidance for expenditures paid or incurred in taxable years beginning after Dec. 31, 2021. With an Oct. 15, 2023, due date, taxpayers wanting to adopt the rules have only a few weeks to study the 45-page guidance and adjust their tax positions accordingly.
Highlights of Notice 2023-63
Importantly, the IRS provides that Notice 2023-63 does not apply for purposes of determining whether an expenditure paid or incurred for taxable years beginning before Jan. 1, 2022, is within the scope of Section 174 as in effect for taxable years beginning before Jan. 1, 2022.
Notwithstanding that limitation, the IRS addresses seven noteworthy topics, as follows:
- Scope of Section 174. The IRS defines the scope of expenditures subject to the new Section 174 capitalization regime. First, all the definitions and requirements of current Reg. §1.174-2 continue to apply. Next, taxpayers are instructed to use a “cause-and-effect relationship” approach to allocate costs between deductible expenditures and capitalized Section 174 costs. Further, a non-exhaustive list of cost categories within the purview of Section 174 is provided, which includes:
- Labor costs
- Materials and supplies
- Cost recovery allowances on capitalized property used in the performance of research activities
- Costs of obtaining a patent
- Operation and management (overhead) costs
- Travel costs
Meanwhile, costs specifically excluded from the purview of Section 174 are provided, which are:
Software development. The IRS provides a basic definition for computer software that is mostly consistent with prior definitions. Also provided is a description of activities that are treated as software development, including development planning, designing, model building, source code writing, testing and defect resolution. Meanwhile, activities excluded from software development include those associated with the installation of purchased software, such as software configuration, planning, designing, modeling, testing and deployment activities. Other activities excluded from software development include employee training, corrective maintenance after software is placed in service, certain data conversion activities and installation activities. Research provided under contract. The IRS generally provides that contracted research activity costs are not capitalizable by a party hired to perform research services for a principal so long as the hired party does not bear financial risk under the terms of the contract with the principal (i.e., “funded research”). But in any case, the research costs of the hired party are capitalizable when the hired party “has a right to use any resulting [research] product in the trade or business of the [hired party] or otherwise exploit any resulting [research] product through sale, lease, or license.” Some observations about this topic appear under the final heading below. Disposition, retirement or abandonment of property. The IRS clarifies how to treat any unamortized balance of capitalized costs when the research property is disposed of, retired or abandoned in certain corporate transactions. However, partnerships may not rely on this guidance for similar transactions, leaving uncertain the appropriate treatment for partnerships. Long-term contracts under Section 460. The IRS favorably retreats from its earlier stance on costs allocable to long-term contracts, whereby contractors subject to the percentage-of-completion method may include only the amortization deduction (and not the total capitalized cost) in the numerator of the contractor’s calculation of its percentage complete. Cost-sharing transaction payments. The IRS describes a proposed revision to regulations concerning cost-sharing transaction payments between participants in certain cost-sharing arrangements. Short taxable years. Mechanical rules are provided to assist in the calculation of the Section 174 amortization deduction for capitalized costs incurred during short taxable years, including the manner in which the midpoint of a short taxable year should be determined.
- Interest on debt to finance research activities
- Costs incurred by general and administrative departments that only indirectly support research activities
- Costs to input content into a website
- Costs for website hosting that involve the payment of a specified or periodic fee
- Costs to register an internet domain name or trademark
- Costs listed in Reg. §§1.174-2(a)(6)(i)-(vii) (quality control testing, efficiency surveys, management studies, consumer surveys, advertising, purchase price for another’s patent and research in connections with literary or historical projects)
- Amortization of previously capitalized Section 174 costs (whether capitalized before or after the effective date of the new regime)
- Other costs later described with respect to software development
Taxpayers choosing to rely on the IRS advance guidance must adopt all its provisions in their entirety and may not cherry-pick only certain provisions while ignoring others.
The advance guidance is intended to profile forthcoming rules that will be part of proposed regulations on the same topic, which will supersede the advance guidance and are anticipated to impact taxable years ending after Sept. 8, 2023.
Regarding costs for funded research, the IRS provides that research costs incurred by a hired party for a principal are capitalizable when the hired party retains the right to use or exploit the developed product, even if the hired party has no risk of loss. For example, taxpayers who receive private or governmental grants to perform “phase 1 and phase 2” preliminary development work in hopes of creating a marketable product typically retain such rights. Both the principal and the hired party would be subject to the new capitalization regime in that situation, and the hired party would experience a mismatch of taxable grant revenues against deferred deductions for research costs. It is curious that the IRS chose to ameliorate similar mismatch problems for Section 460 long-term contracts while specifically denying relief to hired parties who are not subject to Section 460.
We will continue to monitor this topic as additional developments emerge. Should you have any questions concerning the advance guidance, please contact us.
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