The new year is almost here, and it's time to start planning for changes to the tax treatment of research and development (R&D) expenses. The forthcoming changes to the research and development (R&D) tax deduction will affect companies in all stages—from startups to multinational corporations with global interests. Mandated by the 2017 tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA), these changes will no longer allow companies to expense R&D costs immediately.
The change will affect specific areas of tax reporting more than others, such as estimated payments companies must make in the first quarter of 2022. We expect that for most organizations, the rule change will not affect decisions about whether to take the R&D tax credit, but it is important for your organization and its stakeholders to understand the mechanics of the change so they can prepare for its impact.
How the Changes Will Work
Starting Jan. 1, 2022, companies will be required to capitalize and amortize R&D expenses over five years for research performed in the U.S. and over 15 years for research conducted outside the U.S. Amortization begins with the midpoint of the tax year the expenses were paid or incurred. For research performed in the U.S., only 10% of the deductible costs can be claimed in the first year due to the midpoint rule. The TCJA changes do not materially affect the manner in which the R&D credit is calculated.
Initially, the changes may seem overwhelming because the benefits and costs associated with R&D expenses will be more cumbersome to evaluate. Organizations will have to be more careful with their assessment of the applicable expenses they incur, such as wages paid to professionals to conduct research or fees paid to contractors for qualifying development activities. This assessment will be necessary for purposes of both the deduction and the credit, as well as the impact that these changes will have on the company’s cash flows related to the expected taxable income. Where closer scrutiny of these expenses historically has been limited to the associated claims for R&D credits, the additional burden of capitalizing and amortizing the applicable expenses over a period of either five years or 15 years (rather than deducting the expenses immediately) makes tax planning even more challenging.
Initially, smaller companies with fewer capital resources available may be more sensitive to the additional burden and uncertain impact of these changes than will larger entities. It may also influence a company’s decision making. For example, a company may be debating whether to develop its own assets such as creating software or intellectual property (IP), which can be very expensive and comes with a variety of uncertainties, versus purchasing software or previously-established IP. The risk/benefit analysis of this decision must now take into account the fact that the more challenging (but potentially rewarding) development expenses can no longer be immediately expensed.
This may also be enough of a hit to consider whether the documentation efforts associated with the R&D tax credit are worth making. However, it’s important to remember that R&D credit feasibility is not a relevant criteria in determining whether the company has R&D expenses that require capitalization. If your company engages in development activities, which is customary for most software companies or manufacturing companies that release new products, the IRS generally assumes that you have R&D expenses, regardless of whether an R&D credit is claimed.
This may be a particularly thorny area when R&D activities exist but the applicable expenses do not qualify for the R&D tax credit. An example of this is internal-use software development activities. Internal-use software has additional qualifying thresholds that must be met in order for the software development expenses to be included in the R&D credit calculation, but these expenses would need to be capitalized regardless of whether they are includable for the credit calculation.
A Look at Deferred Taxes
If you're operating at a loss, the R&D expenses that are capitalized for tax purposes will count as a deferred tax asset for financial reporting purposes. For instance, if you've expensed an item for financial reporting purposes that you have not deducted for tax purposes, then a book-tax difference is created for these expenses. The deduction is deferred for tax purposes, and you receive it in a year later than the one when the expenses were originally included for financial reporting purposes. Having a deferred deduction for tax purposes, which doesn't exist for book purposes, is represented as a deferred tax asset. For the first time, R&D expenses are going to be capitalized for tax, even though they may continue to be expensed immediately for book purposes, which creates these deferred tax assets.
When it Breaks Even
Companies may owe more tax in the initial years of this rule change. After all, you can only receive up to one-fifth or one-fifteenth of the total deduction in a given year. However, after a few years of recurring investment into R&D projects, the total deduction in any given year will include amortized portions of capitalized R&D expenses from prior years as well. Eventually, you can get closer to where you would have been if you had been able to deduct everything in the first place.
The bottom line is that consistent investments into qualified R&D projects, together with successful efforts, will eventually materialize into tax deductions, perhaps leading to a breakeven situation within a few years.
What Comes Next
Working with a seasoned tax professional who understands these changes can allow your company to run through the process accurately, help you figure out these issues, and identify the potential risks and opportunities for each year.
It is essential that you also keep an eye on the news, as there is still the possibility Congress may delay the change. During early November negotiations on President Biden’s Build Back Better initiatives, lawmakers included a provision to delay the R&D amortization requirement until after 2025. Whether that provision makes it into a final bill remains to be seen as of the date of this publication.
For More Information
For specific comments, questions, or concerns about the change to the tax treatment of R&D expenses and its potential impact to a credit claim, please contact a member of our R&D tax credit team.
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