IRS Issues Interim Guidance on Amortization of Research and Experimental Costs

(Parker Tax Publishing September 2023)

The IRS provided interim guidance intended to clarify the application of Code Sec. 174, as amended by the Tax Cuts and Jobs Act (Pub. L. 115-97), which generally disallows deductions specified research or experimental expenditures for amounts paid or incurred in tax years beginning after December 31, 2021, and requires taxpayers to charge such expenditures to a capital account and amortize them ratably over the applicable amortization period. The IRS anticipates that forthcoming proposed regulations will provide rules that are consistent with the guidance in the notice, and taxpayers generally may rely on the interim guidance prior to the publication of the proposed regulations. Notice 2023-63.

Background

Prior to the enactment of the Tax Cuts and Jobs Act (TCJA) (Pub. L. 115-97), Code Sec. 174 allowed taxpayers to elect to deduct research or experimental expenditures paid or incurred in connection with a trade or business as currently deductible expenses, to capitalize and amortize such expenditures over a period of not less than 60 months, or to charge such expenditures to a capital account. The TCJA amended Code Sec. 174 for amounts paid or incurred in tax years beginning after December 31, 2021. For such amounts, Code Sec. 174(a)(1) disallows deductions for specified research or experimental (SRE) expenditures, except as provided in Code Sec. 174(a)(2). Code Sec. 174(a)(2) requires taxpayers to charge SRE expenditures to a capital account and allows amortization deductions of such capitalized expenditures ratably over the applicable Code Sec. 174 amortization period, beginning with the midpoint of the tax year in which such expenditures are paid or incurred.

Section 13206(b) of the TCJA requires taxpayers to apply the provisions of Code Sec. 174, as amended by the TCJA, as a change in method of accounting for purposes of Code Sec. 481, and applied on a cutoff basis to SRE expenditures paid or incurred in tax years beginning after December 31, 2021. Thus, no adjustments under Code Sec. 481(a) are permitted or required with respect to research or experimental expenditures paid or incurred in tax years beginning before January 1, 2022.

In December of 2022, the IRS issued Rev. Proc. 2023-11 to provide procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with Code Sec. 174, as amended by the TCJA. The change in method of accounting provided by Rev. Proc. 2023-11 was subsequently included in Section 7.02 of Rev. Proc. 2023-24. Section 7.02 of Rev. Proc. 2023-24 implements the requirement imposed by Section 13206(b) of the TCJA that a taxpayer must make this change in method of accounting on a cutoff basis if the change was made during the taxpayer's first tax year beginning after December 31, 2021.

Notice 2023-63

On September 8, the IRS announced in Notice 2023-63 that it intends issue proposed regulations addressing (1) the capitalization and amortization of SRE expenditures under Code Sec. 174, as amended by the TCJA; (2) the treatment of SRE expenditures under Code Sec. 460; and (3) the application of Code Sec. 482 to cost sharing arrangements involving SRE expenditures. According to the IRS, the forthcoming proposed regulations will be consistent with the interim guidance provided in Sections 3 through 9 of Notice 2023-63.

Capitalization and Amortization of SRE Expenditures

Section 3 of Notice 2023-63 addresses the requirement in Code Sec. 174(a) to capitalize and amortize SRE expenditures and the treatment of short tax years. Under Code Sec. 174(a)(2)(B) and Section 3.02 of Notice 2023-63, taxpayers are required to capitalize SRE expenditures and amortize such expenditures ratably over the applicable Code Sec. 174 amortization period beginning with the midpoint of the tax year in which such expenditures are paid or incurred. For purposes of determining when amortization begins, Section 3.05 of Notice 2023-63 provides that the term "midpoint" means the first day of the seventh month of tax year in which the SRE expenditures are paid or incurred.

Section 3.06 of Notice 2023-63 addresses short tax years. Under Section 3.06(1), the amortization deduction for a short tax year is based on the number of months in the short tax year. If a short tax year includes part of a month, the entire month is included in the number of months in the tax year, but the same month may not be counted more than once. If a taxpayer has two successive short tax years and the first short tax year ends in the same month that the second short tax year begins, the taxpayer should include that month in the first short tax year and not in the second short tax year. The midpoint of a short tax year is the first day of the midpoint month. In the case of a short tax year with an even number of months, the midpoint month is determined by dividing the number of months in the short tax year by two and then adding one (for example, for a short tax year consisting of ten months, the midpoint month is the sixth month of the short tax year ((10 / 2) + 1 = 6)). In the case of a short tax year with an odd number of months, the midpoint month is the month for which there are an equal number of months before and after such month (for example, for a short tax year consisting of seven months, the mid-point month is the fourth month of the short tax year).

Example: Taxpayer is a calendar-year taxpayer that incorporated and began operations on October 17, 2022. In 2022, Taxpayer paid or incurred $60,000 in SRE expenditures that were not attributable to foreign research. Taxpayer has no short tax years after its initial tax year. Taxpayer has a short tax year that begins on October 17, 2022, and ends on December 31, 2022, and thus is treated as having a three-month tax year. The midpoint month is November, and thus November 1, 2022, is treated as the midpoint under Notice 2023-63. In 2022, Taxpayer amortizes $2,000 of SRE expenditures ($60,000 / 60 months x 2 months). In tax years 2023 through 2026, each a full 12-month tax year, Taxpayer amortizes $12,000 ($60,000 / 60 months x 12 months) each year, or $48,000 total. In 2027, Taxpayer amortizes the remaining $10,000 ($60,000 / 60 months x 10 months).

Scope of Section 174

The provisions of Reg. Sec. 1.174-2 address the scope and definition of research or experimental expenditures under pre-TCJA Code Sec. 174. Specifically, Reg. Sec. 1.174-2(a)(1) provides that the term "research or experimental expenditures" means those expenditures incurred in connection with a taxpayer's trade or business that represent research and development costs in the experimental or laboratory sense, and generally includes all such costs incident to the development or improvement of a product or a component or subcomponent of the product, as well as the costs of obtaining a patent. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Reg. Sec. 1.174-2(a)(3) defines the term "product" to include any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license.

Section 4.02(3) of Notice 2023-63 defines "research or experimental expenditures" as expenditures that (1) satisfy the requirements under Reg. Sec. 1.174-2 to be research or experimental expenditures, or (2) are paid or incurred in connection with the development of any computer software (as provided in Section 5 of Notice 2023-63), regardless of whether such expenditures are research or experimental expenditures under Reg. Sec. 1.174-2. Section 4.02(4) defines "SRE activities" as (1) software development activities described in Section 5.03 of Notice 2023-63, or (2) research or experimental activities described in Reg. Sec. 1.174-2. SRE expenditures include expenditures that satisfy the requirements under Reg. Sec. 1.174-2 or are paid or incurred in connection with the development of any computer software, regardless of whether such software expenditures satisfy the requirements under Reg. Sec. 1.174-2. Reg. Sec. 1.174-2(a)(1) and (5) provide that research or experimental expenditures under Reg. Sec. 1.174-2 include all costs incident to the development or improvement of a product, a component of a product, or subcomponent of a product, as applicable (that is, research or experimental expenditures under Reg. Sec. 1.174-2 include all costs incident to SRE activities described in Section 4.02(4)(b) of Notice 2023-63). Section 4.03(1) of Notice 2023-63 provides a non-exhaustive list of examples of the types of costs that are SRE expenditures. Section 4.03(2) provides a list of costs that are not permitted or required to be treated as SRE expenditures, regardless of whether they may be incident to SRE activities described in Section 4.02(4) of Notice 2023-63. Section 4.03(3) provides interim guidance addressing the allocation of costs, including those described in Section 4.03(1), to SRE activities.

Section 5 of Notice 2023-63 provides interim guidance for use in determining whether certain activities constitute software development for purposes of Code Sec. 174(c)(3). The TCJA added Code Sec. 174(c)(3) to require that any amount paid or incurred in connection with the development of any software in tax years beginning after December 31, 2021, be treated as a research or experimental expenditure (and thus an SRE expenditure to the extent paid or incurred by the taxpayer during the tax year in connection with the taxpayer's trade or business). Section 5.02 of Notice 2023-63 provides definitions of the terms "computer software" and "upgrades and enhancements." Section 5.03 provides examples of activities that are treated as software development for purposes of Code Sec. 174. Sections 5.04 provides that the purchase and installation of purchased computer are not activities that constitute software development for purposes of Code Sec. 174. Section 5.05 identifies activities associated with software development projects that are not treated as software development for purposes of Code Sec. 174.

Long-Term Contracts Under Section 460

In Section 8 of Notice 2023-63, the IRS provides interim guidance describing a proposed revision to the regulations under Code Sec. 460 regarding how to apply the percentage of completion method (PCM) to account for income from long-term contracts when allocable contract costs include SRE expenditures.

Code Sec. 460(a) generally requires use of the PCM to account for taxable income from a long-term contract. Reg. Sec. 1.460-4(b)(2)(i) provides that under the PCM, the portion of the contract price a taxpayer must report in a tax year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs. This ratio represents the portion of a contract considered completed for purposes of the PCM. Under the PCM, a taxpayer generally deducts allocable contract costs as they are incurred. As provided by Reg. Sec. 1.460-4(b)(2)(iv), an increase in the percentage of the contract price to be reported is matched by deduction of the incurred costs that cause the increase. Under the current Code Sec. 460 regulations in Reg. Sec. 1.460-5(b)(2)(vi), allocable contract costs include research or experimental expenses, other than independent research and development expenses. Thus, when these expenses are incurred, they increase the portion of a contract considered completed and the percentage of the contract price required to be reported. The current Code Sec. 460 regulations were drafted when a taxpayer could deduct currently research or experimental expenses under former Code Sec. 174. Code Sec. 174(a), as amended by the TCJA, requires that SRE expenditures be charged to capital account and deducted over the applicable Code Sec. 174 amortization period. As a result, the current Code Sec. 460 regulations provide that incurred research or experimental expenses increase the percentage of the contract price required to be reported, although Code Sec. 174(a) prevents a corresponding current deduction of incurred SRE expenditures. The resulting mismatch of contract price and contract costs is inconsistent with the contemplated operation of the PCM.

The IRS anticipates issuing proposed regulations that would amend the existing Code Sec. 460 regulations, including Reg. Sec. 1.460-5(b)(2)(vi), to provide that the costs allocable to a long-term contract accounted for using the PCM include amortization of SRE expenditures under Code Sec. 174(a)(2)(B), rather than the capitalized amount of such expenditures, and that such amortization is treated as incurred for purposes of determining the percentage of contract completion as deducted. The amendments would not apply to expenditures previously capitalized under Code Sec. 59(e)(2)(B) or under former Code Sec. 174(b), or to independent research and development expenditures, as defined in Code Sec. 460(c)(5), which are not allocable contract costs. Research or experimental expenditures that are not independent research and development expenditures, however, would remain subject to allocation under Code Sec. 460(c)(1) regardless of whether they are SRE expenditures.

Cost Sharing Regulations in Reg. Sec. 1.482-7

In Section 9 of Notice 2023-63, the IRS states that the forthcoming proposed regulations will revise Reg. Sec. 1.482-7(j)(3)(i), which addresses cost sharing transaction payments (CST Payments) between controlled participants in a cost sharing arrangement (CSA) that are made to ensure that each controlled participant's share of intangible development costs (IDCs) is in proportion to its share of reasonably anticipated benefits from exploitation of the developed intangibles (RAB share). The IRS anticipates amending the regulation to provide that CST Payments owed to a controlled participant reduce:

(1) the amount of the category of IDCs borne directly by that participant that are required to be charged to a capital account; and

(2) the amount of the category of IDCs borne directly by that participant that are not described in (1) and that are deductible.

Further, CST Payments not in excess of the payor's RAB share of the total amount of the IDCs in both categories described in (1) and (2) above reduce the amount of each such category of IDCs in the same proportion that the total amount of the IDCs in each category bears to the total amount of IDCs in both categories. CST Payments in excess of the payor's RAB share of the total amount of IDCs in both categories described in (1) and (2) above will be treated as income.

Applicability Dates

The IRS anticipates that the forthcoming proposed regulations will provide that rules consistent with the rules described in Sections 3 through 9 of Notice 2023-63 would apply for tax years ending after September 8, 2023. Prior to the publication date of the forthcoming proposed regulations, a taxpayer generally may choose to rely on the rules described in Sections 3 through 9 of Notice 2023-63, including for expenditures paid or incurred in tax years beginning after December 31, 2021, provided the taxpayer relies on all the rules in Sections 3 through 9 of Notice 2023-63 and applies them in a consistent manner.

The IRS noted that it intends to issue procedural guidance on how to obtain automatic consent to change methods of accounting to comply with Notice 2023-63. Until the issuance of such procedural guidance, taxpayers may rely on Section 7.02 of Rev. Proc. 2023-24 to change their methods of accounting under Code Sec. 174 to comply with Notice 2023-63.

For a discussion of the amortization of research and experimental expenditures for amounts incurred in tax years beginning after 2021, see Parker Tax ¶95,540.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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