All businesses claiming research and development (R&D) tax credits must be aware of a recently enacted change to claiming research and experimentation (R&E) expenses. The 2017 Tax Cuts and Jobs Act (TCJA) included an amendment to IRC Section 174, which goes into effect for the tax years beginning in 2022. The change states that R&E expenditures can no longer be deducted when incurred. Instead, they must be capitalized and amortized over a five- or 15-year period, depending on where the activities were performed.
Costs subject to the R&E amortization change
The TCJA states that costs eligible for the R&D credit must be amortized under Section 174. The changes to the recovery of R&E expenditures in Section 174 will not directly impact the research credit under Section 41. The TCJA made a conforming amendment to Section 41 to ensure the research credit will still be available for qualifying Section 174 costs, even if they are capitalized, provided that the other three parts of the four-part test are met. It is important to note that Section 174 includes a broader range of expenses than those that qualify for the R&D credit, such as:
- Foreign-based research
- Cost of obtaining a Patent
- Overhead or other indirect costs, such as depreciation and utilities
Due to the broader definition of costs under section 174, you should prepare for Section 174 expenditures to be significantly higher than the number of qualified expenses for the R&D tax credit, especially if you have highly active foreign research activities.
Calculating amortization
To calculate amortization, we utilize a straight-line recovery period of either five years for costs incurred in the U.S. or 15 years for costs that occurred outside the U.S. However, since you must use a mid-year convention to determine first-year amortization, the recovery period is effectively six and 16 years.
How Section 174 amortization will affect other taxable areas?
When assessing the impact of the amortization of section 174 expenses, all other areas affected by a change in taxable income must be addressed, including, but not limited to:
- FDII
- GILTI
- Foreign tax credit limitations
- 163(j))
- State tax considerations and conformity with federal
- Likely will require filing form 3115
Additionally, there could be an impact on your effective tax rate that may affect a permanent provision.
Amortizing R&E costs for third parties
There remains to be certainty around specific circumstances, but under our current understanding of the rule, amounts paid to contractors or third parties are considered section 174 expenses and are subject to the revised rule.
Final thoughts
With the wide-ranging potential impact of the change to Section 174 for technology, biotech/life sciences, SaaS, and other leading-edge companies, e can provide preliminary assessments of R&E expenditure capitalization and its impact on your total tax liability. We can also help you explore your options related to R&D Tax Credits.
