In just under a year, sweeping changes to the tax treatment of Research and Experimentation (R&E) expenditures will go into effect as a delayed provision of the Tax Cuts and Jobs Act (TCJA). While no new guidance from the Department of the Treasury has been released on how to implement these measures, for tax years beginning after Dec. 31, 2021, taxpayers face required capitalization of R&D expenditures.
Historically, taxpayers have been afforded significant flexibility in choosing whether to immediately deduct, capitalize/amortize or indefinitely capitalize R&E expenditures under section 174. Moreover, as a method of accounting, taxpayers have also had the option to change these methods over time as business or project needs change. However, under the TCJA, these options have been removed, forcing capitalization and amortization of items classified under section 174 under a five- or fifteen-year period for domestic or foreign incurred expenditures, respectively.
This creates a potentially significant administrative burden for taxpayers, particularly from a cash tax position.
Identifying section 174 expenditures
Taxpayers must first be able to identify what a section 174 R&E expenditure is. Quite commonly, taxpayers only identify R&E expenditures to the extent that they are also R&D credit eligible under section 41, even though 174 is a much broader provision. Section 174 encompasses foreign-incurred R&E, overhead and utilities, and certain post-development items such as patent application costs.
Even for taxpayers who have already been electively capitalizing/amortizing R&E, the broader definition could require them to look into other accounts or cost centers that are currently being deducted and pull more expenditures into required capitalization.
Cash flow/cash tax burden
In the following example, a domestic product development company is shown under both a pre- and post-Dec. 31, 2021 R&E world, assuming consistent operations from year to year. The difference in methodology is glaring: there is significantly less above-the-line current deduction for the company and a sizeable increase to net cash tax due. You will note that the R&D tax credit under section 41 remains undisturbed, as the credit is typically generated based on the year expenditures were paid or incurred and used or consumed in the R&D process.
Pre-2022 174 expense method |
Post-2022 174 required capitalization |
||
Net Margin |
100 |
100 |
|
R&E expenditures (domestic) |
15 |
3 |
1/5 of the $15 expenditure is amortized in the current year |
R&E expenditures (foreign) |
15 |
1 |
1/15 of the $15 expenditure is amortized in the current year |
Other deductible operating expenses |
30 |
30 |
|
Taxable income |
40 |
66 |
|
Tax due |
10 |
17 |
Assumes combined 25% tax rate |
Less: R&D credit |
(1) |
(1) |
|
Net tax due |
9 |
16 |
Although uncertainty in the practical application of these provisions will remain until the Department of the Treasury or the IRS issue further guidance, taxpayers should begin to evaluate the potential impacts of these delayed provisions. It is unclear whether Congress aims to change these outcomes: With a split Senate and section 174 generally considered a “pay for” provision for certain tax cuts, a future administration may not be incentivized to unwind this revenue generator. In the meantime, with the amount of work required to prepare for this change, taxpayers cannot afford to wait to see if Congress decides to take action. Thus, we recommend taking steps now to address the process and system changes to identifying and accounting for R&E costs under the new rules taking effect next January.
