IRS proposes taxpayer favorable rules for section 174 expenditures
The IRS issued Notice 2023-63 that provides some long-awaited guidance related to section 174’s specified research or experimental (“SRE”) expenditures and indicates that the IRS will be issuing proposed regulations providing additional guidance ’consistent with the rules described in’ the Notice. At a high level, the Notice describes what costs are includible in SRE expenditures, what costs the IRS considers excludible from SRE expenditures, what activities constitute the development of software, how to recover the SRE expenditures, and on the issues the IRS would like the public to comment. The Notice also addresses cost sharing transaction payments under section 482, and some of the potential inequity with the SRE impact on the percentage-of-completion calculation under section 460. The Notice states that the forthcoming proposed regulations are anticipated to apply to taxable years ending after Sept. 8, 2023, taxpayers may choose to rely on the Notice for SRE expenditures paid or incurred in taxable years beginning after Dec. 31, 2021, provided they rely on all the rules provided in the Notice and apply them in a consistent manner.
IRS releases initial rules for expenditures under section 174
On Sep. 8, 2023, the IRS issued Noticed 2023-63 (the 'Notice’) addressing how the IRS intends to implement the capitalization and amortization of specified research or experimental (’SRE’) expenditures under section 174. The IRS intends to issue the rules consistent with those contained in section 3 through 9 of the Notice in forthcoming proposed regulations.
While the guidance’s timing is less than ideal, coming days before calendar-year partnership’s extended tax return deadline, it does provide some welcome news. The IRS took a reasonable approach in how it will apply the new SRE expenditure rules and offers some flexibility for taxpayers in implementing the rules. At a high level, the Notice describes what costs are includible in SRE expenditures, what costs the IRS considers excludible from SRE expenditures, what activities constitute the development of software, how to recover the SRE expenditures, and on the issues the IRS is requesting comments on. The Notice also attempted to address cost sharing transaction ('CST’) payments under section 482 and tried to address some of the potential inequity the amortization of SRE expenditures causes to the percentage-of-completion calculation under section 460.
How are costs recovered under section 174(a)(2)(B)?
Section 3 of the Notice provides the basic rules for capitalizing and amortizing SRE expenditures. It defines what the term 'midpoint’ in section 174(a)(2)(B) means. For a 12-month taxable year, the term midpoint means the first day of the seventh month of the taxable year in which the SRE expenditures are paid or incurred. The amortization deduction for a short taxable year is based on the number of months including partial months. The midpoint of a short taxable year is the first day of the midpoint month. In the case of a short taxable year with an even number of months, the midpoint month is determined by dividing the number of months in the short taxable year by two and then adding one. In the case of a short taxable 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.
The Notice confirms that the domestic SRE expenditure amortization period under section 174 is 60 months, which may cover six or more taxable years, taking into account that the first taxable year’s amortization is based on the year’s midpoint. The rules are also applicable to foreign SRE expenditures, which are amortized over a 180 month period, which could be 16 or more taxable years.
What type of expenditures does the IRS consider to be SRE expenditures?
Sections 4 and 5 of the Notice define SRE expenditures as research or experimental expenditures that are incident to the development or improvement of a product, a component of a product, or subcomponent of a product. The Notice goes on to list examples of costs that may qualify as SRE expenditures including labor cost, materials and supplies, depreciation on equipment, the costs to obtain a patent, travel costs, and overhead costs. As expected, labor costs include all elements of compensation other than severance compensation, such as basic compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan. The Notice includes examples of overhead costs such as rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs used in or in the direct support of SRE activities.
The Notice also provided some examples of what activities are SRE activities when developing software in section 5. These expenditures include planning, designing, building a model, writing source code, converting it to machine readable code, and testing. The IRS also will include a rule that if a taxpayer is producing software to license or sale, then it will have SRE activity up until the software is placed in service or the taxpayer has developed product masters.
What type of expenditures are excludible from SRE activities?
The IRS decided to take a reasonable approach and is proposing to exclude general and administrative service departments that only indirectly support SRE activities. These types of costs include payroll processing, human resources, accounting, and similar type of expenditures. The IRS also believes that neither interest expense, nor training employees on the newly developed or implemented software are SRE activities.
Also, the IRS took a more favorable approach for taxpayers by excluding maintenance from the activities that give rise to the development of software. The Notice defines maintenance activities as corrective maintenance to debug, diagnose, and fix programming errors, but not activities that give rise to upgrades and enhancements, which are defined as modifications that result in additional functionality (i.e., enabling the software to perform task that it was previously incapable of performing), or materially increasing the speed or efficiency of the software.
How should taxpayer allocate costs?
Section 4 of the Notice permits taxpayers to allocate costs to an SRE activity basis of a cause-and-effect relationship between the costs and the SRE activities or another relationship that reasonably relates the costs to the benefits provided to the SRE activities and provides some examples of allocation methods. What is helpful is the Notice allows taxpayers to use different methods for different costs. How a taxpayer allocates labor costs does not have use the same method as say rent. For example, it may make sense to allocate labor costs based on effort while it may make sense to allocate rent based on square feet of the laboratory facility as compared to the square feet of the entire building. However, the Notice provides that the allocation method used for each type of cost must be applied on a consistent basis.
What about research performed under a contract?
Section 6 of the Notice addresses one of the questions taxpayers have struggled with without guidance is whether the performance of SRE activities for another party constituted the performer’s SREs, the paying party’s SREs, or both. The Notice attempts to answer that question. If the party performing the SRE activity does not bear the financial risk of completing the SRE task and does not have a right to use the product or technology resulting from the SRE activity or otherwise exploit the know-how, then the performer is treated similar to a service provider and the performer’s activities are not treated as SREs, and presumably would be treated ordinary and necessary business activities the costs of which would be deductible under section 162. However, if the performer is financially at risk for the outcome or is able to use or exploit the results, then the performer may also have SRE activities and must capitalize the expenditures and recover the costs under section 174(a)(2). While this approach is similar to funded research under section 41, there are some differences, and the IRS has requested comments if the rules should be the same.
What if I sell the SRE product or the business entity that incurred the SRE expenditures ceases to exist?
Under section 174(d), if any property with respect to which SRE expenditures are paid or incurred is disposed, retired, or abandoned during the period during which such expenditures are allowed as an amortization deduction, no deduction shall be allowed with respect to such expenditures on account of such disposition, retirement, or abandonment and such amortization deduction shall continue with respect to such expenditures. This means that if the SRE product is a failure, is abandoned, or sold, the taxpayer must continue to amortize the SRE expenditures over the remaining life. However, what happens if the entity ceases to exist?
Section 7 of the Notice addresses the disposition, retirement, or abandonment of property in general terms and specifically addresses certain corporate transactions as well as applicable asset acquisitions described in section 1060(c) (generally transfer of assets which constitute a trade or business and that basis is determined by the purchase price paid by the acquirer). The Notice defers guidance for other transaction types to a later date.
The Notice requires a corporation / successor in interest to continue to amortize the SRE expenditures if the taxpayer ceases to exist under a transaction or series of transactions described in section 381(a). However, if a corporation ceases to exist for Federal income tax purposes in a transaction or series of transactions to which section 381(a) does not apply, the corporation is allowed a deduction equal to the unamortized SRE expenditures in its final taxable year. The Notice also addresses SREs in the context of a section 351 transfer. In effect, SRE costs are not transferred to the transferee corporation and the transferor would keep the costs. Overall, these rules are subject to an anti-abuse exception in the Notice. The IRS requested comments on other transactions which involve the disposition, retirement, or abandonment of property to which SRE expenditures have been paid or incurred.
Is there any relief for SRE expenditures incurred under a section 460 long-term contract?
What is thought to be an unintended consequence of section 174 is its application under section 460 and its requirement to recognize income under the percentage-of-completion method (’PCM’). Usually under the PCM, taxpayers deduct their contract costs as incurred while realizing the corresponding income to which the contract costs relate. Under the current rules, if a taxpayer has SRE activity while using the PCM, the taxpayer will realize the proportionate income related to the SRE expenditures as incurred but defer the recognition of the expense over the amortization period. The IRS plans to issue proposed regulations under section 460 that only require an allocation to a long-term contract using the PCM of the amortization of the SRE expenditures, and that such amortization is treated as incurred for purposes of determining the percentage of completion as the amortization is deducted. The IRS has requested comments on whether a taxpayer needs to allocate all the SRE expenditures paid or incurred that directly benefit or are incurred by reason of the performance of the long-term contract or, alternatively, only that portion of the SRE expenditures expected to be amortized during the term of the contract in the PCM calculation.
Does the Notice contain any relief for CST agreements?
Section 9 of the Notice indicates that the IRS will also revise the regulations under section 482 to treat a deemed reimbursement of SRE expenditures under a CST as a reduction of SREs expenditures and the mechanics of how it is accomplished. These rules are similar to the current netting of costs under Reg. section 1.482-7(j)(3)(i).
When do the rules in the Notice take effect?
Section 10 of the Notice provides that it is anticipated that the forthcoming proposed regulations will provide that rules consistent with the Notice would apply for taxable years ending after Sept. 8, 2023. However, taxpayers can largely rely on the Notice for costs paid or incurred in taxable years beginning after Dec. 31, 2021, provided all the rules of the Notice are applied in a consistent manner.
Will I have to file another accounting method change in 2023?
Unless a taxpayer can fully comply with the Notice before the taxpayer reaches the extended due date or its initial implementation is already complying with all the rules set forth in the Notice, then yes taxpayers will have to file a second accounting method change. However, the IRS is anticipating that taxpayers’ treatment of SRE expenditures may need to be tweaked and are planning to issue new guidance allowing taxpayers to take advantage of automatic consent procedure for the taxpayer to fully comply with the rules contained in the Notice.
Washington National Tax Takeaways
The IRS in trying to implement the rules under section 174 have taken a reasonable approach that allows some flexibility for taxpayers in applying the rules. The Notice provides examples of includible costs, excludible costs, and how to recover the expenditures in various situations. The IRS acknowledged some of the intended consequences and have proposed rules to mitigate these scenarios. For those taxpayers that may need to tweak their treatment of SRE expenditures, the IRS will issue additional procedural guidance that will allow taxpayers to use automated procedures. It is a welcome relief that the IRS did not take a more conservative approach in applying the rules. Please consult with your tax advisor on what adjustments you may need to make to be compliant with the new SRE expenditure rules.