Amortizing R&E expenditures under the TCJA

Most of the tax provisions enacted under the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, became effective on Jan. 1, 2018, such as the 21% corporate tax rate, the $10,000 limitation on the itemized state and local taxes deduction, and the elimination of tax exemptions. However, some of the provisions under the TCJA were not immediately effective but were delayed. One of those provisions was the amortization of research or experimental (R&E) expenditures. Section 13206 of the TCJA amended Sec. 174 to require taxpayers to amortize specified R&E expenditures ratably over a five-year period for domestic expenditures and a 15-year period for specified R&E expenditures attributed to foreign research, using a half-year convention. This provision became effective for tax years beginning after Dec. 31, 2021, and will have a ripple effect in both financial and tax reporting.

Legislative proposals with bipartisan support have sought to delay or repeal the amortization of R&E expenses. Notably, the House-passed version of the budget reconciliation bill then known as the Build Back Better Act would have delayed the effective date to amounts paid or incurred in tax years beginning after Dec. 31, 2025. However, this provision did not survive in the version of the reconciliation bill that was enacted in August 2022, the Inflation Reduction Act, P.L. 117-169. Similarly, a repeal provision was included in an early version of the bill that eventually passed as the CHIPS and Science Act, P.L. 117-167 — only to be left out of the enacted version. Although support for modifying the provision remains, and a revision could be advanced as part of an “extender” legislative package, companies engaged in research and development (R&D) activities should be implementing this significant change.

They should also be prepared for effects that amortization of R&E expenditures may have on other tax issues, such as estimated tax payments and year-end tax planning, as well as on financial reporting.

BACKGROUND

For tax years beginning before Dec. 31, 2021, taxpayers were allowed to treat R&E expenditures in one of four ways: (1) They could currently deduct these costs under Sec. 174(a); (2) they could capitalize them (if not subject to depreciation or depletion allowances under Sec. 167 or 611) and then amortize them over a period of not less than 60 months under Sec. 174(b), beginning with the month in which they first realize benefits from the expenditures; (3) if these costs were neither treated as a current deduction nor amortized over 60 months, then taxpayers could charge them to capital account under Regs. Sec. 1.174-1; or (4) under Sec. 59(e), they could capitalize and amortize ratably certain qualified expenditures over a 10-year period. Under Sec. 59(e)(2), a qualified expenditure is any amount that would have been allowable as a deduction for the tax year in which the expenditure was paid or incurred. Under Sec. 59(e)(2)(B), expenditures under Sec. 174(a) would have qualified for the 10-year amortization treatment.

Example 1: A taxpayer incurs $1 million in domestic R&E expenditures in 2021 (pre–rule change). Assume these R&E expenditures meet the conditions of R&E expenditures provided in Regs. Sec. 1.174-2 and are qualified expenditures under Sec. 59(e), and the taxpayer first realizes benefits from the expenditures in the first month of the year. The taxpayer could either (1) deduct the full $1 million in 2021 (Sec. 174(a)); (2) capitalize the amount and then deduct the ratably amortized amount of $200,000 in 2021 (Sec. 174(b)); (3) capitalize the entire $1 million under Regs. Sec. 1.174-1; or (4) capitalize the $1 million under Sec. 59(e) and deduct the ratably amortized amount of $100,000 in 2021.

For tax years beginning after Dec. 31, 2021, the option to deduct these expenditures currently has been eliminated. Therefore, if a taxpayer incurs $1 million in domestic R&E expenditures in 2022, the taxpayer is allowed to either (1) capitalize and then amortize $100,000 in 2022 using a half-year convention for the new rule under Sec. 174(a); (2) capitalize and amortize $100,000 in 2022 under Sec. 59(e) (assuming, again, that the benefits are realized in the first month); or (3) capitalize the entire amount with no amortization under Regs. Sec. 1.174-1. The taxpayer can no longer deduct the full $1 million, as in Example 1, under the new rules in the year the expenditure is incurred.

The TCJA also changed the term “research or experimental expenditures” under the old Sec. 174(a) to “specified research or experimental expenditures.” Sec. 174(b), as amended by the TCJA, defines specified research or experimental expenditures as “research or experimental expenditures which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.” Under the old Sec. 174(a), R&E expenditures were defined as “research or experimental expenditures which are paid or incurred by [the taxpayer] during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account.” Therefore, it appears that Congress has not significantly changed the definition of R&E expenditures, since Treasury and the IRS have yet to amend Regs. Sec. 1.174-2, which contains the definition of R&E expenditures.

THE RIPPLE EFFECT

This rule change will cause a ripple effect that will impact other reporting as well as other activities of the taxpayer. This is probably why bipartisan legislation has been introduced in Congress to delay or repeal it. Since it is becoming less likely that any of this pending legislation will pass before year end, taxpayers should prepare for the rule change by amortizing their current R&E expenditures and consider these other areas:

Estimated tax payments: Under the new rule, 90% of a taxpayer’s current R&E expenditures are not currently deductible under a half-year convention in the year of the rule change. Therefore, the taxpayer’s taxable income for that year will increase, potentially requiring greater quarterly estimated tax payments. Assuming taxpayers did not account for this rule change when making quarterly payments due this year, the remaining payments for the year may have to be adjusted upward.

State and local taxes: Most states conform to or follow the new federal rule under Sec. 174, which may increase tax liability at the state level.

Sec. 163(j) business interest deduction: Taxpayers with business interest expense may find that a smaller amount of their business interest deduction is disallowed under the limitation in Sec. 163(j) because the decrease in the amount of deductible R&E expenses after Dec. 31, 2021, increases their taxable income. Under Sec. 163(j)(1), the amount of business interest a taxpayer subject to the Sec. 163(j) limitation can deduct for a year may not exceed the sum of (1) the taxpayer’s business interest income for the tax year, (2) 30% of the taxpayer’s adjusted taxable income (ATI) for the tax year, plus (3) the taxpayer’s floor plan financing interest for the tax year. The decrease in the current deduction for R&E expenditures caused by the amortization requirement will increase income, thereby increasing ATI and increasing the limit on deductible business interest expense under Sec. 163(j).

Another new rule applying to the calculation of the business interest expense deduction limitation will generally offset this increase in the limitation. Prior to 2022, under Sec. 163(j)(8), ATI is defined as the taxpayer’s taxable income calculated without regard to certain items including any deduction allowable for depreciation, amortization, or depletion. For tax years beginning after Dec. 31, 2021, depreciation, amortization, and depletion are taken into account when calculating ATI. Because the amount of amortization of R&E expenditures will be taken into account in calculating ATI, for taxpayers with amortizable R&E expenditures, ATI will decrease, thus causing the Sec. 163(j) limitation amount to be smaller.

Charitable contribution deduction: A corporate taxpayer is limited to a charitable contribution deduction not to exceed 10% of the taxpayer’s taxable income. Taxable income for this purpose is computed without regard to charitable contributions, any dividends-received deduction, any net operating loss (NOL) carryback to the tax year, and any net capital loss carrybacks, among other items. As a result of amortizing R&E expenditures, a taxpayer’s taxable income may increase, which will also increase the taxpayer’s taxable income for purposes of the charitable contribution limit. Consequently, a corporate taxpayer’s available deduction for charitable contributions may also increase.

NOL carryforwards and tax credits: For taxpayers with NOL carryforwards or tax credits, more of the net loss carryforward or the tax credit may be used to reduce tax liability to zero, assuming the taxpayer has sufficient loss carryforwards or unused credits to do so.

Sec. 250 foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI): Under Sec. 250(a), a domestic corporation is allowed a deduction equal to the sum of 37.5% of FDII plus 50% of GILTI. The calculations for FDII and GILTI are too complex to be discussed here. However, both would include deductions for R&E expenditures as shown on Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI). With the amortization of R&E expenditures instead of fully deducting them, both FDII and GILTI may increase, possibly creating a larger deduction for the taxpayer under Sec. 250.

ASC Topic 740: The change under Sec. 174 should not influence the financial accounting for R&E expenses under ASC Topic 730, Research and Development. FASB has not amended or changed ASC Topic 730; therefore, R&E expenditures will continue with the same treatment for book purposes. However, there should be adjustments under ASC Topic 740, Income Taxes.

Under ASC Topic 740, the federal financial income tax expense will increase, since the temporary book-tax difference for R&E expenditures will become more unfavorable. This will increase the reported effective tax rate. In addition, both short-term and long-term deferred tax asset accounts should increase for taxpayers with significant R&E expenditures. Further, the valuation allowance account may also need to be adjusted. Still further, any business interest deduction under Sec. 163(j) or charitable contributions will further impact the effective tax rate and deferred tax assets.

These are only some of the possible areas of impact of the Sec. 174 change that CPAs can help affected business clients identify.

OTHER TCJA ADDITIONS TO SEC. 174

The TCJA added a special rule under Sec. 174(c)(3) for the treatment for software development costs, stating that “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” Prior to this addition, taxpayers relied on Rev. Proc. 2000-50, which stated that the costs of developing computer software so closely resemble Sec. 174 R&E expenditures that a similar accounting treatment should be used. When this revenue procedure was issued, R&E expenditures were currently deducted. Under the TCJA, software development costs are treated as R&E expenses but are now subject to five- or 15-year amortization.

The TCJA also added a provision to Sec. 174 regarding the tax treatment of disposition, retirement, or abandonment of property. Under new Sec. 174(d), taxpayers cannot deduct the capitalized expenditures when the property or project is disposed of, retired, or abandoned. The taxpayer must continue to amortize those costs until the amortization period is completed.

Example 2: Taxpayer X capitalizes R&E costs incurred in the development of a new product and amortizes them over five years. The taxpayer eventually abandons this project, with remaining R&E costs that have yet to be amortized. Under Sec. 174(d), the taxpayer is not allowed to deduct the remaining capitalized costs in the year of abandonment but must continue to amortize them over the remaining amortization period.

IMPACT TO THE R&D CREDIT

Under the TCJA, the definition of qualified research under Sec. 41(d)(1) was changed to “specified research or experimental expenditures under Section 174” from “expenses under section 174.” This change aligns the definitions of qualified research in Secs. 41 and 174. In other words, specified R&E expenditures for the credit under Sec. 41 must first be included in specified R&E expenditures under Sec. 174. Prior to the TCJA, the Sec. 41 credit only required that R&E expenditures were eligible for Sec. 174 treatment.

The TCJA also made a conforming amendment to Sec. 280C(c), which precludes taxpayers from receiving a double benefit. Sec. 280C(c)(1) provides that if the amount of the credit under Sec. 41(a)(1) exceeds the amount allowable as a deduction for a tax year for qualified research expenses or basic research expenses, then the amount chargeable to capital account for the tax year for such expenses is reduced by the amount of the excess. In other words, if the amount of the Sec. 41 credit exceeds the amount of deductible qualified R&E expenditures, then the amount of the capitalized R&E expenditures must be reduced by this excess.

Example 3: A taxpayer has a $115,000 research credit and an allowable $100,000 qualified research expense deduction. The taxpayer must reduce the capitalized portion of the R&E expenditures by $15,000 ($115,000 credit less $100,000 deduction). The taxpayer may avoid this result by instead electing to reduce the credit under Sec. 280C(c)(2) on a timely filed tax return.

ACCOUNTING METHOD CHANGE

Section 13206(b) of the TCJA provides that this change to amortization of R&E expenditures is treated as a change in accounting method for purposes of Sec. 481. It also provides that this change is (1) treated as initiated by the taxpayer; (2) treated as made with the consent of the IRS (i.e., an automatic change); and (3) applied only on a cutoff basis for any R&E expenditures paid or incurred in tax years beginning after Dec. 31, 2021, and no adjustments under Sec. 481(a) are made.

CONSISTENT ANNUAL R&E EXPENSES MAY EVEN OUT

Assuming Congress does not delay, postpone, or repeal the amortization of R&E expenditures this year, federal tax liabilities of taxpayers with these expenditures may increase. The current R&E expenditure deduction will be cut by 90% in the first year under a five-year amortization period (15-year for foreign R&E expenditures) and a half-year convention. State tax liabilities may also increase with respect to states that have adopted or conformed to the new federal rule. In addition, affected taxpayers need to consider the changes and adjustments that will occur to financial reporting because of this rule change as well as the adjustments occurring in other areas of tax reporting and liability. The first few years of this change will present some challenges. However, as time passes, the impact of this rule change should diminish.

For taxpayers with a relatively stable R&E pattern, the amount of currently deductible R&E expenditures will approach the levels that were deductible before this change.

Example 4: Taxpayer A incurs $100,000 per year in R&E expenditures. In year 1, Taxpayer A can deduct only $10,000 of these expenses (20% per year, with a half-year convention). In year 2, Taxpayer A can deduct $30,000 ($20,000 from year 1 and $10,000 from year 2). In year 3, Taxpayer A can deduct $50,000 ($20,000 from year 1, $20,000 from year 2, and $10,000 from year 3). By year 6, Taxpayer A can deduct the current level of R&E expenditures, or $100,000 ($10,000 from year 1; $20,000 from year 2; $20,000 from year 3; $20,000 from year 4; $20,000 from year 5; and $10,000 from year 6). Therefore, after the sixth year, the amount of deductible R&E expenditures will be at the levels prior to the rule change, assuming a stable spending pattern (see the chart, “Stable R&E Expenditures,” below).