Capitalizing research costs delays tax deductions | Baker Tilly
Article | Tax alert
Capitalizing research costs delays tax deductions
Jan. 11, 2023 · Authored by Michelle Abel, Jim Lawson, Kathleen Meade, Brian Simpson, Mark Zurales
For tax years beginning after Dec. 31, 2021, taxpayers may no longer take current deductions for research and experimental expenditures. Instead, these costs must be capitalized when paid or incurred.
As a result of this new research cost capitalization requirement, taxpayers will need to:
Identify costs requiring capitalization, and
Change their tax accounting method for those costs.
Additionally:
Companies preparing provisions for income taxes for their financial statements will need to account for the effects of capitalizing research costs.
Businesses with foreign subsidiaries will need to consider additional complications including potential changes to tax elections.
Taxpayers should consider state income tax implications of research cost capitalization, including reviewing state conformity to the federal capitalization requirement.
Background
For tax years beginning after Dec. 31, 2021, research and experimental expenditures must be capitalized when paid or incurred. Current deduction of these costs is no longer permitted.
Taxpayers now generally must deduct these costs ratably over a five-year period. Expenditures attributable to foreign research, however, must be amortized over a 15-year period. For this purpose, characterization of research as foreign research is based on the place activities are performed and not the residence of the party incurring the expense.
These newly effective rules were enacted by Congress back in 2017 with the Tax Cuts and Jobs Act (TCJA) revisions to section 174 of the federal tax code (the Code). Unfortunately, congressional initiatives toward delaying or repealing these changes in 2022 were fruitless. It does not appear likely that Congress will soon act to delay or repeal the taxpayer-unfavorable capitalization requirement, although repeal or deferral remains possible.
Identifying capitalized section 174 costs
Taxpayers need to decide which of their costs are covered by the section 174 capitalization requirement. This process presents a challenge because (1) significant work may be required to make the determination, (2) many taxpayers have not previously established a process to track these costs, and (3) there are gray areas without clear guidance as to which costs must be capitalized.
Historically, taxpayers previously had little reason to categorize R&D costs as is now required. Consequently, many taxpayers do not have a methodology already in place.
Section 174 now specifies that no current deduction is allowed for research or experimental expenditures paid or incurred by the taxpayer in connection with the taxpayer’s trade or business. Regulations generally define those expenditures as representing research and development costs in the experimental or laboratory sense.
These are expenditures for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. A product is defined as 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 174 specifically identifies software development costs as research or experimental expenditures. Specific exclusions are provided for expenditures to acquire or improve land. Although expenditures for the acquisition or improvement of property subject to depreciation or depletion fall under another exception, the depreciation or depletion they produce is not excepted from the capitalization rule.
While there is limited IRS guidance outlining how to identify expenditures under section 174, taxpayers still need to calculate the amount to capitalize as well as document their efforts. Businesses should be prepared to allocate potentially significant time to those efforts. In addition to accounting and finance personnel, a company may need input from other personnel. For example, the participation of a company’s engineering, facilities, information technology and/or management personnel groups may be required.
A detailed analysis of both direct and indirect costs generally will be required. If the company has performed federal research credit calculations under section 41, those should be considered. To categorize an expenditure as included in the research credit calculation requires meeting tests generally more stringent than the section 174 standard. As a result, costs capitalized under section 174 are likely to exceed those included in the section 41 research credit calculation.
Research and development costs reported for financial accounting purposes should be considered as well. These costs may include direct and indirect costs. Note, however, that relevant financial accounting standards such as those under generally accepted accounting principles (GAAP) in ASC 730, Research and Development, differ from the standards set out for tax purposes in sections 41 and 174. For example, the GAAP rules do not rely on the tax rules’ “uncertainty” standard.
Once expenditures capitalized under section 174 have been identified, those expenditures must further be categorized as domestic or foreign in order to apply the appropriate five- or 15-year amortization period. This classification will be particularly relevant for third-party contract research.
Accounting method change
Complying with the newly effective section 174 capitalization rule requires a tax accounting method change. The IRS has granted automatic permission to make this change under a Revenue Procedure issued in December 2022 and modified in January 2023.
Timely action will be required to implement method changes under the new procedures. They require disclosure of the amount of capitalized expenditures, and computing the amount requires a potentially complex and time-consuming effort as discussed above. The accounting method change procedures do not provide guidance for determining which costs must be capitalized.
The newly required accounting method for research and experimental costs involves capitalization and amortization. The amortization period is five years for U.S. research activities and 15 years for foreign research activities. Amortization expense in the year the costs are incurred is determined using the midyear convention and ratable (straight-line) amortization over the relevant period. For example, this convention would result in a 2022 deduction of 10% of the capitalized U.S. research expenditures paid or incurred in 2022.
The filings required to make the accounting method change vary depending on the taxpayer’s circumstances. To change for the first tax year for which the capitalization requirement applies (i.e., beginning after Dec. 31, 2021), filing Form 3115 (Application for Change in Accounting Method) with the IRS is not required. Instead, a statement describing the types of capitalized costs must be filed with the taxpayer’s federal income tax return for the year.
To make the change in a later tax year would require filing Form 3115 with the IRS, even though the IRS’ consent to the method change would remain automatic. Additionally, special procedures are provided for taxpayers who have already filed a federal income tax return for a short taxable year beginning after Dec. 31, 2021 (e.g., a short taxable year beginning Jan. 1, 2022, and ending July 30, 2022).
Tax provisions – ASC 740
A corporation’s tax provision applies the tax rules in effect at year-end and is not based on subsequent changes made to the tax rules. Since Congress did not repeal or delay the research costs capitalization rule prior to Dec. 31, 2022 year-end, the tax provision for a corporation’s year ended Dec. 31, 2022, must consider the section 174 capitalization rule’s effects. Those effects may include, for example, recording deferred tax assets as a result of the newly required cost capitalization or utilization of a deferred tax asset recorded prior to 2022 due to the reduction in tax deductions for research costs incurred in 2022.
Under U.S. GAAP, if Congress subsequently repeals or changes the law, the impacts will be recorded in that subsequent period. This means that even if the capitalization requirement is repealed in 2023, a corporation with a Dec. 31, 2022, year-end will still need to record the impact of research cost capitalization in its Dec. 31, 2022, income tax provision and record the repeal’s effects in a subsequent period.
Foreign subsidiaries
The new capitalization requirements could have a pervasive impact on U.S. taxation of foreign subsidiaries’ activity. Research activities performed by controlled foreign corporations (CFCs) in particular may require a closer focus.
When determining the U.S. federal tax liability of an owner of a CFC that is a “U.S. shareholder,” section 174 capitalization should be considered. U.S. rules imposing tax on a U.S. shareholder include the global intangible low-taxed income (GILTI) and Subpart F income rules. The capitalization requirement is anticipated to increase the number of U.S. shareholders who must report U.S. taxable income under these rules.
A CFC’s capitalization of research costs may have a number of effects on a U.S. shareholder. Favorable tax rules that may have been available in previous years — the GILTI high-tax exclusion and Subpart F high-tax exception elections — may no longer provide comparable tax savings. In addition, individual taxpayers may have a reduced benefit from any section 962 elections, which are U.S. deemed income inclusion elections to potentially take advantage of both a lower tax rate on GILTI (and Subpart F income) and different foreign tax credit computations.
Companies should carefully address the new capitalization requirement in the context of contract research activities. For example, if a CFC performs research services for its U.S. parent company, the new capitalization requirement may have unfavorable tax consequences that were not anticipated when the research service contract was established.
The new capitalization requirements might also result in changes in effective tax rate from a financial statement perspective. For example, consider a corporation that owns a CFC. Assume the corporation has elected period cost treatment for GILTI liability as permitted by a Financial Standards Accounting Board (FASB) Staff Q&A. The section 174 deferral of deductibility for the CFC’s research costs generally would not cause the corporation to record a deferred tax asset because that company is not providing deferred taxes with respect to GILTI. As a result, applying the capitalization rule could alter the corporation’s effective tax rate as reported on its financial statements.
State and local tax
The research cost capitalization rule brings state and local income tax consequences too. For tax years beginning after Dec. 31, 2021, taxpayers need to consider state conformity to section 174 and incorporate state-specific modifications where applicable.
Most states conform to the section 174 capitalization rule. Companies subject to tax in these states may see an increase in state tax liability starting in 2022.
Some states do not conform to the federal research cost capitalization rule. Here are three examples of states that do not yet require research cost capitalization.
California law conforms to the Code as of Jan. 1, 2015, and therefore has not adopted the section 174 capitalization rule added to the Code by TCJA in 2017. California allows taxpayers to immediately expense research costs or capitalize and amortize those costs over a five-year recovery period.
Wisconsin law conforms to section 174, but specifically to section 174 as it stood prior to TCJA’s enactment in 2017.
Tennessee specifically decouples from section 174 for tax years beginning on or after Jan. 1, 2022, allowing for the immediate deduction of research costs.
Businesses should incorporate applicable changes for 2022 income tax extensions and continue to monitor for updates as state legislatures may take further action.
Specialists from our tax services team will discuss methods for identifying costs and how to file a change in method of accounting that must be capitalized under Section 174 during an upcoming webinar on Jan. 31. Registration and webinar details will be available soon.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
