IRS Provides Clarity on the Treatment of Research & Experimental Expenditures Under Section 174
Unpacking the IRS Notice 2023-63 on R&E Costs
The IRS released pre-regulatory guidance on Sept. 8, 2023, regarding the requirement to capitalize and amortize specified research and experimental (SRE) expenditures under Internal Revenue Code Section 174, as revised by the 2017 Tax Cuts and Jobs Act (TCJA). Notice 2023-63 is a substantive counterpart to the procedural guidance now included in Section 7.02 of Rev. Proc. 2023-24. In this Notice, the IRS has provided detailed information about the new rules. For general background on the TCJA’s revisions, click here to read a previously published article – Exploring the Impact of Section 174 on R&E Expenditures.
It is important to note that reliance on the pre-regulatory guidance contained in the Notice is voluntary. Notice 2023-63 announces and requests comments concerning the IRS’s intentions for future regulations. While the Notice allows for reliance, it carries no regulatory weight.
The Notice addresses seven key areas of uncertainty concerning the implementation of revised Section 174:
- Short Taxable Years: The Notice clarifies that in a shortened taxable year, taxpayers should prorate the amortization deduction according to the number of months in that year. This clears up confusion regarding whether the recovery period references calendar years or taxable years.
- Identification of SRE Expenditures: Although the costs that can be categorized under capitalizable SRE expenditures are nuanced, the IRS has given clarity on several. Notable inclusions encompass all compensation elements (except severance), travel expenses, and a vast array of overheads like rent, utilities, security, insurance, and more. Standout exclusions comprise service departments indirectly supporting SRE activities and interest on debt financing SRE endeavors.
- Scope of Software Development: The Notice clarifies the scope of software development subject to capitalization under Section 174. While the Notice’s guidance is detailed and nuanced, it centers mainly around two loose concepts. The first concept is that data or information bases are not software, nor is data entry software development. The second concept is that an item’s ready-for-sale date (or placed-in-service date for internal-use software) is a pivotal point: before that point the scope of capitalizable software development is reasonably comprehensive, capturing a wide range of activities. After that point, however, the scope is limited unless the activity involves material upgrades or enhancements to the software.
- Research Performed Under Contract: This section brings clarity on who bears the SRE expenditures in contract research – the provider, recipient, or both. Typically, a research provider comes under Section 174’s purview only if they hold financial risk or have rights to utilize the research output.
- Treatment of Unamortized SRE Expenditures in a Year of Disposition: A key area of uncertainty within revised Section 174 involves what happens to unamortized SRE expenditures when a taxpayer undergoes a transaction resulting in a cessation of the taxpayer’s trade or business. The Notice clarifies corporate transactions (dividing treatment based on whether the transaction is or is not described in Section 381(a)). With respect to partnerships, however, the Notice primarily signals the IRS’s concern for abuse and requests public comments concerning the appropriate application of Section 174(d) to various partnership transactions.
- Long-Term Contracts: For research tied to contracts under the percentage of completion method (Section 460), the Notice offers relief. The IRS signals its intent to adjust the Section 460 regulations, ensuring only a taxpayer’s SRE cost amortization is included in the completion factor, rather than the full SRE expenditure.
- Cost Sharing Arrangements: The Notice states that the IRS intends to revise existing transfer pricing regulations under Section 482 to clarify the appropriate allocation of SRE costs between controlled participants in a cost sharing arrangement.
Note: Section 174 is related to §41 R&D credit, but this does not change the benefits of those tax savings. For more information read our previously published article – Businesses May Find Significant Tax Savings in R&D Tax Credit.
This guidance from the IRS represents a significant step towards clarifying the intricate web of rules governing SRE expenditures under Section 174. By providing clear guidelines in these key areas of uncertainty, the IRS empowers businesses to make informed decisions, fosters compliance and promotes innovation – a win-win for both businesses and the broader economy. The implications of Notice 2023-63 depend on each taxpayer’s specific circumstances. If you have questions about how the new rules could impact your business, contact an Adams Brown advisor.