Mandatory Capitalization of Research and Experimental Costs for Income Tax Reporting Purposes
What Your Business Needs to Know
Since late 2017, taxpayers have been implementing the changes brought forth by the Tax Cuts and Jobs Act (TCJA). After five years, businesses will need to grapple with the provisions of TCJA scheduled to change at the end of this year. One of the most impactful changes relates to IRC Section 174, Research and Experimental (R&E) Expenditures. In tax years beginning after December 31, 2021, taxpayers will lose the ability to immediately expense their R&E costs for income tax reporting purposes. Beginning in 2022, this change will require R&E expenditures to be capitalized and amortized over a period of five years for activities performed in the U.S. and fifteen years for activities performed outside of the U.S.
Additionally, software development costs are specifically included as R&E expenditures under Section 174(c)(3) and, therefore, will be subject to the same mandatory amortization period of five or fifteen years irrespective of whether these costs are for development of internal use software or software to be sold, leased or marketed.
The rules specify amortization will begin at the midpoint of the taxable year in which the R&E expenses are paid or incurred, creating a significant impact in the first year. Loss-making companies will need to evaluate and administratively prepare to make estimated income tax payments should the new rules result in a projected taxable income position.
The immediate impact of new rule will result in a temporary increase to taxable income (or reduction of taxable loss) that will ultimately reverse in future years.
Example Scenarios
Example 1:
Assume a calendar-year taxpayer incurs $5 million of U.S. based R&E expenditures in 2022. Prior to the passage of TCJA, the taxpayer would have immediately expensed all $5 million assuming no other applicable elections to capitalize were made. Under the new rule, the taxpayer will only be entitled to amortization expense of $500,000 in 2022. If these same costs were non-U.S.-based, the taxpayer will be entitled to amortization expense of $166,667 in 2022.
Example 2:
Consider a company that performs a significant amount of U.S. based research relative to other expenditures and historically would have reported a significant income tax loss:
| Book Income | Tax Income under New Rules | ||
|---|---|---|---|
| Revenue | $ 10,000,000 | $ 10,000,000 | |
| S,G&A Expense | $ (5,000,000) | $ (5,000,000) | |
| R&E Expense | $ (25,000,000) | $ – | |
| Allowable Amortization Under 174 |
$ – | $ (2,500,000) | |
| NOL Loss Deduction & Application of R&D Credits | $ – | $ (2,500,000)** | |
| Net Income (Loss) | $ (20,000,000) | $ – |
** This may require a section 382 study or R&D study to be performed prior to utilization of tax attributes.
Considerations for Taxpayers with R&E Expenditures
Due to the new R&E capitalization requirements commencing in 2022, businesses should ensure R&E expenditures are properly identified and accounted for by applicability and geography. For instance, businesses that include all salaries and wages in a single trial balance regardless of location, should consider what reporting information is available to allocate between Section 174 (U.S. Based), Section 174 (Foreign Based) and non-Section 174 amounts. It may be prudent to begin accounting for these costs separately within the trial balance.
Financial and Tax Reporting Implications
With the mandatory capitalization requirement in place, businesses should pay attention to the following when considering their income tax provision, taxable income projections and estimated payment implications:
The capitalization of R&E is considered a temporary difference, which will result in a new deferred income tax asset for businesses. Depending on the complexity of your business, the temporary difference could have a tax impact in other areas.
- Net Operating Loss (NOL) Availability – Section 382 can limit the use of NOL carryforwards. The ability to support the utilization of NOLs to offset current taxable income can be a complex endeavor which may require a formally documented study.
- Foreign Derived Intangible Income (FDII) deduction: FDII benefits, which typically are treated as permanent book/tax difference, may increase due to increased taxable income as a result of capitalized R&E expenditures.
- Disallowed Business Interest: Increased taxable income resulting from the capitalization of R&E expenditures may reduce disallowed business interest expense.
- Global Intangible Low-Taxed Income (GILTI) calculation: GILTI, which typically is treated as permanent book/tax difference may be significantly impacted with the requirement to capitalize and amortize foreign R&E expenses over fifteen years.
Please consult with your tax accountant for any questions on the above considerations.
Next Steps for Your Business
Legislative action will be required to change the treatment of R&E expenditures for tax years beginning after December 31, 2021. The delay of the effective date to capitalize R&E expenditures has broad bipartisan support, however, there is no guarantee any law will be enacted to change the current TCJA rules.
Until, when and if a new law is enacted, businesses need to plan for the implications of the above TCJA rule changes and assess the impact of the R&E cost capitalization on their 2022 taxable income for financial reporting purposes and income tax payment purposes.
