Beginning in 2022, the Tax Cuts and Jobs Act’s (TCJA) newly effective amortization requirement of research and experimental (R&E) amortization stands to impact multiple aspects of tax and financial statement planning.
Signed into law on December 22, 2017, the TCJA eliminated a long-standing rule allowing taxpayers to elect to either currently deduct or to capitalize and amortize R&E expenses. Effective for tax years beginning after December 31, 2021, taxpayers must instead capitalize and amortize US-based R&E expenses over five years and foreign R&E expenses over 15 years.
Significant uncertainty remains about how organizations should treat R&E expenses in light of the TCJA rules. However, absent any legislative action that delays or repeals the R&E amortization requirement, taxpayers must now consider the TCJA provisions, beginning in the short term with quarterly estimated tax payments and financial statement impact.
This article covers the following:
Definitions of R&E Expenses
The Internal Revenue Code (IRC) doesn’t define the term R&E expenses. However, Treasury Regulations Section 1.174-2(a)(1) defines the term as “expenditures incurred in connection with the taxpayer's trade or business which represent research and development expenses in the experimental or laboratory sense.”
According to Treas. Reg. Section 1.174-2(a)(1), an expenditure meets this definition if it’s “for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.”
According to Treas. Reg. Section 1.174-2(a)(10), such an expenditure may be for R&D undertaken directly by the taxpayer for its own benefit, or for R&D that a taxpayer engages a related or unrelated R&D service provider to perform, or contract R&D.
The regulations also provide specific examples of activity types that don’t constitute research or experimental expenses.
Activity Types that Don’t Constitute R&E Expenses
- Ordinary testing or inspection of materials or products for quality control
- Efficiency surveys
- Management studies
- Consumer surveys
- Advertising or promotions
- The acquisition of another’s patent, model, production, or process
- Research in connection with literary, historical, or similar projects
To identify R&E expenses, taxpayers must:
- Establish the connection to elimination of uncertainty for the developed product
- Exclude general and administrative or routine maintenance-based expenses
Previous Treatment of R&E Expenses
Prior to the TCJA cutoff, taxpayers had the following options available for treatment of R&E expenses:
- Adopt a tax method of accounting to deduct these expenses under IRC Section 174(a)
- Capitalize and amortize these expenses over no less than 60 months starting with benefit onset under IRC Section 174(b)
- Charge these expenses to a capital account under Treas. Reg. Section 1.174-1
- Elect to amortize R&E expenditures over 10 years under IRC Section 59(e)
- For software development expenses, taxpayers were able to utilize treatment provided by Revenue Procedure 2000-50 of amortizing over 36 months
Consequences of TCJA to R&E Expenses
Beginning in 2022, the TCJA specifically impacts the above noted options with respect to possible Section 174 treatment, including:
- The option to deduct R&E expenses under IRC Section 174(a) is now eliminated by TCJA. Taxpayers are now required to capitalize and amortize over a period of either five years for domestic or 15 years for foreign expenses, depending on the location in which the services or activities are occurring.
- Charge these expenses to a capital account under Treas. Reg. Section 1.174-1.
- Software development expenses are subject to the same mandatory amortization period of either five or 15 years.
Section 59(e) hasn’t been formally repealed, so the option to elect for 10-year amortization under this section is technically still available. However, the benefit of this election would be significantly curtailed by TCJA, and it stands to reason that this section could be repealed through technical correction in the future.
Conformance with TCJA by individual state tax codes is still a significant question, as some states have stated they won’t conform to the TCJA amendments. As such, determination of whether the R&E amortization rules are necessary should also be considered on a state-by-state basis.
TCJA Impact to IRC Section 41 and Section 280C
The TCJA also amended IRC Sections 41 and 280C, which are also effective for tax years beginning after December 31, 2021. TCJA amended IRC Section 41(d)(1) to define qualified research as research “with respect to which expenditures may be treated as specified research or experimental expenditures under Section 174.”
The TJCA amendment of Section 280C includes removal of the former requirement of a corresponding reduction to the Section 174 deduction by an amount equal to the research credit claimed in such tax year.
As amended Section 280C requires that if the amount of the research credit determined for the taxable year exceeds the amount allowable as a deduction for such taxable year, the amount chargeable to a capital account for the taxable year for such expenses shall be reduced by the amount of the excess.
Historically, a taxpayer’s Section 280C election reduced the amount of addback against taxable income resulting from claiming the R&D credit. This decision must factor the taxpayer’s full tax profile to determine whether such an election is advantageous. However, given the TCJA amendment to Section 280C, combined with the reduced Section 174 deductions, it remains to be seen whether the reduced credit election will create a benefit for taxpayers going forward.
Change in Accounting Method for R&E Expenses
The TCJA-mandated change to amortization for R&E expenses may constitute a change in accounting method requiring a Form 3115, Application for Change in Method of Accounting.
The change to R&E expense amortization would likely be applied on a cutoff basis, with no adjustment required under Section 481(a) for R&E expenditures paid or incurred in tax years beginning before January 1, 2022. However, no guidance currently exists on whether or not taxpayers will need to file Form 3115 for the change.
Impact to Financial Statements and Tax Provisions
In addition to the loss of current deductions, the R&E amortization requirement has potential for significant impact on the broader tax profile for certain taxpayers. This broader impact would also flow to a company’s 2022 financial statements and tax provision calculations.
The additional areas of relevance include:
- Section 250 Foreign Derived Intangible Income (FDII) deduction. FDII benefits may increase upon an increase in taxable income. Consequently, deduction-eligible income and foreign-derived deduction-eligible income also increases as a result of capitalized R&E expenditures.
- Section 250 Global Intangible Low-Taxed Income (GILTI) calculation. With foreign-based R&E expenses now required to be capitalized and amortized over 15 years, the amount of tested income in the applicable GILTI calculations may be significantly impacted as well.
- Section 163(j). Increased taxable income resulting from the amortization of R&E expenditures may increase allowable business interest expense under Section 163(j) in a given year.
- Section 861 allocations. Provisions involving the allocation of R&E expenditures, including FDII, GILTI and the foreign tax credit, should ensure that all expenses identified as Section 174 amounts are allocated in accordance with the rules provided under Treas. Reg. Section 1.861-17.
Estimated Tax Payments
In spite of the uncertainty around R&E amortization, some taxpayers are still required by IRC Section 6655 to make four quarterly estimated tax payments that would cover the current year’s income tax liability.
With substantially reduced R&E deductions, certain taxpayers face the distinct possibility of having taxable income. Since the TCJA provisions are now effective law, this would create the need to estimate the full impact on total tax due in all areas, including federal, state, and any applicable international provisions.
Options in Determining Quarterly Estimated Tax Payments
C Corporation taxpayers have the following options available in determining quarterly estimated tax payments:
- Determine 100% of the tax shown on the return for the taxable year
- Annualize based on available current year income and expenses incurred
- Use prior tax year’s total income tax amount as the estimate—this option is only available to large companies for the purpose of calculating Q1 estimated payment
While the first option is extremely difficult to calculate at such an early stage, and the third option is only available to certain taxpayers in specified quarters, TCJA creates a significant challenge for corporate taxpayers to determine an appropriate estimated tax payment.
If a taxpayer has a short taxable year that ends in 2022, prior to any possible legislative resolution to the issues noted above, taxpayers could face the need to prepare the short tax year return with the TCJA impact included in the returns.
The above points pertain to C Corporation taxpayers. However, owners of passthrough entities with R&E expenses should also consider the Section 174 amortization impact on their personal estimated tax payments as well.
Example of TCJA Tax Impact to Industries
The following is an example of how industries may be impacted by the TCJA provision.
Company X is a calendar year C corporation taxpayer, with substantial prior year net operating losses. Company X develops therapeutics, with numerous ongoing clinical programs. Company X has historically utilized IRC Section 174 to currently deduct its R&E expenses. In 2021, Company X offset revenue earned from a significant collaboration agreement, the payments for which are received on January 1 of each year, resulting in another taxable loss for 2021.
In 2022, TCJA takes effect, Company X is no longer able to fully deduct its R&E expenses, and instead these expenses are amortized over a period determined by the location of where the services are provided. Here, Company X has only US-based R&E expenses, thus a five year amortization period is applicable. Assuming R&E expenses remain constant from 2021 to 2022, and because the change in method is done on a half-year convention, the resulting 2022 deduction is roughly 1/10 of the 2021 R&E tax deduction amount.
The collaboration revenue payment is received and recognized on January 1, 2022. Without sufficient deductible expenses, Company X is now taxable as a result of the receipt of the January 1 collaboration payment.
Company X should initiate estimated tax payments for Q1 2022, which would be due April 18, 2022.
Legislative Outlook
While the TCJA R&E tax provisions are currently effective, there’s still a possibility of delay or outright repeal of the new requirements.
Since becoming effective after December 31, 2021, lawmakers continue to consider potential legislation that could postpone or even repeal the R&E expense amortization rules.
As of April 2022, there are bills in both the Senate and House of Representatives under consideration that would delay the R&E amortization rule anywhere from two to four years, or even repeal the provision outright.
Actual passage of these measures is uncertain; and as a result, the same can be said for the timing in which taxpayers would receive such relief.
As noted, taxpayers should prepare for reduced R&E tax deductions and the resulting impact to taxable income, beginning with estimated tax payments for Q1 2022.
We’re Here to Help
For guidance in understanding the impact of the TCJA provision on your organization and how you can capitalize your R&E expenses, contact your Moss Adams professional.
You can also visit our R&D Tax Credit Services or our Tax Credit & Incentive Services for additional resources.