Effective for tax years beginning after December 31, 2021, research and experimental (R&E) expenditures as defined by Internal Revenue Code (IRC) Section 174 are subject to new rules that could impact your organization’s financial statement reporting and cash flow.
Explore how the mandatory capitalization of IRC Section 174 costs could affect your organizations quarterly financial statement reporting and 2022 estimated tax payment calculations.
Which Organizations Should Be Concerned?
The new capitalization requirements under Section 174 will impact taxpayers who incur R&E expenses—and it’s a consideration that should be addressed immediately.
For SEC filers with quarterly financial statement reporting requirements, consideration should be given as to whether the new rules impact the forecasted effective tax rate (ETR) for Q1 and if additional disclosure is needed to describe the impact.
For taxpayers making estimated tax payments using current year taxable income, consideration should be given to how the capitalization of costs incurred impact taxable income and the overall timing of cash tax payments during the year.
The Fundamentals of Section 174 Cost Treatment
Treasury Regulation (Treas. Reg.) Section 1. 174-2(a) defines R&E expenditures as expenditures incurred in connection with the taxpayer’s trade or business in the experimental or laboratory sense, including all such costs incident to the development or improvement of a product. This definition of R&E expenditures is broad and includes allocated overhead. Revenue Procedure 2000-50 clarified the treatment of software development as similar to a Section 174 cost. Section 174(c) added “the development of any software” specifically as a R&E expenditure subject to the new rules.
Prior to 2022, a taxpayer had the option to deduct Section 174 costs in the year incurred or capitalize and amortize R&E expenditures. Also, a Section 59(e) election was available to capitalize and amortize over a 10-year recovery period. These options are no longer available.
Changes to Section 174 Treatment
As of January 1, 2022, these changes are in effect:
- R&E expenditures for domestic activities are required to be capitalized and amortized over a period of 5 years
- R&E expenditures for foreign activities are required to be capitalized and amortized over a period of 15 years
- Mandatory mid-year convention applies to the amortization period
- IRC Section 174(c)(3) amended by the Tax Cuts and Jobs Act (TCJA) includes software development costs, eliminating the ability to expense software development as allowed by Revenue Procedure 2000-50.
- Section 59(e) election may not be available as the election is available for R&E expenditures that are otherwise deductible under IRC Section 174(a)
How Changes Impact Calculations Under ASC 740
The mandatory capitalization of Section 174 costs may create an adjustment to the calculation of taxable income for taxpayers performing R&E activities. For US taxpayers performing R&E activities, the mandatory capitalization of R&E costs may impact deferred tax calculations.
Companies should be mindful of whether a new deferred tax asset is created due to the legislative changes or an adjustment of existing deferred taxes is needed, for example, if the taxpayer previously expensed software development costs under Revenue Procedure 2000-50.
Taxpayers should also consider whether the changes impact the realizability of their deferred tax assets and if a full or partial valuation allowance is needed. Revised scheduling of a taxpayer’s deferred tax assets may need to be performed as part of the valuation allowance assessment.
For taxpayers with controlled foreign corporations (CFC) conducting R&E activities–including cost-plus CFCs performing R&E or software development services–there could be impacts to the calculation of the CFC’s global intangible low-taxed income (GILTI). GILTI is required to be calculated using US tax rules.
Many taxpayers have adopted an accounting policy to treat GILTI as a period cost rather than accounting for outside basis differences in GILTI, meaning, the impacts of GILTI are included in the calculation of the effective tax rate.
Increases to a taxpayer’s GILTI-tested income generally result in an adverse impact to the company’s effective tax rate. However, there could be mitigating factors, such as increased foreign tax credit utilization, that would need to be considered.
How Changes to Section 174 Cost Capitalization Will Affect Quarterly Reporting
The requirement to capitalize foreign R&E expenditures over 15 years could increase a taxpayer’s GILTI tested income and impact a taxpayer’s calculations under ASC 740.
Considerations include, but aren’t limited to, the following:
- The increased foreign taxable income for GILTI purposes could dilute the effective foreign tax rate impacting prior qualification for the GILTI high-tax exclusion election. Previously excluded GILTI may now be subject to inclusion which could increase the effective tax rate.
- The increase in tested income could result in increased utilization of US net operating losses, impacting net operating loss carryforward disclosures and deferred tax asset calculations.
Given the various ways the Section 174 capitalization requirements may impact a taxpayer’s GILTI inclusion, additional disclosures regarding the comparative ETR may be necessary to provide financial statement users with sufficient information for understanding the year-over-year change in ETR.
The capitalization of IRC Section 174 costs for US entities could also impact a taxpayer’s ETR by affecting a taxpayer’s foreign derived intangible income (FDII) deduction.
Although temporary differences generally aren’t considered for quarterly financial statement reporting, significant changes in temporary differences could impact a taxpayer’s deduction eligible income (DEI) for purposes of calculating the FDII deduction.
Assessment of the increase to US taxable income because of R&E capitalization should be performed to determine if the impact to DEI materially impacts the FDII deduction. The allocation of R&E expenditures to DEI should be considered because changes in this allocation could impact the FDII deduction.
Generally, taxpayers don’t adjust their deferred tax balances on a quarterly basis.
However, if the forecasted change for a deferred tax item is material, taxpayers should consider whether the balance sheet classification between current taxes payable and noncurrent deferred taxes should be accounted for as part of quarterly reporting.
Other Considerations: Quarterly Estimated Tax Payments
A corporation is required to make quarterly estimated tax payments. There are multiple ways to compute payments:
- Based on 100% of tax on prior year’s return. If a taxpayer qualifies for this method, estimated tax payments for 2022 can be made without consideration given to the impact of Section 174 capitalization until tax return extension deadlines. This option is only available for large corporations—corporations that had taxable income of $1 million or more for any of the three tax years immediately preceding the 2022 tax year—for the first required installment only. The required installments for the rest of the year must use one of the next methods.
- Based on expected tax. Taxpayers attempting to pay estimated taxes based on 100% of the expected tax on the return for the taxable year will need to estimate the impact of Section 174 capitalization on their 2022 taxable income by considering the forecasted 174 costs to be capitalized.
- Based on calculation of tax due using the annualization method. This method annualizes year-to-date taxable income for estimating the tax due for the year. Taxpayers would need to estimate the impact of Section 174 capitalization by considering the 174 costs incurred year-to-date.
The impact of Section 174 on taxable income should be considered when using one of the above methodologies with appropriate thought given to the impact on timing and amounts of cash tax payments to make during the year.
We’re Here to Help
If you have questions about research and experimental expenditure capitalization under Section 174 and how the new rules could impact your business, contact your Moss Adams professional.