Changes to Tax Deductibility of R&D Costs Create Cash and ETR Impacts for Life Sciences Companies

The reduction in the corporate tax rate from 35% to 21% in the 2017 Tax Cuts and Jobs Act (TCJA) required Congress to use the budget reconciliation process, which requires a revenue neutral tax bill. To achieve revenue neutrality for a reduced corporate rate, Congress enacted limitations on certain deductions, but delayed the effective date for the changes until several years in the future. Beginning in 2022, one such limitation becomes effective and will result in life sciences companies losing the ability to currently deduct what for many is the single largest expense item on their income statement, research and development (R&D) costs. Wall Street analysts have begun to ask the multimillion (and sometimes billion) -dollar question—“what impact will this have on your company’s cash tax and effective tax rate (ETR) positions beginning next year?”

Beginning in 2022, the TCJA will require capitalization of R&D costs including software development costs, allowing a deduction over five years if these activities take place in the U.S. and its possessions, or over 15 years for outside-U.S. activities. The impact of these changes to the current expensing of R&D and software development costs to tax planning will be significant and may not be limited to cash tax considerations. Many tax calculations are impacted by R&D deductions, including foreign tax credit computations as well as international reform under the TCJA targeting the foreign earnings of a multinational, also with ETR implications.

Finally, and perhaps most troubling for the life sciences industry with many co-development, collaboration and intercompany funding agreements, the limitation on current deductions for R&D costs may often create a mismatch between the timing of revenue recognition for R&D funding from related or unrelated parties and the corresponding deduction for relevant expenses.

There is always the chance the Congress will further delay or repeal the limitation on the current deduction for R&D costs, but pending legislation and its timing is uncertain. At the time of this writing, making its way through Congress is a bill, H.R. 1304—the American Innovation and R&D Competitiveness Act of 2021—which would repeal mandatory capitalization of R&D costs. However, there are many competing legislative priorities making the future of this bill unclear.

Until it becomes clearer that Congress will repeal or delay the TCJA changes to R&D deductions, companies should begin to assess and model the potential impact of these changes from both a cash tax and ETR perspective. Unfortunately, if recent history tells us anything, many tax bills come out the very end of the calendar year as a “holiday surprise.” Given that these provisions take effect Jan. 1 (for calendar year companies) waiting and hoping for that holiday surprise would not be advisable since R&D literally is the biggest issue for many clients in the industry. In simple terms, if you spend $1 billion on R&D in 2022 instead of receiving a tax deduction for that amount, you will spread those costs over five years (domestic)/15 years (foreign), which will have a very material impact to your tax budgets, forecasts, estimated payments, and financial statements.

R&D Changes Made by the TCJA

The statute governing the tax treatment of R&D expenses currently allows three elective, alternative treatments:

(1) current expensing,
(2) capitalization and amortization over at least 60 months, or
(3) charged to a capital account.

This provision, as amended by the TCJA, will require mandatory capitalization of R&D costs, with amortization over five years if the activities are in the U.S. and its possessions, or over 15 years for foreign research activities (i.e., they take place outside the U.S. and its possession). The amortization will take effect beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.

A new provision impacting the treatment of software development expenditures is included in the TCJA, providing that any amount paid or incurred in connection with the development of any software shall be afforded the same treatment as R&D expenditures.

Issues to Consider

• How does this provision apply to software development?

The TCJA does not address what constitutes software development that is required to be capitalized and amortized under five or 15 years, however, there is long standing guidance on this topic that should be considered. Generally, software development, including the design, coding, and testing of new or improved software, is treated in the same manner as capitalized R&D costs under these provisions. Conversely, the costs associated with the purchase or license of off-the-shelf software, requiring little to no customization, software maintenance, training, or business process-related activities, and costs are generally excluded from such treatment. However, as noted above, it may be necessary to consider the current year amortization cost of software within the total R&D expenses to the extent the software is utilized in the R&D function of the organization.

• How is the tax treatment of R&D costs incurred in collaboration with or funded by other parties impacted?

Many life sciences companies engage in strategic alliances, co-development, collaboration and/or cost sharing arrangements with related and unrelated parties to share in the cost and intellectual property resulting from R&D efforts. In some cases, companies receive funding in the form of upfront payments, milestone payments, or cost sharing payments. Post-TCJA, there is now the potential for a significant mismatch in the timing of revenue recognition for R&D and the timing of the corresponding R&D deductions for tax purposes. A review of these arrangements and the assessment and modeling of income/expense recognition is important as a result of the new R&D provisions, and certainly these new provisions should be considered when entering into new agreements.

• How will the R&D tax credit be impacted?

A company’s R&D tax credit might not be negatively impacted by the limitation on R&D cost deductions. The R&D tax credit rules require taxpayers to include only costs meeting the definition of an eligible R&D cost, with certain other criteria also applied to limit the creditable costs to include wages, supplies, or certain payments to third-party vendors for R&D. Whether a taxpayer currently expenses or capitalizes and amortizes these costs has no bearing on R&D expense eligibility.

• What other tax calculations are impacted by the new R&D capitalization provisions?

Life sciences companies include R&D expenses in several other calculations impacting both cash tax and the ETR. Specifically, R&D expenses are permitted to be excluded from inventory capitalization calculations required for tax purposes. R&D expenses are also allocated/apportioned for purposes of determining a company’s foreign tax credit (FTC) position, as well as in complying with new provisions enacted by the TCJA, including the calculations required under base erosion and anti-abuse tax (BEAT), global intangible low-taxed income (GILTI), and foreign-derived intangible income (FDII). The impacts of capitalization vs. current deductibility cannot be underestimated on these complex and interdependent calculations. Careful modeling of these impacts is advised.

Conclusion

While it is possible the requirement to capitalize and amortize R&D and software expenses may be delayed or repealed, there are no guarantees, so it is important for life sciences companies to consider these potential impacts sooner rather than later, recognizing that detailed modeling is needed due to the interdependencies of many complex tax calculations leveraging the R&D expense amount. Further, companies may want to consider the possibility of an increase in the corporate tax rate, which would have a more costly impact on delayed R&D deductions than anticipated.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Christine Kachinsky is U.S. Life Sciences Tax Industry Leader at KPMG LLP as well as the New Jersey Tax Practice leader based in Short Hills, New Jersey. Tyrone Montague, who is based in New York, is a Managing Director in KPMG’s Washington National Tax Income Tax and Accounting practice.

These comments represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.