Tax Pros Crunching R&D Expenses Must Parse Complex Rules

Businesses still face compliance challenges despite IRS interim guidance last year and clarification and modification this year about specified research or experimental expenditures under Section 174 of the tax code.

These challenges seem even more frustrating with the prospect of legislation that would retroactively defer the capitalization requirements of such expenditures, known as SRE.

Regardless, businesses must continue to evaluate and understand the complexities of Section 174 to foster innovation and maintain compliance. Tax professionals should consider several critical issues regarding capitalization and amortization requirements.

Software Development

The IRS guidance refreshed definitions of software development, holding that costs incurred for upgrades and enhancements to modify existing software resulting in additional functionality or materially increase the speed or efficiency of the software constitute SRE activities, whereas “maintenance” costs do not.

It stops there, creating confusion over the definitional bounds of additional functionalities and what could be deemed a material upgrade or enhancement (versus maintenance).

Software development is a widely important business process. It might serve as the core business offering, power a web portal or mobile application, or underpin internal systems to keep a company operational. Activities that might seem standard yet vital (security patches, cloud computing platform conversions, or customizations to off-the-shelf software) generally were deductible under prior law, regardless if they were considered software development costs or other ordinary and necessary business expenses.

Now careful consideration must be applied, as these costs might no longer result in a current deduction. As a starting point, tax practitioners should seek to understand how development costs are treated for financial accounting purposes. After considering what costs hit the balance sheet and which are expensed, practitioners should enlist development or IT teams to confirm how SRE activities and costs compare to the definitions outlined in the interim guidance.

Research Under Contract

Businesses often engage with customers or vendors for scopes of service that include research and development activities. The IRS guidance offers some direction for the research recipient and provider roles and attempts to avoid double capitalization between the parties involved.

But there’s still considerable uncertainty due to the open-ended nature of how financial risk and the right to exploit R&D are determined. This uncertainty is compounded due to varying contractual language between parties that might inadvertently trigger unfavorable Section 174 outcomes.

Understanding development agreements, including the payment structure and development rights provisions, can help businesses ascertain who ultimately bears the Section 174 costs.

Intragroup Transactions

Like third-party contracts, thoughtful analysis is required for a business’s own entity organizational chart. Businesses must examine any formal agreement in place (if applicable), the intracompany transaction amounts related to R&D, and the right to exploit the R&D.

Under cost-sharing arrangements specifically, determining the proper allocation of SRE expenditures can be highly complex and result in varying treatments with the total R&D spend.

Consider a US parent company and a foreign subsidiary that have a cost-sharing arrangement to develop a product. Both parties need to understand the share of the cost incurred by the US parent and foreign subsidiary under the arrangement’s terms (how much?), whether intracompany payments cause an offset of intangible development costs incurred or income to a payee (who?), and where the work was conducted (how long is the amortization period—five or 15 years?).

Allocation Methods

The interim guidance says allocation of SRE expenditures should represent a cause-and-effect relationship between the costs and the SRE activities. The allocation method for each type of cost also must be applied on a consistent basis.

For example, labor costs might be allocated based on the percentage of time employees of a specific department spent on SRE activities or a headcount ratio for the department; depreciation might be allocated based on square footage of the facility; utilities might be allocated based on kilowatt-hours used by department.

The challenges for tax professionals involve identifying an objective and reasonable methodology that can be administered in a practical way. In balancing precision and efficiency, especially given the available data and resources, a simpler approach could produce higher SRE expenditures, whereas the tradeoff of a more detailed approach could result in lower SRE expenditures.

Dispositions From Transactions

The general rule under the statute is clear: The disposition of property doesn’t result in an accelerated deduction of any unamortized SRE expenditures. Some exceptions were expected, but the interim guidance provided only a hint of what those exceptions ultimately might look like.

Specific exceptions and special rules were provided solely for transactions in which a corporation ceases to exist, but notably absent from the interim guidance were transactions involving partnerships—contributions, distributions, transfers, and mergers.

Businesses engaging in transactions not explicitly addressed in the interim guidance need to carefully evaluate the nuances of the disposition rules in developing a tax position that aligns compliance with their strategic objectives.

Outlook

These critical considerations, while not exhaustive, represent significant areas of uncertainty that businesses must navigate with caution, factoring both law and implementation burdens.

As businesses await further guidance and legislative updates, it remains essential to consider the provisions in the available guidance. The complexities underscore the need for a proactive approach ahead of each filing season, as well as the value of consulting with tax specialists.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

A.J. Schiavone is partner on the national R&D tax team at Crowe in Columbus, Ohio.

Sophia Shah is senior tax manager on the federal tax consulting services team at Crowe in New York.

Andrew Eisinger is senior tax manager in the Washington national tax team at Crowe.

Write for Us: Author Guidelines