IRS’s New R&E Proposal Clashes With Its Long-Term Contract Rules

The IRS recently proposed some welcome guidance for capitalization rules of specified research or experimental (SRE) expenditures under Section 174 of the tax code.

However, the SRE guidance in Notice 2023-63 has forced companies to try to make sense of how to properly account for revenue recognition and expense deductions for long-term contracts. This article explores the interaction of Section 174 with the revenue recognition rules for long-term contracts in Section 460.

Long-term contracts are defined as any contracts for the manufacture, building, installation, or construction of property that aren’t completed within the taxable year in which a taxpayer enters into them.

Section 460 provides that taxpayers must recognize long-term contract revenue using the percentage of completion method, or PCM. The completed contract method was an alternative method but was repealed to prevent taxpayers from deferring revenue recognition.

Under PCM, a taxpayer recognizes revenues equal to the contract price multiplied by the completion factor, which is defined as the ratio of costs allocated to the contract and incurred before the close of the taxable year over the total estimated contract costs, less any revenues recognized on the contract in the prior years.

The following example illustrates how the rules may apply and whether they achieve the policy objectives and intended purposes of these code sections.

• A company has a long-term contract with a contract price of $200. Total estimated costs are $100 and are to be incurred over three years within the US.
• In the first year, the company incurs $20 of costs. Under PCM, it recognizes $40 of revenues, as the completion factor is 20% ($20 divided by $100) multiplied by its contract price of $20.
• If these costs are SRE expenditures but were incurred prior to Jan. 1, 2022, all incurred costs would be fully deductible, resulting in taxable income of $20.
• Assuming no material book-tax differences, the net income for financial reporting purposes also would be $20 under accounting rules similar in concept to PCM.

Fast forward to Jan. 1, 2022. Notice 2023-63 describes an interpretation of the current rules that would create a mismatch of revenue recognition and related expense deduction. The completion factor under PCM continues to be based on when allocable costs are incurred. However, Section 174 would prevent the current year deduction of the allocable costs to the extent that they’re SRE expenditures.

Continuing with the example—assuming all of the costs ($20) incurred in the first year are SRE expenditures—only $2 would be deductible that year. This means the company recognizes $40 of revenues in the first year but is only allowed a $2 deduction, resulting in taxable income of $38.

Notice 2023-63 recognizes this interpretation would significantly accelerate income recognition, and it proposes to revise the computation of the completion factor under Section 460 to account for the timing of SRE expenditure amortization deductions.

However, the notice indicates that the company would have to recognize any remaining revenues on the contract in the year after it’s completed under Section 460(b)(1), even if any SRE expenditures remain unamortized at that time.

Under the proposed change, the completion factor decreases to 2%, since only $2 of total estimated costs of $100 are deductible in the first year. The company recognizes revenues of $4 in the first year, resulting in taxable income of $2.

Here are a few observations, continuing with the example with an additional $50 of costs incurred in the second year and $30 in the third year:

• While contract costs are incurred over three years, the costs can only be fully amortized at the end of eight years.
• A company would fully recognize the revenues by the end of the third or fourth year, but approximately half of the costs wouldn’t be deducted by that time.
• The amortization deductions would create significant losses in years five through eight, and the company would need other income to absorb the losses (unless a carryback provision is available).

A company may have to account for tens or hundreds of long-term contracts each year, if not more. These contracts tend to have high-dollar values and affect a company’s taxable income position. The example demonstrates that a mismatch of revenue recognition and related cost deductions still happens with the proposed change to Section 460.

What may be more problematic is that the revised rule produces significant income deferral in the early years and appears to defeat the purpose of Section 460. Is income clearly reflected under any interpretation of these rules? The timing of revenue recognition and expense deduction differ from the actual progress of the contract and differ from financial reporting.

While the IRS’s effort to coordinate the long-term contract rules with the amortization of SRE expenditures is commendable, it would make more sense for the revenue recognition rules under Section 460 and the SRE expenditures allocable to long-term contracts to be excepted from the mandatory capitalization rules of Section 174. This is another reason to support the repeal of the mandatory capitalization rules.

Since this is one area without easy solutions, the IRS would benefit from constructive comments by taxpayers. Time is of the essence—comments on the Notice 2023-63 are due by Nov. 24, 2023.

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   

Betty Mak is a CPA and tax director with Maxar Technologies. She is also vice chair of Tax Executives Institute’s federal tax committee and a member of TEI’s executive committee.

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