Taxpayers Need More Guidance for Compliance With New R&E Rules

Mandatory capitalization and amortization rules under Section 174 of the tax code, amended as part of the Tax Cuts and Jobs Act of 2017, became effective in 2022 for most taxpayers. Although it was enacted more than five years ago, the government has only provided taxpayers with guidance for changing their methods to comply with the new law. That leaves many substantive questions unanswered.

One key issue arises when a taxpayer enters into a contract research agreement to perform research on behalf of another party. Are the costs incurred by the taxpayer performing the research Section 174 research and experimental expenditures?

If so, could the costs incurred by the service recipient to pay for the research also be Section 174 R&E expenditures, possibly resulting in both parties incurring these expenditures? Or is the definitional scope limited, such that only one party or the other (not both) are treated as incurring Section 174 expenditures?

Given the lack of guidance, one could reasonably interpret the statute as supporting either position. This issue is particularly prevalent among taxpayers with multinational operations—for example, where controlled foreign corporations perform contract research services for a controlling US parent.

Another area where taxpayers need guidance is in determining the costs that are Section 174 research and experimental expenditures. Specifically, costs that are incident to the research are included, but there’s no regulatory definition of “incident to” under Section 174. This leaves taxpayers to apply what they consider to be a reasonable approach. Case law suggests the scope of Section 174 includes at least some allocable share of overhead.

The amended Section 174 also includes software development costs. Historically, software development costs have been treated in a manner similar to Section 174 expenditures under Rev. Procs. 69-21 and 2000-50. In a 2002 Private Letter Ruling addressing enterprise resource planning software implementation, the government narrowly defined software developments to include only costs of coding, and an allocable portion of the modeling and design costs for the software.

The government chose not to include that definition in regulations on capitalization of intangibles issued in 2003, instead indicating it would consider computer software in a separate project. Lack of guidance in this area has resulted in a wide array of definitions of computer software used by taxpayers.

Taxpayers also lack guidance in computing the Section 174 amortization for short tax years. Is the amortization allocated to the short tax years based on an annual, monthly, or daily pro ration? Does the taxpayer simply claim one-half year of amortization as if it had a full 12-month tax year?

The new Section 174(d), which provides that “if any property with respect to which specified research or experimental expenditures are paid or incurred is disposed, retired, or abandoned during the period during which such expenditures are allowed as an amortization deduction under this section, no deduction shall be allowed with respect to such expenditures on account of such disposition, retirement, or abandonment and such amortization deduction shall continue with respect to such expenditures,” also has no guidance.

For example, it’s not clear where a taxpayer that has transferred intellectual property in a tax-free transaction (such as Section 721 or Section 351) must continue to amortize the capitalized Section 174 expenditures, or whether the transferee is the party that would continue the amortization. If the unamortized costs stay with the transferor, it’s unclear what happens to those costs if the transferor ceases to exist—would it be entitled to a deduction in its final year of business?

There’s no guidance as to whether section 174(d) precludes a taxpayer from reducing its basis in the sold property by the unamortized balance of the capitalized Section 174 costs when the property is sold in a taxable transaction. In other words, does “no deduction” mean “no reduction in basis,” or does it mean no loss deduction and any amounts that would be a loss continue to be amortized?

Section 174 expenditures interact with a number of other provisions in the tax code—Sections 460, 482, 280C, and 59(e) are just a few. The impact on these provisions resulting from the change to capitalization and amortization is unclear.

The lack of substantive guidance under Section 174 likely will result in disparate treatment by taxpayers as they apply subjective reasonable interpretations of the law. In the absence of clear guidance, the positions taken by calendar year taxpayers on their 2022 returns may vary widely—not just among similarly situated taxpayers, but from guidance ultimately issued by the government.

The lack of guidance also may create risk and uncertainty for taxpayers that could somewhat be mitigated by the government providing prospective guidance with non-inference language and limiting exam activities for these issues.

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

Jane Rohrs is managing director in Deloitte Tax’s Washington National Tax practice.

Mark Hindes is a senior manager in Deloitte Tax’s Washington National Tax practice.

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