The businesses that invest in research and development should familiarize themselves with the major tax changes for R&E expenses. Effective for the tax years, taxpayers are required to capitalize and amortize US-based R&E expenses over a period of five years and non-US R&E expenses over a period of 15 years. The software development costs are specifically included as mandatory capitalization of R&E expenses under Internal Revenue Code (IRC) Section 174(c)(3) and are subject to the same mandatory amortization period of either 5 years or fifteen years.
Under the 2017 Tax Cuts and Jobs Act (TCJA), research and experiment expenditures incurred or paid for tax years starting after December 31, 2021, no longer receive deductions for tax purposes. The new mandatory capitalization rules apply to the software development costs. This remains regardless of whether the software develops for sale or licensed to customers for internal use. Here is everything you need to know about the mandatory capitalization of R&E expenses and how the new rules will impact your business.
Mandatory Capitalization Section 174
The new requirement to capitalize and amortize all the R&E expenditures requires taxpayers to determine the proper amount of their Section 174 costs. Taxpayers can treat their expenditure, characterized as R&E on the financial statements as their Section 174 costs as long as there is no difference between the current deduction under Section 174 and a current deduction under Section 162. However, avoid making mistakes of improper characterization. Improper characterization of cost expenditure could potentially impact your inventoriable costs under the Section 263A and Section 59(e) elections. This is because engineering and design costs are usually inventoriable unless they are under Section 174 costs. Basically, ensure that expenditures receive proper characterization under Section 174.
Other Effects of the New Section 174 Rule
The most obvious impact of the new Section 174 is a temporary increase or decrease of taxable income. This will likely reverse in the coming years. There are other important tax provisions in which the treatment of R&E expenditure and determination of taxable income is relevant, and could be impacted by the change. In certain instances, the difference could lead to a permanent difference to your company's lifetime taxable income and tax rate. With new capitalization in place, pay more attention to tax provision and taxable income projection. This includes the following:
- Section 250 Foreign Derived Income (FDII) deduction. The FDII benefits could potentially increase as a result of increased taxable income.
- Section 163(j). An increase in taxable income from capitalization of R&E expenditures can potentially reduce disallowed business interest expenses under this section.
- Section 250 Global Intangible Low-Taxed Income (GILTI) calculation. The amount of tested income will potentially be affected by the requirement to capitalize and amortize foreign R&E expenses over 15 years.
- Section 861 allocations. provisions consisting of the allocation of research and equipment expenditures include FDII, GILTI, as well as the foreign tax credit. The law requires that all costs allocate in accordance with the rules provided under Section 861.
Cost/Benefit of Offshoring R&E Activities
It is clear that R&E expenditures that are incurred for actions performed in foreign countries are subject to an amortization period of 15 years. This is better when compared to in-country, which offers a five-year amortization period for R&E activities that are carried out in the United States. Your business should carefully evaluate the tax impact of both the 5 year and 15 year recovery periods, weighing the cost savings from shifting R&E activities to foreign countries. Given the current prevalence of outsourcing R&E as well as software development activities to foreign jurisdictions, taxpayers that incur these costs outside the United States are more likely to encounter an even more significant impact from the new rules than their counterparts that carry out R&E activities within the nation.
Impact on Financial Reporting Under ASC 740
You should also consider the impact of mandatory capitalization on your tax provisions. Technically, the research and equipment expenditures in circumstances with amounts deducted create a net deferred tax asset. Even though many consider the tax disparity in R&E treatment of expenditures as a temporary difference, the effects of the new rules result in other tax impacts. For example, calculation of Global Intangible Low-Taxed Income (GILTI) inclusions and Foreign-Derived intangible Income (FDII) deductions.
This gives rise to permanent differences that can increase or decrease your company's effective tax rate. The United States valuation allowance assessment for deferred tax assets may change as a result of increased taxable income. Therefore, you should carefully consider changes to both GILTI and FDII in the valuation allowance assessments. Indeed, these amounts are factors in forecasts of future profitability.
Planning for Change
The mandatory capitalization rules began from 1st January 2022, and potentially have a significant impact on your business if you perform R&E activities or claim research credit. You, therefore, need to plan, model, and evaluate the impact of these new rules. Do this for taxable income, cash taxes, tax rate, estimated tax, estimated tax payments, state tax posture, and international provisions. You should therefore develop a process that helps you to efficiently capture and allocate the probable costs. Your business should also provide clear documentation to the IRS substantiating their Section 174 costs. Essentially, this leads to greater compliance efforts and additional analysis outside of the typical research credit analysis.
The mandatory Section 174 capitalization rules and the R&Es expenditures are complex to analyze, calculate, and document. H&CO can help you to handle every aspect of this process while maintaining high standards. Contact us to learn more.
