Stay Up to Date on the Latest Tax News
- Interim guidance was released on September 8, 2023 on Section 174 of the Internal Revenue Code.
- The guidance relates to capitalization and amortization of specified research or experimental expenditures.
- The effective date for the guidance is for tax years ending after September 8, 2023 and can be retroactively applied.
The IRS recently released interim guidance on Section 174 of the Internal Revenue Code (IRC) in the form of Notice 2023-63. This notice states the government intends to issue proposed regulations regarding the capitalization and amortization of specified research or experimental (SRE) expenditures.
The effective date for the guidance is for tax years ending after September 8, 2023. The guidance may also be applied retroactively and can be relied upon if all aspects of the notice are applied.
Section 174 is a particularly impactful item for companies engaged in research and development (R&D) activities.
Background on Section 174 Guidance
In 2017, Congress passed the Tax Cuts and Jobs Act, which, in part, requires the capitalization and amortization of SRE costs incurred in tax years beginning after 12/31/2021. Generally, SRE costs are capitalized and amortized over five years if incurred in the United States and over 15 years if incurred in a foreign country.
What’s Included in the New Section 174 Guidance
Key issues addressed in the new interim guidance include items such as foreign research, allocation methods, contract research, and software development. The notice also provides examples of costs that should and should not be capitalized in accordance with Section 174.
This term is defined as software development activities or research or experimental activities.
These expenditures include all costs resulting from SRE activities. Examples of costs that are SRE expenditures include:
- Labor costs (including elements of compensation other than severance compensation such as overtime pay, vacation pay, payroll taxes, etc.)
- Materials and supplies costs
- Cost recovery allowances (i.e., depreciation, amortization, and depletion allowances)
- Patent costs
- Certain operation and management costs (e.g., rent, utilities, insurance, taxes, etc.)
- Travel costs for SRE activities or direct support activities
Not SRE Expenditures
Examples of costs that are not to be treated as SRE expenditures include:
- Costs from general and administrative service departments that only indirectly support SRE activities
- Interest on debt to finance SRE activities
- Costs to input content into a website
- Amounts representing amortization of SRE expenditures
- Costs to register an internet domain name or trademark
Section 41 Applicability
Simply taking the Section 41 R&D tax credit costs as the amount required to be capitalized under Section 174 is insufficient.
To account for SREs attributable to foreign research, costs should be amortized over the appropriate timeframe dependent on where the research activities are performed. For foreign research activities where a cost sharing arrangement is in place with a related U.S. entity, an analysis of the cost sharing arrangement is necessary to allocate the costs appropriately.
Notice 2023-63 provides that reasonable allocation methods may be used to allocate costs and the methods can vary based on the type of cost. However, the method for each type of cost should be consistent from year to year.
Software development activities are subject to capitalization under Section 174 and include upgrades and enhancements to software. Capitalization of costs is required through the lifecycle of the development (from planning through writing and testing of the software). Further guidance is expected in the proposed regulations.
Costs for research activities performed under a contract are includable under Section 174 if there is financial risk to the taxpayer or if the taxpayer has a right to use the resulting research product. Further guidance is expected in the proposed regulations. Additional guidance is expected with respect to foreign-related party research performed under contract.
Disposition, Retirement, or Abandonment of Property
Taxpayers must continue to amortize specified research costs even if property has been disposed, retired, or abandoned; however, special rules are provided for the treatment of costs following certain transactions. Further guidance is expected in the proposed regulations.
Section 174 and Section 460
Notice 2023-63 also clarifies the interaction between the Section 174 capitalization requirement and the long-term contract accounting rules under Section 460. Under the notice, taxpayers are only required to include the amount of allowable amortization as a contract cost incurred during the year and not the entire amount of capitalized Section 174 costs incurred.
How to Apply the New Section 174 Interim Guidance
Future regulations are expected to be consistent with the interim guidance provided in Notice 2023-63. However, the Notice also asks for commentary on many of the positions outlined, so changes may happen. Proposed regulations will be forthcoming.
Additionally, proposed legislation would repeal the Section 174 amortization requirements, although it is uncertain whether this proposed legislation will be enacted into law.