At this morning’s Federal Bar Association breakfast briefing hosted by Eversheds Sutherland, officials from the Internal Revenue Service (IRS) and Department of the Treasury (Treasury) discussed the recent substantive guidance released addressing the treatment of specified research and experimental (SRE) expenditures under Section 174, Notice 2023-63 (Notice). The IRS and Treasury officials provided insight into not only the drafting and approval process of the guidance, but also the rationale behind certain positions taken and language used in the Notice. This alert highlights the major topics discussed at the breakfast briefing. For a more thorough analysis of the Notice, please see our prior alert, An Olive Branch or Shot Across the Bow? IRS Issues Notice 2023-63 Providing Welcome Substantive Section 174 Guidance.
- The government confirmed the Notice was always a priority, but due to competing TCJA demands, multiple pieces of pandemic legislation, as well discussion of Congress delaying and/or repealing the provision, they did not start drafting in earnest until last winter.
- The guidance was released as a Notice because it is easier to shepherd a notice through the clearance process as opposed to proposed regulations, and a notice gives taxpayers an additional opportunity to provide comments.
- Following the 60-day comment period, the government is not going to delay on releasing proposed regulations, but an NPRM will realistically not be released before next year at some point.
- To that extent, to reduce the potential for a flurry of non-automatic change in method of accounting filings, the government hopes to release procedural guidance by year-end to assist taxpayers in evaluating whether and when an accounting method change should be filed, and under what terms and conditions, i.e., waiver of the five-year limitation, audit protection, Section 481(a) adjustment or cut-off basis.
- The government used months to interpret the statutory references to 5- and 15-year amortization periods to make the math work in applying the midpoint concept; a similar approach using months has been taken in other depreciation and amortization contexts.
Scope of 174 – Costs Included (and Excluded) as SRE Expenditures
- In response to discussion regarding the delineation of cost categories required to be capitalized under the Notice and those that are “neither required nor permitted,” the government indicated they generally make an effort to avoid optionality when writing rules unless there’s a valid reason, e.g., administrative complexity, hence, the attempt at providing a non-exhaustive list in this circumstances. The government is open to comments in this area though.
- The government indicated because the existing regulations under Section 174 did not provide guidance or detail on costs that are “incident to” research and now that capitalization is mandatory, they thought it was appropriate to provide taxpayers with more detail. They looked at Section 41, which mandates a narrower scope of expenditures that qualify, and Section 263A, which provides a wider approach, and sought the middle ground with Section 174. They did not want to create a UNICAP 2.0.
- In connection with the comment re: Section 41, the government noted the scope of this Notice was not to do anything with Section 41 itself. They acknowledged the interplay between the provisions, and welcome comments from the public, but with the Notice attempted not to touch Section 41.
- With respect to cost recovery allowances, the government confirmed the Notice’s use of broader language, specifically amortization available under Section 167, and the intent to include property subject to Section 197 as such property is within the Section 167 umbrella.
- The government indicated their authority for requiring taxpayers to include depreciation on property acquired before the effective date stemmed from two cases, San Jose Wellness and Idaho Power, which they interpreted as suggesting depreciation is the amount paid or incurred in that taxable year.
Scope of 174 – Cost Allocations
- The government indicated that flexibility was provided with respect to appropriate allocation methods to determine the amount of SRE expenditures because there is no one-size-fits-all rule with the variety of industries and fact patterns implicated by the provision.
- In response to concerns that Exam activity might be heightened in this area, the government stated they are open to comments recommending safe harbors and/or simplifying methods to reduce controversy in this space.
- The government confirmed a taxpayer’s allocation method for SRE expenditures should arguably be treated as a method of accounting because it involves timing.
- The government confirmed that certain software development concepts, i.e., “upgrades and enhancements,” will have to be fleshed out more, but needed the concept to be introduced first so taxpayers can comment.
- Similarly, the government is open to ideas on safe harbors and/or bright-line tests, although cognizant of the constant evolution of technology and want to avoid having to update the regulations annually for new technological developments.
- The government is still discussing internally the distinction between rights in software (e.g., copyrights) versus the copy, and did not intend to answer that question in this Notice.
- With respect to contract research, the government indicated they developed the “risk and rights” approach to hone in on expenditures that are capital in nature (as opposed to service costs). The government indicated, for example, if a taxpayer has no financial risk but walks away with rights to use or exploit the SRE product, then they have future benefit and must capitalize. An exception would be if the taxpayer’s right to use was contingent, indicating that’s not really a right that warrants capitalization.
- The government also indicated that separately bargained-for rights do not trigger capitalization, for example, if the taxpayer is separately paying a royalty, the right for which you’re paying the royalty shouldn’t trip capitalization. The Notice language was intended to address rights that arise from work under the contract.
- In looking at the “subject to protection” language in the Notice and the idea of non-exclusive rights, the government indicated the analysis hinges on the value of the right, noting this is an area they welcome comments to assist in defining rights and what exceptions may exist for nominally-valued rights.
- With respect to the transactional rules implicated by dispositions, abandonment or retirement of property, the government confirmed that Section 174 was intended to be a timing provision, not a permanent disallowance that strands unamortized SRE amounts.
- In applying the concept to a disposition resulting in gain, the government stated the statute seems to treat SRE as separate from the property, but that creates a tricky situation. Either: SRE expenditures are separate from the property, so theres no basis to recover the property when disposed of; or basis in the resulting property. The government struggled with whether Section 174(d) overrides recovery of basis/gain provisions. In the Notice, they went with no recovery on the gain sale computation, and to treat the amounts as a separate account rather than a component of basis (similar to Section 195).
- In response to what happens if the research effort fails, the government indicated likely in that context the taxpayer would keep amortizing (based on the argument that some underlying research property is abandoned as a result of the failure). Government welcomes comments in this area.
- The government included the anti-abuse provision to focus on the intent of the transaction: if the intent is cost recovery, the provision applies; if there are valid purposes aside from the acceleration, the government is not worried about those transactions.
- Partnership transactions were carved out because of their inherent complexity. The government could not get to a resolution in time to include guidance in the Notice.
- Similarly, the government has considered the character implications of detaching costs from IP, and acknowledging that is a side effect of the approach they’ve taken in the Notice, but haven’t resolved that issue yet.
Section 460 Implications
- With respect to the updates to the Section 460 regulations, i.e., long-term contracts, the government did want to highlight the numerator of the PCM completion factor includes only the amortization incurred, not the entire amount of the expense. The government also noted they did not answer what amounts are in the denominator in this guidance. The government is seeking comments regarding long-term contract issues.