Not unlike the last minute procedural guidance released at the end of last year addressing Section 174, on December 22, 2023, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released Notice 2024-12 (Notice) and Rev. Proc. 2024-9 providing taxpayers with timely information concerning accounting method changes and the treatment of specified research and experimental (SRE) expenditures under Section 174.
Most notably, Notice 2024-12 substantively clarifies the scope of contract research costs subject to Section 174, while Rev. Proc. 2024-9 offers taxpayers an automatic accounting method change to comply with interim guidance offered in Notice 2023-63.Not only do the clarifications in Notice 2024-12 afford welcome relief to taxpayers regarding language initially included in Notice 2023-63, but more importantly, Rev. Proc. 2024-9 may alleviate the need for certain taxpayers to file non-automatic accounting method changes by year-end as the revenue procedure makes available an automatic accounting method change so that taxpayers may comply with the guidance set forth in Notice 2023-63.
This Alert summarizes the clarifying guidance offered in the Notice, while also highlighting the significant accounting method change provisions in Rev. Proc. 2024-9 and the related terms and conditions that taxpayers should be carefully evaluated as taxpayers consider how to implement these new rules in upcoming Federal income tax filings.
Background and Overview
Prior to the Tax Cuts and Jobs Act (TCJA), Section 174 offered varied treatment for otherwise capitalizable research or experimental (R&E) expenditures with an uncertain useful life. Former Section 174 offered taxpayers a choice between an election to immediately deduct R&E expenditures, to capitalize and amortize R&E expenditures over a period of not less than five years, or to charge R&E expenditures to a capital account. R&E expenditures under former Section 174 are defined in Treas. Reg. §1.174-2.
While the regulations under former Section 174 addressed costs paid by a taxpayer for research or experimentation carried on by a third party on behalf of the taxpayer, these regulations did not address the treatment of expenditures paid by a contractor for research or experimentation carried on for another person or organization (contract research). Software development costs were permitted similar, albeit slightly different, treatment from that afforded R&E expenditures under Section 174.Specifically, Rev. Proc. 2000-50 allowed taxpayers to treat software development costs as currently deductible expenses or as capital expenditures amortizable over a period of either 60 months or 36 months. However, Rev. Proc. 2000-50 did not specifically define which activities constitute software development or further describe software development activities.
The TCJA amended Section 174 to require taxpayers to charge SRE expenditures to a capital account and amortize such expenses over the applicable amortization period. Further, the TCJA amended the scope of Section 174 to include software development costs. These amendments, among others, apply to amounts paid or incurred in connection with a taxpayer’s trade or business in any taxable year beginning after December 31, 2021.
To provide taxpayers with procedural guidance to implement these statutory changes to Section 174, the IRS issued Rev. Procs. 2023-8 and 2023-11 in late December 2022 to stipulate procedural guidance for complying with Section 174. This guidance was subsequently incorporated into Section 7.02 of Rev. Proc. 2023-24, the list of automatic accounting method changes. Notwithstanding the issuance of this procedural guidance, many substantive questions remained outstanding regarding the application of Section 174.Notice 2023-63 was released on September 8, 2023 and offers guidance regarding various substantive issues, including: (i) the obsolescence of Section 5 of Rev. Proc. 2000-50; (ii) the scope of SRE activities and costs that are considered incident to SRE expenditures; (iii) appropriate methodologies to allocate costs to SRE activities; (iv) the definition of “computer software” and software development activities; (v) the treatment of costs paid or incurred by research providers in contract research arrangements; as well as, (vi) contemplated revisions to regulations under Section 460 addressing long-term contracts and the cost sharing regulations under Treas. Reg. §1.482-7 to reflect the change in treatment of SRE expenditures under Section 174 from immediately deductible expenses to being charged to a capital account and amortized.
Although Notice 2023-63 is expansive, it failed to provide taxpayers with procedural guidance regarding substantive determinations provided therein, leaving many taxpayers questioning whether the interim procedural guidance allowed an automatic accounting method change timely filed with upcoming Federal income tax returns, or whether a non-automatic accounting method change filed by the end of the 2023 year was required. Because the availability and timing of such accounting method changes also affect provision determinations, additional guidance was warranted.
The guidance package released last week, Notice 2023-12 and Rev. Proc. 2024-9, answer many of these questions. Notice 2024-12 offers more complete guidance regarding the scope of the contract research rules set forth in Notice 2023-63, it clarifies the reliance on the earlier notice during the pendency of proposed regulations, and it addresses the status of Rev. Proc. 2000-50. Rev. Proc. 2024-9
Notice 2024-12
Notice 2023-63 offers valuable insight regarding issues that the government plans to address in proposed substantive regulations under Section 174.Importantly, the Notice address the treatment of SRE expenditures incurred in contract research arrangements. Section 6.04 of Notice 2023-63 establishes that if a research provider bears financial risk under the terms of a contract with a research recipient, then costs paid or incurred by the research provider that are incident to the SRE activities performed by the research provider under the contract are SRE expenditures. Section 6.04 further provides that even if the research provider does not bear financial risk under the terms of the contract with the research recipient, if the research provider has an “SRE product right” (that is, a right to use any resulting SRE product in a trade or business of the research provider or otherwise exploit any resulting SRE product through sale, lease, or license), then costs paid or incurred by the research provider that are incident to the SRE activities performed by the research provider under the contract are SRE expenditures of the research provider for which no deduction is allowed except as provided in Section 174(a)(2).
Taxpayers expressed concern that Section 6.04 could be interpreted to require a research provider, which does not bear financial risk under the terms of the contract with the research recipient, to improperly treat as SRE expenditures the costs paid or incurred by the research provider to perform SRE activities on behalf of the research recipient under such contract if the research provider obtains an SRE product right that (1) is separately bargained for (i.e., an SRE product right that arose from consideration other than the cost paid or incurred by the research provider to perform SRE activities under that contract) or (2) was acquired for the limited purpose of performing SRE activities under that contract or another contract with the research recipient (“excluded SRE product right”).
To address this potential misinterpretation, the Notice clarifies that if a research provider that does not bear financial risk under the terms of the contract with the research recipient obtains an “excluded SRE product right” but does not obtain any other SRE product right under the terms of such contract, then the costs paid or incurred by the research provider to perform SRE activities on behalf of the research recipient under such contract are not SRE expenditures. Taxpayers will appreciate the clarification in Notice 2024-12 that the scope of contract research subject to Section 174 is narrower that the earlier notice may have indicated.
In addition to limiting the scope of the contract research rules, the Notice also confirms that taxpayers seeking to rely on any of the rules described in the substantive sections of Notice 2023-63 (i.e., Sections 3 through 9 of the notice) may do so irrespective of whether they rely on all the rules described in those sections. Due to the timing of the release of Notice 2023-63 in September 2023, Treasury and the IRS has learned of situations in which taxpayers that intended to consistently rely on all the rules described in Sections 3 through 9 of Notice 2023-63 for expenditures paid or incurred in taxable years beginning after December 31, 2021, may be required to amend a tax return that was filed before or shortly after Notice 2023-63 was issued in order to do so because such taxpayer may not be able to change, through a change in method of accounting, certain positions taken on returns that were inconsistent with certain sections of Notice 2023-63.Accordingly, in order to afford administratively ease, Notice 2024-12 removed the requirement that a taxpayer must rely on all the rules described in Sections 3 through 9 of Notice 2023-63 if it chooses to rely on any of such rules.
Lastly, the Notice offers some guidance regarding software development costs. These costs were addressed in Rev. Proc. 2000-50 and part of the revenue procedure was obsoleted subsequent to the TCJA amendments to Section 174 and with the issuance of Notice 2023-63. As a result, questions had arisen regarding the effective date of the obsolescence. The Notice clarifies that Section 5 of Rev. Proc. 2000-50 was obsoleted, but only for expenditures paid or incurred in taxable years beginning after December 31, 2021, and not for expenditures paid or incurred for taxable years beginning on or before December 31, 2021. Consequently, the revenue procedure remains controlling for amounts incurred in periods prior to the effective date of the TCJA amendments to Section 174.
Rev. Proc. 2024-9
In addition to the substantive guidance set forth by Treasury and the IRS in the Notice, Rev. Proc. 2024-9 permits an automatic accounting method change filing for expenditures paid or incurred after December 31, 2021, relying on the guidance announced in Notice 2023-63.Importantly, Rev. Proc. 2024-9 allows not only an automatic accounting method change for taxpayers seeking to change their method of accounting from capitalizing SRE expenditures to inventoriable property or depreciable property and recovering such expenditures through cost of goods sold or depreciation, respectively, to capitalizing and amortizing such expenditures under Section 174, but also from treating an expenditure that does not meet the definition of an SRE expenditure as an SRE expenditure subject to capitalization and amortization under Section 174 to otherwise treating that expenditure under the appropriate provision of the Code.
Importantly, any automatic accounting method change filed for the 2022 tax year under Rev. Proc. 2024-9 continues to be filed on an expedited basis, including a change to rely on the interim guidance from Notice 2023-63.Such accounting method changes are made with a Section 481(a) adjustment determined on a cut-off basis and without the requirement to file a Form 3115.However, Rev. Proc. 2024-9 specifies that for tax years filed later than the first tax year beginning after December 31, 2021, such an accounting method change is made by filing a Form 3115 with a modified Section 481(a) adjustment that takes into account only SRE expenditures incurred in 2022 and beyond, unless such change results in a negative Section 481(a) adjustment, in which the taxpayer may make the change on a cut-off basis. Thus, although taxpayers may not take into account a Section 481(a) adjustment for amounts paid or incurred prior to the effective date of the TCJA under the automatic change provisions, a Section 481(a) adjustment is available for amounts paid or incurred in tax years beginning after December 31, 2021.
Beyond the particularities of the implications of Section 481(a), Rev. Proc. 2024-9 further provides that the five-year limitation under Section 5.01(1)(f) of Rev. Proc. 2015-13 is waived for the taxpayer’s first or second taxable year beginning after December 31, 2021; thus, eliminating the restriction that prevents a subsequent accounting when a previous accounting method change has been filed for the same item within the past five years. Consequently, taxpayers are permitted to file an accounting method change to comply with the interim guidance provided in Notice 2023-63 for the second tax year beginning after December 31, 2021, even if a previous accounting method change was filed for the first tax year beginning after December 31, 2021.Because many taxpayers filed an accounting method change to comply with the TCJA’s changes to Section 174, waiver of the five-year rule is appreciated.
Lastly, although audit protection is generally made available whenever an accounting method change is filed such that the IRS cannot challenge the treatment of the item changed during an earlier tax year during the course of an IRS Examination, Rev. Proc. 2024-9 limits audit protection for accounting method changes to conform with the interim guidance offered in Notice 2023-63 regarding the treatment of SRE expenditures. Specifically, the revenue procedure specifies that a taxpayer does not receive audit protection with respect to expenditures paid or incurred in taxable years beginning on or before December 31, 2021.Further, a taxpayer does not receive audit protection for a change in the second taxable year beginning after December 31, 2021, with respect to expenditures paid or incurred in the first taxable year beginning after December 31, 2021, if the taxpayer did not make, or attempt to make, a change for the first taxable year beginning after December 31, 2021. This limitation leaves open to challenge the treatment of such amounts in future IRS Examinations.
______________
[View source.]
