Democratic leadership announced today that an agreement has been reached to fund the pending infrastructure and budget reconciliation measures. There does not appear to be any agreement regarding which specific tax measures that will be included, however, it is hoped that continued deductibility of research and experimental (R&E) expenditures will be included.
Treatment of R&E expenditures under Section 174
Section 174 permits taxpayers to currently deduct, or elect to amortize, R&E costs paid or incurred in tax years beginning before January 1, 2022. Eligible R&E expenses for purposes of Section 174 include those paid or incurred for research conducted by the taxpayer as well as research performed by certain third parties on the taxpayer’s behalf. A looming change to Section 174, brought about by the Tax Cuts and Jobs Act of 2017 (TCJA), subjects R&E costs to mandatory capitalization and amortization over five years (15 years for foreign research) for tax years beginning after December 31, 2021.
Legislative consideration to extend the deductibility of R&E expenditures
In accordance with the Biden Administration’s Green Book, released on May 28, 2021, which stated an intent to “encourage R&E,” various policies could be implemented to achieve this goal. Democrats on the Ways & Means Committee initially adopted an approach put forward by Rep. John Larson (D-Conn.) in February 2021 as part of a bipartisan effort to retain the deductibility of R&E costs. In a letter to the House, Rep. Larson urged the House to temporarily extend immediate deductibility of R&E costs under Section 174, explaining that, “a four-year deferral of the requirement [to capitalize and amortize R&E costs] would incur a relatively minor revenue cost within the 10-year budget period as most of the expenses would have been amortized within the period under present law.” Rather than extending pre-TCJA law and permanently allowing a current-year deduction in full for R&E expenses, the Ways & Means Committee proposed the four-year extension for the immediate expensing of such costs advocated for by Rep. Larson. The four-year extension amounts to a compromise that is likely attributable to the directive in budget reconciliation rules to evaluate an item of cost to the federal government within the prospective ten-year budget window. The cost of a permanent extension was estimated to be approximately $124 billion, while the four-year extension is less expensive. Specifically, the Joint Committee on Taxation estimates that the Ways & Means Committee’s proposed approach would cost the federal government $125.2 billion over the next four years, but only $4 billion over the entirety of the ten-year budget window.
The tax policy underlying a taxpayer’s ability to expense R&E costs in full for the current tax year is that it would incentivize investments in technology and innovation and spur the economy by promoting job creation. Studies support the conclusion that deductible R&E costs result in increased investment in research, leading to trademarks, copyrights, patents, and industry innovations. US R&E activities have led directly to, among other things, the development of jet airplanes, satellites, semiconductors, the internet, MRIs and breakthrough drugs to treat cancer, heart disease and other illnesses. According to the Tax Foundation, deduction treatment for R&E costs would boost long-term GDP by 0.1%, the capital stock by 0.2%, wages by 0.1%, and would lead to approximately 19,500 additional full-time equivalent jobs. Rep. Larson cited to a recent Ernst & Young economic study supporting the proposition that a four-year delay of the requirement to capitalize and amortize R&E costs would promote job growth. The study specifically found that a four-year extension would result in an additional $50 billion in R&E investment and support, on average, 167,000 jobs annually. In light of the economic impact the COVID-19 pandemic has had on US employment numbers, this favorable impact to job growth could not be timelier. In addition, according to Rep. Larson, the temporary nature of the proposed extension should affect taxpayer behavior and cause an acceleration of R&E costs to within the four-year period.
Maintaining the historic deduction for R&E expenditures
Requiring the capitalization and amortization of R&E costs, rather than permitting immediate deduction for the current year, also runs counter to the historical tax treatment of such expenses from both a domestic and international perspective. R&E expenses have been currently deductible since 1954, intended to eliminate uncertainty with respect to the tax treatment of R&E expenses and encourage taxpayers to engage in research activities. Mandatory capitalization and amortization of R&E expenses would mark the first time that R&E expenses have not been subject to immediate deduction in nearly 70 years. Perhaps more significant is the trend among OECD countries to permit the immediate expensing of such expenditures or more generous treatment in the form of “super-deductions” worth more than 100% of the value of the research and development investment.
Legislative considerations to treat domestic and foreign R&E expense differently
In order for the US to remain competitive in the global R&E environment, immediate expensing of R&E costs, or a close corollary of such, is a necessity. Interestingly, and as a result of the changes made by the TCJA, there appears to be a divergence in the benefit afforded to companies incurring R&E expenses, with more favorable treatment provided to companies incurring R&E expenses within the United States. Under the TCJA, while domestic R&E expenses must be capitalized and amortized over five years for tax years beginning after December 31, 2021, R&E expenses incurred abroad must be amortized over fifteen years. As the legislative proposals work their way through the Senate, it will be interesting to monitor how this divergence of treatment plays out, particularly with so many references to building back our domestic infrastructure. Depending on the underlying cost, there are a number of alternatives to consider, including delaying the TCJA’s changes specifically for domestic R&E expenditures, thereby reinforcing the Administration’s initiative to “build back better.”
Accounting method considerations implicated by the looming change to Section 174
The looming change to Section 174 also has implications with respect to a taxpayer’s accounting method. For amounts paid or incurred in tax years beginning after Dec. 31, 2021, any amount paid or incurred in connection with the development of any software will be treated as an R&E expenditure for purposes of Section 174. Under Rev. Proc. 2000-50, software development costs may either be (i) treated as expenses and deducted in the year paid/incurred, or (ii) amortized and deducted ratably over a period of at least 60 months from the date of completion of development or over 36 months from the date the software is placed into service. The TCJA provides that a change to a five-year period for amortization purposes constitutes a change of accounting method. If the TCJA provisions go into effect, the changes to Section 174 will be treated as a change in method of accounting for purposes that is initiated by the taxpayer with the IRS’ consent. This change in method could impact taxpayers in the Exam context, and it is unclear what approach the Service will take to handling this issue.
From this point, the proposed legislation is being evaluated by the Senate where members of the Senate Finance Committee previously released draft legislation that repurposed the FDII deduction with the apparent intent of bolstering R&E activity. While the Senate may press forward with its initial proposal, negotiation and ultimate enactment will likely hinge on minimizing the overall cost of the package. From a cost perspective, the Ways & Means Committee’s approach would seem favorable. Taxpayers should be aware of the uncertainty surrounding Section 174 and monitor what is sure to be an interesting negotiation process. However, under the Ways & Means Committee’s recent proposal, R&E expenses would remain immediately deductible in full for the current taxable year.