The Tax Cuts and Jobs Act (TCJA) included a sunset provision for immediate expensing of research and experimentation (R&E) expenditures, generally providing that such expenses would be subject to five-year (domestic R&E) or fifteen-year (foreign R&E) amortization for taxable years beginning after December 31, 2021. Despite repeated attempts to repeal or delay the provision, we are now well into the new framework’s effective period. This alert summarizes recent developments regarding the treatment of R&E expenditures and provides insight into lingering taxpayer questions and what guidance may be on the horizon.
Out with the old, in with the new
The TCJA amended section 174 for amounts paid or incurred in taxable years beginning after December 31, 2021. Under former section 174, taxpayers generally had the option to deduct reasonable R&E expenditures in the taxable year in which they were paid or incurred in connection with a trade or business or to amortize R&E expenditures ratably over no less than five years. As a result, taxpayers had the option to either claim tax deductions currently, or defer them to a later tax year depending on the taxpayer’s specific tax posture. Taxpayers also had the option to elect ten-year amortization for certain R&E expenditures under sections 174(f)(2) and 59(e).
The TCJA eliminated the option to take a current deduction for R&E expenditures. Under new section 174, specified R&E expenditures are required to be charged to capital account and amortized over five years (or fifteen years for foreign research), following a half-year convention. Foreign research for purposes of section 174 includes any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States. Specified R&E expenditures include R&E expenditures paid or incurred by the taxpayer in the taxable year in connection with its trade or business, and the revised statute explicitly treats software development expenses as an R&E expenditure. Under new section 174, taxpayers may not accelerate the recovery of R&E expenditures upon the disposition, retirement, or abandonment of property with respect to which the R&E expenditures were incurred. Rather, amortization of the R&E expenditures continues for the entire five- or fifteen-year period, as applicable.
Procedural guidance under new Section 174
On December 12, 2022, the IRS and Treasury issued Rev. Proc. 2023-8, providing procedural guidance under which taxpayers could implement the TCJA’s required amortization for R&E expenditures and software development costs previously subject to Rev. Proc. 2000-50.
Under Rev. Proc. 2023-8, taxpayers may receive automatic consent to change their methods of accounting for R&E expenditures to comply with the required amortization provision. Further, the guidance provides streamlined procedures whereby taxpayers may attach a statement to their return in lieu of filing a Form 3115 for their first taxable year beginning after December 31, 2021. Changes made for the first taxable year beginning after December 31, 2021, are made on a cut-off basis, and changes for later years are made with a modified section 481(a) adjustment, taking into account only those R&E expenditures paid or incurred in taxable years beginning after December 31, 2021. The procedural guidance waives the five-year eligibility rule only for changes made in the first taxable year beginning after December 31, 2021.
The government has not yet released any substantive guidance under new section 174.
Effort to roll back TCJA R&E amortization
Congress has made persistent attempts to delay or repeal required amortization of R&E expenditures prior to the provision becoming effective. The House-passed version of the Build Back Better Act included a provision that would have delayed implementation of required R&E amortization to 2026. Similarly, an early version of the CHIPS and Science Act included a provision repealing required R&E amortization. According to the Tax Foundation, rolling back the TCJA amendments to section 174 would result in a 15 percent larger economy, a 26 percent larger capital stock value, 12 percent higher wages in the United States, and 30,600 full-time equivalent jobs.1 While these efforts to delay or repeal the amortization provision have had broad bipartisan support, none have been successful.
Although we are now in the effective period of new section 174, the efforts to delay or repeal required R&E amortization continue. In March, Senators Maggie Hassan and Todd Yong re-introduced a bipartisan bill to roll back the amortization provision and to expand eligibility for the research credit under section 41. In April, Representatives Ron Estes and John Larson reintroduced, along with nearly 60 cosponsors, a bipartisan bill that would repeal the TCJA amendments to section 174 and allow businesses to deduct R&E expenditures in the year in which they are incurred. Senators Estes and Larson have been introducing similar bills since September of 2019. Most recently, on June 9, Republicans on the House Ways and Means Committee introduced the Build It in America Act2 as part of a larger tax package sent to the House floor. The Build It in America Act includes a provision that would retroactively restore research and development expensing through 2025, along with other expired tax incentives.
Rev. Rul. 2023-8
In Rev. Rul. 2023-8, released April 12, the IRS obsoleted Rev. Rul. 58-74. The ruling suggested an incorrect application of section 174 could be corrected with an amended return rather than an accounting method change requiring a Form 3115. By revoking Rev. Rul. 58-74, the IRS has made clear its view that an amended return may not be used to correct missed R&E expenditures. The IRS indicated that it was eliminating the ruling because it did not provide enough factual support for distinguishing an error from a method change. The elimination of Rev. Rul. 58-74 is effective July 31, 2023, which means that taxpayers may continue to use amended returns to correct erroneous treatment for R&E expenditures. The delayed effective date appears to have been chosen to provide notice to taxpayers relying on Rev. Rul. 58-74 with respect to amended returns that were in process when the older revenue procedure was obsoleted.
Forthcoming Section 174 guidance
Treasury and the IRS are actively working on substantive guidance under new section 174, which they hope to release as an Advance Notice of Proposed Rulemaking. The much-anticipated guidance is expected to include definitions, particularly concerning the scope of computer software costs that fall under section 174, rules governing the allocation of costs between domestic and foreign R&E expenditures, and examples demonstrating application of the new guidance.
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1 Tax Foundation, Amortizing Research and Development Expenses Under the Tax Cuts and Jobs Act, February 5, 2019.
2 H.R.3938, 118th Cong. (2023), https://www.congress.gov/bill/118th-congress/house-bill/3938.
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