September 19, 2023

The Internal Revenue Service (IRS) and the Treasury Department have indicated their intent to propose regulations regarding the amortization of research and development (R&D) costs. The amortization of R&D costs was enacted in the Tax Cuts and Jobs Act (TCJA) in 2017 as a delayed revenue raiser to take effect in tax years starting after January 1, 2022.  Beginning in 2022, the TCJA  mandates companies to treat their R&D and software development costs as Section 174 expenses that must be amortized over a five-year period instead of fully deducting them in the year they are incurred.  This new amortization requirement has led to some taxpayer uncertainty and a need for additional IRS guidance.  

This proposal was announced in Notice 2023-63, where the agencies also provided interim guidance that offers more clarity on the new amortization requirements, including how to treat short tax years, cost deduction by providers of contracted research, treatment of software development costs, abandoned property, and more. The proposed regulations and interim guidance aim to clarify which costs can be amortized under the TCJA provision and which ones cannot.

• Amortizing R&D Expenses in Short Taxable Years: Beginning with tax returns for 2022, the new Section 174 amortization rules require businesses that invest in R&D to spread domestic R&D expenses over five years (fifteen years for R&D conducted abroad). For any business that has a short tax year, the Notice provides guidance on the amount of the R&D costs that can be amortized in the initial short tax year and in subsequent years.
• Contracted R&D Costs: Some of the big questions raised by the Section 174 amortization rules dealt with situations in which a business contracts with another party to do R&D on their behalf. It was unclear to many taxpayers whether the research provider, the research recipient, or both parties would need to capitalize the costs of contracted research. The interim guidance provided by the Notice gives some clarity to contracted research providers and research recipients on how the retention of rights to sell or use the research or the financial risk in the performance of the research determines which party needs to capitalize the research expenses.
• Software Development Costs: The Notice provides guidance on which software development costs should be treated as specialized research and experimentation (SRE) costs, subject to Section 174's capitalization and amortization rules. It also clarifies which types of costs ancillary to software development can be deducted in the year they were paid or incurred, instead of having to be amortized and spread out over several years.
• Percentage-of-Completion Method: For taxpayers with long-term contracts who recognize income under the "percentage-of-completion method” (PCM), the new Section 174 capitalization requirements for R&D and software development led to taxpayer questions around the timing of income recognition as PCM income was generally recognized as allocable costs were deducted. This created uncertainty as to the timing of income recognition as most R&D and software development costs can no longer be deducted, and instead must be amortized. To address this issue, the Notice announced proposed regulations to have businesses to use the amortized amount of their R&D and software development expenses when calculating their income under the PCM.

The Notice also raised several issues that were not addressed, such as whether the new rules related to Section 174’s required amortization should apply to start-up companies or small firms.  Adjustments to cost sharing arrangements will also be part of new proposed regulations. Interested parties have been invited to file comments with the IRS and Treasury by November 24.

Furthermore, the IRS released guidance earlier this year in Revenue Procedure 2023-11 for how to report the changed treatment of R&E expenses for 2022 tax returns. This provides a way for taxpayers to obtain automatic consent to change the method of accounting for specified research or experimental expenditures under Section 174, as amended by the TCJA, via an attached statement rather than completing Form 3115.

While proposals in Congress seek to eliminate the amortization requirements for R&D and software development, these have yet to succeed. As we continue to monitor legislative developments, it's crucial for businesses to plan ahead and adjust their tax strategies accordingly. The IRS Notice 2023-63 offers an insight into the direction of these proposed regulations, and it is essential for businesses to familiarize themselves with these changes. Despite the contention, the new guidance provided by the Notice presents an opportunity for businesses to reshape their R&D strategies and potentially maximize their benefits under the tax law as it currently exists.