The Tax Cuts and Jobs Act (TCJA) passed in December of 2017 made a significant change to the treatment of specified research and experimental expenditures (SRE) covered by Sec. 174. Effective for tax years beginning after December 31, 2021, Section 13206 of the TCJA requires taxpayers to amortize SRE, including software development costs, over a 5-year period for domestic activities and a 15-year period for foreign activities, using a half-year convention. In September 2023, the IRS released its initial guidance, Notice 2023-63, on the treatment of Section 174 SRE expenditures.
The Notice informs the taxpayers of the IRS’s intent to issue proposed regulations to clarify the application of the new Sec 174, which the IRS expects to be consistent with the interim guidance included in the Notice. The taxpayer can rely on the notice until the proposed regulations are issued. The guidance covers the following topics:
Capitalization and amortization of SRE Expenditure: The notice provides information on what constitutes foreign research and how to determine a midpoint for amortization purposes, including short taxable years.
Scope of Section 174: The Notice provides a lot of guidance on what expenditures would fall into the SRE category for capitalization purposes. It provides definitions, as well as a list of costs that would and would not be considered SRE expenditures. It discusses certain indirect costs that would need to be allocated to SRE expenditures and which indirect costs are not required to be capitalized. It also includes an example of the indirect cost allocation.
Software Development: TCAJ included software development costs in SRE expenditures. The Notice provides guidance on which activities would be treated as software development costs under Sec 174.
Research Performed under Contract: Taxpayers had a lot of questions on the applicability of the new Sec. 174 to research performed under the contract. The IRS has included a lot of guidance on this subject in the Notice. Several definitions have been provided, including Research Provider, Research Recipient, Specified SRE Product, and Financial Risk. The capitalization requirement has been linked to several factors, including whether the SRE product is subject to protection under domestic or foreign law, whether the Research Provider bears financial risk, and whether the Research Provider has a right to use the resulting SRE product.
Disposition, Retirement, or Abandonment of Property: In general, no recovery is allowed with respect to the unamortized SRE expenditures on account of disposition, retirement, or abandonment of related property. The notice discusses the application of this provision to transactions in which the corporation ceases to exist.
Long-Term Contract Under Section 460: The Notice discusses how to recognize revenue in a long-term contract that includes SRE expenditures and uses a percentage-of-completion method.
Cost-Sharing Arrangements: The Notice provides information on proposed changes to Sec. 1.482-7(j)(3)(i), which includes rules for tax treatment of payments in certain cost-sharing arrangements.
Accounting Method Change
The Treasury Department and IRS intend to issue guidance in the Internal Revenue Bulletin to provide procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with this Notice. Until the issuance of such procedural guidance, taxpayers may rely on section 7.02 of Rev. Proc. 2023-24 to change their methods of accounting under § 174 to comply with this notice.
The IRS has requested that taxpayers and tax professionals submit comments on the proposed guidance by November 24, 2023. The proposed regulations are expected to be issued early in 2024.
By Renata Dabrowska, CPA, and Brittany Burke