What changed and what stayed the same
Notable changes to the 2017 directive made by the 2020 directive include:
- Approval requirement to find the taxpayer ineligible for the directive. The 2020 directive prescribes the documentation taxpayers must retain and timely submit to the IRS to support QREs. If the IRS examination team is not satisfied with the documentation provided, it can request additional information with territory manager approval. In addition, with territory manager approval, the IRS may find that a taxpayer is ineligible under the directive if it fails to provide underlying books and records or satisfactory documentation to substantiate its ASC 730 financial statement R&D amount.
- Identification of internal use software development costs and excluded activities. Under U.S. GAAP, costs to develop software that is not sold, leased, or otherwise marketed generally are accounted for under ASC 350, “Intangibles – Goodwill and Other,” and are not includable in ASC 730 R&D amounts. Moreover, ASC 730-10-55-2 details activities that generally are not considered R&D for U.S. GAAP purposes. Due to the IRS concern that taxpayers have been including these non-ASC 730 costs in adjusted ASC 730 financial statement R&D amounts, these activities and costs now are required to be specifically identified and quantified to document that they are not included in adjusted ASC 730 financial statement R&D amounts. Although these types of costs are not includable in adjusted ASC 730 financial statement R&D, taxpayers still may consider positions for claiming these costs as QREs in excess of adjusted ASC 730 financial statement R&D.
- Heightened documentation requirements. Taxpayers must maintain a written narrative of the methodology and calculations for determining excludable internal use software and ASC 730-10-55-2 amounts. If no amounts are identified, the taxpayer must provide an explanation of the methodology used to verify that none of these expenses are present in the U.S. financial statement R&D amount. The explanation must include sufficient information to show that the taxpayer made a reasonable effort to quantify non-ASC 730 financial statement R&D.
- Substantiation of internal controls. Taxpayers must provide substantiation of their internal control over financial reporting designed to mitigate material misstatement of the taxpayer’s expenses reported per financial statements. Substantiation may be provided during the examination by a presentation or in writing.
The 2020 directive continues to permit taxpayers to include in QREs the eligible wages, costs of supplies, and computer rental or lease costs reflected in their adjusted ASC 730 financial statement R&D amounts. This includes 95% of W-2 wages for employees defined as qualified individual contributors and first-level supervisor managers. Other aspects of the 2017 directive retained by the 2020 directive include:
- The option to include in QREs the upper-level managers’ W-2 wages reflected in adjusted ASC 730 financial statement R&D amounts, subject to certain limits
- The definitions of qualified individual contributors, first-level supervisor managers, upper-level managers, and the upper-level manager limit
- The option to claim as QREs upper-level manager wages outside of the adjusted ASC 730 financial statement R&D amount
In addition, taxpayers still are permitted to claim contractor costs and other IRC Section 41-eligible expenses not accounted for under ASC 730 as QREs determined in excess of their adjusted ASC 730 financial statement R&D amount. QREs claimed in excess of adjusted ASC 730 financial statement R&D amounts are subject to risk assessment by examining agents to determine the scope of an examination, if warranted.
Finally, the 2020 directive retains the requirement that an individual who can sign the taxpayer’s return must certify under penalties of perjury the accuracy of the information regarding financial reporting for R&D amounts and the R&D credit.
Planning ahead
The 2020 directive is effective for original timely filed returns for tax periods ending on or after July 31, 2020. The 2017 directive remains in effect for tax periods ending prior to July 31, 2020. The new streamlined process could be a positive step toward reducing the cost and burden of R&D examinations. However, eligible taxpayers will need to meet the enhanced documentation requirements and be ready to produce any required records during the examination. Advance preparation and enhanced scrutiny of financial accounting for R&D expenses is key to meeting the new directive requirements and reducing the cost and burden of R&D examinations. Taxpayers should contact their tax adviser to determine whether they are eligible to take advantage of these new procedures.
