Requirement for R&D cost capitalization is approaching fast

| 5/13/2021
Requirement for R&D cost capitalization is approaching fast

The Tax Cuts and Jobs Act of 2017 (TCJA) reduced taxes for businesses, including a reduction in corporate tax rates from a top rate of 35% to a flat rate of 21%. The legislation included certain pay-for provisions to offset the cost of the overall package. One of the most surprising pay-for provisions in the TCJA is the elimination of immediate expensing of research and development (R&D) costs. 

The TCJA requires capitalization of all R&D costs, including software development costs incurred in tax years beginning after Dec. 31, 2021. Capitalized R&D costs will be deductible over five years if the R&D activities are performed in the U.S. or 15 years if the activities are performed outside of the U.S. This rule is a major change in tax policy as since 1954 taxpayers have been able to choose to deduct R&D costs as incurred. The new rule also is a departure from GAAP, which normally requires immediate expensing of R&D expenditures under Accounting Standard Codification 730, “Research and Development.”

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Congress could repeal the R&D cost capitalization requirement

U.S. tax policy historically has permitted immediate expensing of R&D costs to encourage businesses to carry on R&D activities. Most TCJA provisions were effective in 2018. Although ostensibly a mechanism to offset the cost of the TCJA and to stay within the $1.5 trillion budget limit, the 2022 effective date for R&D capitalization gives the government time to weigh the effect of the capitalization provision and contemplate whether to reinstate immediate expensing of R&D costs.

On Feb. 24, 2021, H.R. 1304, the American Innovation and R&D Competitiveness Act of 2021, was introduced in the House with bipartisan support. The proposed legislation would permit immediate expensing of R&D costs, but to date the proposed legislation has not been brought to a vote before the House. The Biden administration has voiced support for tax policies designed to encourage investments in R&D. Although elimination of the five-year R&D amortization requirements has broad appeal, the current political landscape in Washington and competing legislative priorities make uncertain whether action will be taken to reinstate immediate expensing of R&D costs before the capitalization requirements take effect in 2022. 

Hope for the best, prepare for the worst

Because immediate expensing of R&D costs has been permissible for nearly 70 years, many businesses have not given much thought to specifically identifying and distinguishing R&D costs from otherwise deductible production-related or general and administrative expenses. To prepare for the possible change in 2022, businesses should consider evaluating their accounting policies and functions to ensure suitable processes are in place to properly identify and track R&D expenditures, defined under IRC Section 174 and related guidance. 

Following are other issues to consider in preparation for the TCJA change to expensing R&D costs:

  • Cash flow impact. Businesses should plan for how the change will affect estimated tax payments needed to cover additional federal and state tax liabilities due to the deferred R&D deductions.
  • Tax provision impact. Unless repealed, the TCJA provision creates a disparity between the timing of deductions for R&D costs for GAAP and the timing of deductions for income tax accounting purposes. Therefore, businesses should plan for how they will account for deferred tax assets attributable to capitalized R&D costs.
  • Foreign tax issues/199A deduction. The allocation of R&D costs under U.S. Department of the Treasury Regulation Section 1.861-17 affects foreign tax credit usage, the foreign-derived intangible income deduction, the determination of effectively connected income, and the Section 199A qualified business income deduction. Businesses should consider the impact that the deferral of deductions for R&D costs will have on these items.
  • Tax accounting method changes. Taxpayers historically have been required to file an automatic accounting method change to change from expensing to capitalizing R&D costs. This method change has been on a cutoff basis without requiring an IRC Section 481(a) adjustment, meaning changes are applied on a prospective basis. At this time, it is unclear how the IRS will implement the TCJA change to IRC Section 174. While the IRS could require a method change similar to the current automatic change, this is not the only way that the law could be implemented. Therefore, taxpayers should be working with their tax advisers to model the effect of various options for implementation. 
  • Loss on abandoned projects. Historically, taxpayers choosing to capitalize R&D projects were permitted to write off the remaining basis when they disposed of or abandoned the projects. Under the TCJA, taxpayers are required to continue to amortize these R&D projects over their remaining useful life. This rule seems contrary to other provisions in the code relating to abandonment costs, such as IRC Section 165. It is unclear whether this treatment will change if the TCJA R&D expensing rule goes into effect. 
  • R&D credits. Federal and state R&D credits are available to taxpayers meeting the qualification criteria outlined in IRC Section 41. The credit qualification criteria specify that qualified R&D expenses must meet the definition of research and experimental expenditures under IRC Section 174. Consequently, businesses should consider how capitalizing qualified research expenses will affect the R&D credit. On the bright side, a more thorough analysis of R&D expenditures might result in opportunities for additional R&D credit benefits.

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