Fernway DiarySM

Dec 15, 2022

The 2017 Tax Cuts and Jobs Act (TCJA) made many significant changes to business taxes, but not all its provisions took effect immediately. One of the tax changes among those scheduled to phase in from 2022 to 2026 is the amortization of research or experimental (R&E) expenditures. For tax years beginning after December 31, 2021, businesses must amortize specified R&E expenditures over 5 years for domestic expenditures and 15 years for expenditures attributed to foreign research.

For tax years beginning prior to December 31, 2021, taxpayers had the option of deducting R&E expenditures under Section 174(a); the TCJA eliminated this option. Under a half-year convention, the first-year deduction will be 1/10^th of the amortized amount for domestic expenditures, and 1/30^th of the amortized amount for expenditures attributed to foreign research. As noted in the Journal of Accountancy, this change will produce a ripple effect in reporting and other taxpayer activities due to the change in taxable income.

For instance, because 90{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} of current R&E expenditures will not be currently deductible in the first year of the rule change under a half-year convention, taxable income for that year will increase. This will potentially require higher quarterly estimated tax payments; if the rule change was not accounted for previously, remaining payments for the year may need to be adjusted. In addition, state tax liability may also increase, as most states conform to the new federal rule. Calculations of other deductions such as the Section 163(j) business interest deduction, charitable contribution deduction, NOL carryforwards and tax credits, and Section 250 foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) may also be affected by the rule change. Businesses are advised to seek the advice of a qualified tax professional to determine the effect on their tax liability.

Other Changes to Section 174 in the TCJA

Under the TCJA, software development costs are now explicitly considered R&E expenditures, with the addition of a special rule under Section 174(c)(3) stating that “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” Such costs are now also subject to five or fifteen-year amortization and cannot be currently deducted.

Additionally, under the new Section 174(d) adopted under the TCJA, taxpayers cannot deduct capitalized R&E expenditures when a project is abandoned, retired, or disposed of. Instead, the costs must continue to be amortized on schedule until the amortization period is complete. Thus, if a taxpayer abandons a project in development, they are not permitted to deduct remaining R&E costs that have not been amortized yet in the year of abandonment.

Again, companies potentially affected by these provisions should consult a qualified tax professional to ensure accurate compliance.

Prospects of Legislative Relief

There is bipartisan support for delaying or repealing the amortization of R&E expenses, because as the Tax Foundation has pointed out, the new provisions will raise the cost of making research investments in the US and increase the tax burden on businesses with R&E expenditures. However, to date efforts to pass proposals modifying or canceling the scheduled business tax increases in the TCJA have not come to fruition.

The version of the Build Back Better Act passed in the House of Representatives would have delayed the effective date of R&E amortization to amounts paid or incurred in tax years after December 31, 2025; however, the bill that was ultimately passed in August 2022, the Inflation Reduction Act, did not include this provision. Similarly, an early version of the CHIPS and Science Act would have repealed amortization, but the enacted bill left that provision out. It seems unlikely that legislative action will be taken prior to the end of the year; therefore, taxpayers should be prepared to comply with the law as it now stands.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

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The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.