Corporate tax specialists need to take a closer look at what does and doesn’t qualify as research and development expenditures under Section 174 Capitalization
Section 174 Capitalization — one of the most radical components of the Tax Cuts and Jobs Act (TCJA) which was enacted in 2017 — continues to create many questions for corporate tax departments. With Section 174 requiring companies capitalize and amortize corporate Research & Development (R&D) expenditures, the level of complexity related to what information needs to be gathered and how to access that data from the company should be approached.
The complexity and confusion are only compounded by pending legislation. On January 31, HR 7024 was passed by the U.S. House of Representatives, by a vote of 357-70. A portion of this bill includes the repeal of Section 174; however, the likelihood of its passage is slim.
At the base of all businesses is innovation and growth strategies; for most companies, R&D is their bedrock. In the United States, to help spawn innovation as part of the Economic Recovery and Tax Act of 1981, the Research & Experimentation Tax Credit was introduced. Although it was initially supposed to last three years as a specific incentive to encourage companies to invest in R&D, Congress recognized its value in helping businesses create more products and services.
However, it was quickly realized that this tax code made calculations for R&D complicated, especially for small businesses, which led the government to create other iterations of tax codes in order to help clarify the situation. However, not until 2017 and the enactment of Section 174 of the TCJA has there been such a comprehensive change to R&D accounting.
Indeed, before the TCJA’s enactment, businesses deducted the total amount of R&D expenditures as an expense in the taxable year. Beginning in 2022, all costs related to R&D must now be amortized over five years for US-based companies or 15 years for non-US companies.
Critical components of R&D under Section 174
The definition of research and development or experimental expenditures is quite broad, making it a challenge for most businesses to determine how to categorize or re-categorize expenses that might be related to research.
However, in September 2023, the Internal Revenue Service provided more guidance that addressed several issues, including the definition of software and the treatment of research performed under contract. Some of these issues included:
Technological information — Technology or software companies may have a greater challenge than some as they sort through the complexities of understanding that all expenses, in theory, incurred in connection with software development must now be amortized. Many technology and software companies will face significant increases in their taxable income because they are no longer allowed to deduct certain expenses.
Business component — For any research related to a new function of a current business component or one used to improve on an existing function (such as a software update), it must be proved that the update will increase the product or service performance, make it more reliable, and in general increase its quality.
Process of experimentation — The activities must involve a process of experimentation. This means there should be an evaluative process to identify and consider alternatives to achieve a result. This process must be technological in nature and must fundamentally rely on principles of physical or biological sciences, engineering, or computer science.
Elimination of uncertainty — Companies will have to document and report the purpose of the research. It must show that the research must eliminate uncertainty concerning a product’s development or improvement. This includes uncertainty about the appropriate design of a product or process.
Exclusions from Section 174
It is worth noting what situations or conditions are not covered or are explicitly excluded from the definition of R&D for the Section 174 tax benefit. These exclusions include:
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- market research, advertising, and sales promotions;
- research after commercial production of a product has begun;
- quality-control testing;
- research funded by another party (in which the taxpayer does not retain substantial rights); and
- research conducted outside of the United States.
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For businesses, the ability to deduct R&D expenditures under Section 174 can significantly reduce taxable income. Section 174 requires companies to document their R&D activities carefully and ensure that expenditures qualify for the specific deductions. This includes maintaining records that demonstrate how the expenses directly relate to qualified research activities. Not surprisingly, the expansive nature of this kind of work requires that corporate tax departments do their best to leverage technology to ensure proper compliance with the tax code.
Given this, it is not surprising that a few years ago, a group of chief financial officers reported that they weren’t confident that their companies were taking full advantage of all the R&D credits to which the companies were entitled. The reason cited was the difficulty in accessing specific information that would help support proper claims of Section 174 qualification.
