On Sept. 8, the IRS published Notice 2023-63 providing interim guidance on the capitalization and amortization of SRE expenditures incurred in taxable years beginning after Dec. 31, 2021, under Section 174 as amended by the Tax Cuts and Jobs Act of 2017 (TCJA). This long-awaited guidance outlines some of the provisions that will be included in future proposed regulations. The interim guidance addresses many questions while leaving other anticipated questions unaddressed.
Crowe observation
Until now, the IRS had provided only procedural guidance on how to make changes to the Section 174 accounting method, which is unchanged by the notice but could be revised by subsequent guidance.
The following are key provisions of the interim guidance:
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Midpoint amortization: Under Section 174, taxpayers must capitalize SREs, but they can amortize costs paid or incurred beginning at the midpoint of their taxable year. The notice clarifies the definition of midpoint to provide that for full, 12-month taxable years, amortization begins on first day of the seventh month of the taxable year, and for short taxable years, amortization begins on the first day of the midpoint month. If a short taxable year encompasses a fraction of a month, the entire month counts in the calculation, avoiding double counting of the same month.
- Identification and allocation of costs: Examples of costs that are SRE expenditures are provided, including costs considered incident to research and experimental activities, as well as a nonexhaustive list of costs not treated as SRE expenditures.
- Software development: Software development is broadly defined in the notice and includes upgrades and enhancements (such as modifications to existing software that add functionality or improve its speed and efficiency). Activities considered as software development for Section 174 purposes include planning, designing, modeling, coding, and testing.
- Research performed under contract: The notice provides that the existing rules for the treatment of costs paid or incurred for research performed under contract are unchanged. However, the notice clarifies that costs incurred by the research provider (the party contracting to perform research services or develop an SRE product) are SRE expenditures if the provider assumes financial risk within the contract or possesses the right to use or exploit the resulting SRE product within its trade or business, including through methods such as sale, lease, or licensing.
- Disposition, retirement, or abandonment of property: Section 174(d) prohibits a deduction of SRE expenditures on account of disposition, retirement, or abandonment; however, the notice provides relief to corporations by stating if a corporation ceases to exist in a transaction or series of transactions not covered by Section 381(a), the corporation is allowed a deduction equal to the unamortized SRE expenditures in its final taxable year. This provision does not apply if the principal purpose of the transaction is to claim a deduction for the unamortized SRE expenditures or if the SRE expenditures are paid or incurred with respect to property that is contributed to, distributed from, or transferred from a partnership.
If a corporation ceases to exist for federal income tax purposes in a transaction described in Section 381(a), the acquiring corporation continues to amortize the distributor or transferor corporation's unamortized SRE expenditures over the remainder of the distributor or transferor corporation's applicable Section 174 amortization period, starting from the month of transfer.
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Long-term contracts under Section 460: The current regulations under Section 460 require taxpayers to allocate research or development expenses (other than independent research and development expenses) to long-term contracts using the percentage-of-completion method (PCM) and to deduct such costs as they are incurred. Because the Section 460 regulations were drafted when SRE expenditures were immediately deductible under the former Section 174, Section 460 will be revised to provide the following:
- The costs allocable to a long-term contract accounted for using the PCM include amortization of SRE expenditures rather than the capitalized amount of such expenditures.
- Such amortization is treated as incurred for purposes of determining the percentage-of-contract completion as deducted.
- Cost-sharing regulations: Changes will be made in how cost-sharing transaction payments within cost-sharing arrangements between controlled participants are treated under Treasury Regulation Section 1.482-7(j)(3)(i).
The notice requests comments, specifically feedback on partnerships; merger, consolidation, division, or liquidation scenarios; startup companies; and the Section 280C election.
Applicability dates
Taxpayers may choose to rely on the interim guidance for expenditures paid or incurred in taxable years beginning after Dec. 31, 2021, provided the taxpayer relies on the guidance in its entirety and in a consistent manner.
The U.S. Department of the Treasury and the IRS intend to issue additional procedural guidance, but, until such time, taxpayers may rely on the existing procedural guidance in Section 7.02 of Revenue Procedure 2023-24 to change their methods of accounting under Section 174 to comply with Notice 2023-63.
Looking ahead
Although Congress still is considering the possibility of repealing or delaying Section 174, no significant progress has been made to date. Taxpayers currently preparing their 2022 federal income tax returns should work with their tax advisers to consider how the interim guidance in Notice 2023-63 might impact their returns.
