The Internal Revenue Service (IRS) has issued interim guidance (Notice 2023-63) aimed at providing clarity regarding the treatment of specified research and experimental expenditures (SRE) under Section 174.
IRS Issues Interim Guidance on Capitalization and Amortization of Research Expenditures Under Section 174
This clarification is particularly relevant due to the requirements imposed by the Tax Cuts and Jobs Act (TCJA), which mandate the capitalization and amortization of SRE expenditures. The IRS’s recent guidance marks a significant step beyond the initial procedural guidance, offering substantive information for compliance with these new rules.
Key Points Addressed in the Interim Guidance
The interim guidance covers several essential topics, including:
- Definition of Software Development: This section clarifies the definition of software development for tax purposes.
- Treatment of Research Performed Under Contract: The guidance outlines how research performed under contract should be treated for tax purposes.
- Identification and Allocation of SRE Expenditures: It provides insight into the identification and allocation of SRE expenditures.
- Interaction of Section 174 with Long-term Contracts under Section 460: This section discusses how Section 174 interacts with long-term contracts under Section 460.
- Cost Sharing Arrangements under Section 482: The guidance addresses cost sharing arrangements under Section 482.
- Disposition of Property: It discusses the treatment of SRE expenditures in the event of the disposition, retirement, or abandonment of property.
Taxpayers have the option to rely on the interim guidance immediately but must adhere to all the rules outlined in the notice. It’s not permissible to selectively adopt specific sections while diverging on others. The IRS intends to propose regulations consistent with this guidance, applicable for taxable years ending after September 8, 2023.
Automatic Consent Procedures
The IRS also plans to provide procedures for taxpayers to obtain automatic consent to change their accounting method to comply with this guidance. These procedures will apply to both those who have already changed their methods to comply with Section 174 and those who have yet to do so.
The TCJA amended Section 174, requiring taxpayers to capitalize and amortize SRE expenditures over specific periods. This change also applies to software development costs. Additionally, the TCJA introduced Section 174(d), disallowing deductions for SRE expenditures upon the disposition, retirement, or abandonment of related property.
These amendments apply to SRE expenditures incurred after December 31, 2021, and constitute a change in accounting method.
The guidance in Notice 2023-63 addresses key aspects of Section 174, including the identification and allocation of SRE expenditures, software development, research performed under contract, and more.
Identification and Allocation of SRE Expenditures
This section defines essential terms related to the identification and allocation of SRE expenditures for taxable years beginning after December 31, 2021. It outlines what constitutes SRE expenditures and SRE activities, providing examples of costs considered incident to SRE activities.
Cost Allocation Rules
Taxpayers must allocate costs to SRE activities based on a cause-and-effect relationship or another reasonable relationship between the costs and the benefit provided by the activities. The consistent application of allocation methods is required.
The guidance defines computer software and provides an extensive list of activities considered as software development for Section 174 purposes. It also differentiates between activities related to purchased software and those that do not constitute software development.
Research Performed Under Contract
The guidance defines terms related to research performed under contract, including research provider, research recipient, and SRE product. It also establishes criteria for costs incurred by both parties to be considered SRE expenditures.
Application to Long-term Contracts under Section 460
This section clarifies how costs related to SRE expenditures are treated in long-term contracts accounted for using the percentage-of-completion method (PCM).
Cost Sharing under Section 482
The guidance addresses Cost Sharing Transactions (CST) under Cost Sharing Arrangements (CSA) and how they affect the capitalization of SRE expenditures.
Short Taxable Years
It provides clarity on the application of these rules for short taxable years and explains how to calculate the amortization deduction for such periods.
Disposition, Retirement, or Abandonment of Property
This section explains the treatment of SRE expenditures when property related to them is disposed of, retired, or abandoned. It also addresses various corporate transactions involving the cessation of a trade or business.
While the guidance offers valuable insights, its release timing may pose challenges for taxpayers who have already filed their tax returns for the first taxable year beginning after December 31, 2021. Taxpayers intending to implement the guidance for future tax years should carefully assess their positions and computations to align with the notice’s guidance.
Tax Professional Standards Statement
This content is intended to support the marketing of professional services by Grant Thornton LLP and should not be considered specific tax advice for individual circumstances. Taxpayers should consult with tax professionals to address their unique situations. Tax laws are subject to change, and the information provided may not be applicable to all circumstances. Grant Thornton LLP assumes no obligation to inform readers of any changes in tax laws or other factors that may affect the information contained herein.
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