The IRS has released Notice 2023-63 ("the Notice") providing interim guidance on §174 specified research or experimental (SRE) expenditures in relation to the changes made to those SRE’s in the Tax Cuts and Jobs Act (TCJA). The TCJA, which contained massive §174 changes for amounts paid or incurred in tax years beginning after 12/31/21, included the important requirement that taxpayers must charge SRE expenditures to a capital account and amortize them over 5 years (15 years for expenditures attributable to research performed outside the US).
What the Notice Does
One of the main things the Notice does is delineate what expenses should be included as §174 SRE, and which should not be. For example, software development activities (even if they do not qualify as experimental activities) are to be included as SRE. The specifics of exactly which costs must be included are different for software that is developed for internal use versus software that is developed for sale. Importantly, if the software development costs are associated with purchasing, installing, or configuring commercially available software, then those would not be included as §174 SRE.
Other examples that are included in the Notice as §174 SRE are labor costs related to the research activities by employees or contractors (including but not limited to performing, supervising, or supporting the activities), the costs of materials, supplies, tools, and equipment that are not depreciable under §163, and used or consumed by the research activities, and the costs of obtaining a patent.
The Notice Specifies That The Following Are Not To Be Included As §174 SRE
The Notice specifies that the following are not to be included as §174 SRE: general and administrative services, such as payroll, human resources, and accounting, interest on debt to finance research activities, and certain specific website and software costs. Additionally, the Notice holds that if property was previously included in §174, but is later retired or disposed of, the amortization is not accelerated, but rather the amortization schedule continues for the remainder of the original schedule (note, there is an exception specified where a company ceases to exist entirely, not through an acquisition).
Section 8 of the Notice
Section 8 of the Notice, relating to treatment of SRE expenditures under §460 states that the IRS plans to issue proposed regulations amending existing §460 regulations to “provide that the costs allocable to a long-term contract accounted for using the percentage-of-completion method (PCM) include amortization of SRE expenditures under § 174(a)(2)(B), rather than the capitalized amount of such expenditures, and that such amortization is treated as incurred for purposes of determining the percentage of contract completion as deducted.” They note that these proposed changes would not apply to expenditures previously capitalized or to independent research and development expenditures (i.e., not allocable contract costs). Importantly, the Notice states that research or experimental expenditures that are not independent research and development expenditures, would remain subject to allocation under § 460(c)(1) regardless of whether they are SRE expenditures.
Examples Within the Notice
One of the most significant aspects of this Notice is that it is rich with examples. Out of the Notice's 45 pages, about 15 of them are examples demonstrating the guidance therein. For example, the Notice states that allocation methods must be consistently applied to an activity, but not necessarily across activities, and proceeds to provide both specific examples and tables demonstrating this in plain language and actual numbers.
The interim guidance indicates that proposed regulations will be coming after a comment period in response to this guidance, and that comments should be submitted by 11/24/23 (but can still be submitted thereafter as well). The Notice has 5 pages of specific questions for commenters to consider and reply to, and interested parties are encouraged to do so. Until those proposed regulations are released, taxpayers may generally on most of the interim guidance (i.e., Notice sections 3-9). The Notice does indicate that taxpayers should not rely on the rules for SRE expenditures paid or incurred with respect to property that is contributed to, distributed from, or transferred from a partnership, so we anticipate different final regulations for such expenditures in the future.
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