Effective for tax years beginning after December 31, 2021, research and experimental (R&E) expenditures as defined by Internal Revenue Code (IRC) Section 174 are subject to new rules that could impact your organization’s financial statement reporting and cash flow.
Explore how the mandatory capitalization of IRC Section 174 costs could affect your organizations quarterly financial statement reporting and 2022 estimated tax payment calculations.
The new capitalization requirements under Section 174 will impact taxpayers who incur R&E expenses—and it’s a consideration that should be addressed immediately.
For SEC filers with quarterly financial statement reporting requirements, consideration should be given as to whether the new rules impact the forecasted effective tax rate (ETR) for Q1 and if additional disclosure is needed to describe the impact.
For taxpayers making estimated tax payments using current year taxable income, consideration should be given to how the capitalization of costs incurred impact taxable income and the overall timing of cash tax payments during the year.
Treasury Regulation (Treas. Reg.) Section 1. 174-2(a) defines R&E expenditures as expenditures incurred in connection with the taxpayer’s trade or business in the experimental or laboratory sense, including all such costs incident to the development or improvement of a product. This definition of R&E expenditures is broad and includes allocated overhead. Revenue Procedure 2000-50 clarified the treatment of software development as similar to a Section 174 cost. Section 174(c) added “the development of any software” specifically as a R&E expenditure subject to the new rules.
Prior to 2022, a taxpayer had the option to deduct Section 174 costs in the year incurred or capitalize and amortize R&E expenditures. Also, a Section 59(e) election was available to capitalize and amortize over a 10-year recovery period. These options are no longer available.
As of January 1, 2022, these changes are in effect:
The mandatory capitalization of Section 174 costs may create an adjustment to the calculation of taxable income for taxpayers performing R&E activities. For US taxpayers performing R&E activities, the mandatory capitalization of R&E costs may impact deferred tax calculations.
Companies should be mindful of whether a new deferred tax asset is created due to the legislative changes or an adjustment of existing deferred taxes is needed, for example, if the taxpayer previously expensed software development costs under Revenue Procedure 2000-50.
Taxpayers should also consider whether the changes impact the realizability of their deferred tax assets and if a full or partial valuation allowance is needed. Revised scheduling of a taxpayer’s deferred tax assets may need to be performed as part of the valuation allowance assessment.
For taxpayers with controlled foreign corporations (CFC) conducting R&E activities–including cost-plus CFCs performing R&E or software development services–there could be impacts to the calculation of the CFC’s global intangible low-taxed income (GILTI). GILTI is required to be calculated using US tax rules.
Many taxpayers have adopted an accounting policy to treat GILTI as a period cost rather than accounting for outside basis differences in GILTI, meaning, the impacts of GILTI are included in the calculation of the effective tax rate.
Increases to a taxpayer’s GILTI-tested income generally result in an adverse impact to the company’s effective tax rate. However, there could be mitigating factors, such as increased foreign tax credit utilization, that would need to be considered.
The requirement to capitalize foreign R&E expenditures over 15 years could increase a taxpayer’s GILTI tested income and impact a taxpayer’s calculations under ASC 740.
Considerations include, but aren’t limited to, the following:
Given the various ways the Section 174 capitalization requirements may impact a taxpayer’s GILTI inclusion, additional disclosures regarding the comparative ETR may be necessary to provide financial statement users with sufficient information for understanding the year-over-year change in ETR.
The capitalization of IRC Section 174 costs for US entities could also impact a taxpayer’s ETR by affecting a taxpayer’s foreign derived intangible income (FDII) deduction.
Although temporary differences generally aren’t considered for quarterly financial statement reporting, significant changes in temporary differences could impact a taxpayer’s deduction eligible income (DEI) for purposes of calculating the FDII deduction.
Assessment of the increase to US taxable income because of R&E capitalization should be performed to determine if the impact to DEI materially impacts the FDII deduction. The allocation of R&E expenditures to DEI should be considered because changes in this allocation could impact the FDII deduction.
Generally, taxpayers don’t adjust their deferred tax balances on a quarterly basis.
However, if the forecasted change for a deferred tax item is material, taxpayers should consider whether the balance sheet classification between current taxes payable and noncurrent deferred taxes should be accounted for as part of quarterly reporting.
A corporation is required to make quarterly estimated tax payments. There are multiple ways to compute payments:
The impact of Section 174 on taxable income should be considered when using one of the above methodologies with appropriate thought given to the impact on timing and amounts of cash tax payments to make during the year.
If you have questions about research and experimental expenditure capitalization under Section 174 and how the new rules could impact your business, contact your Moss Adams professional.