Released on September 8, 2023, IRS Notice 2023-63 provides wide-ranging and potentially controversial guidance on the capitalization and amortization of research and experimentation expenses under section 174.
The Notice addresses several key questions on capitalization under section 174, which is required for tax years beginning on or after January 1, 2022:
- When are amounts paid by a service provider in a contract research arrangement subject to capitalization rules?
- How do the rules apply to R&D costs incurred as part of a qualified cost-sharing arrangement under Treas. Reg. § 1.482-7?
- What happens to capitalized R&D costs when the related IP is disposed of in a taxable or a non-taxable transaction?
- What are “specified research or experimental expenditures” (SREs), and which costs are included in that definition as software development expenses?
The answers to these questions are relevant for taxpayers performing R&D, analyzing or implementing intercompany transactions such as contract R&D services arrangements, or planning for sales or dispositions of self-created IP. Assuming Congress does not restore expensing, the guidance provided by the Notice will be important for most U.S. taxpayers that engage in R&D activities.
The Notice is effective for taxable years ending after September 8, 2023, although it may be early adopted for earlier tax years, until proposed regulations are issued. Taxpayers early adopting the Notice for 2022 would be required to apply all of its provisions consistently.
Contract Research Arrangements
Section 174 has no explicit statutory rules on research performed under contract. Notice 2023‑63 fills that gap by addressing contract research arrangements. These rules are important for any entity that contracts to provide or receive research services, whether those contracts are between related or unrelated parties.
Specifically, section 6 of the Notice applies to research providers who contract to either (i) perform research services for a principal, called the “research recipient”; or (ii) develop a product for the research recipient.
A research provider’s research costs must be amortized under section 174 in two circumstances. First, section 174 applies to a research provider if it contractually bears the risk that it may suffer a financial loss related to failure to produce the desired product. The research provider is considered to bear this risk only if its contract with the research recipient caused the provider to bear the risk.
Second, section 174 applies to a research provider if it has a right to use any resulting product in its trade or business or otherwise exploit any product through sale, lease or license. If the research provider must obtain an unrelated party’s approval to use or otherwise exploit the product, the research provider is not treated as having the right to use or exploit for purposes of the Notice. The only example provided in the Notice involves contract research performed by an unrelated party.
These rules will be a welcome confirmation for U.S. companies that hire foreign affiliates to perform research under R&D service agreements in certain circumstances. If section 174 does not apply to the foreign affiliate’s costs, those costs would generally be currently deductible under section 162 for computing subpart F income and GILTI, allowing the subpart F or GILTI inclusion to take into account current deductions for payments to employees, rent and so on.
A research recipient’s (i.e., the IP owner’s) research costs continue to be subject to section 174 amortization under Treas. Reg. § 1.174-2(a)(10) and (b)(3).
Cost Sharing Arrangements
In the context of a qualified cost-sharing arrangement (CSA) under Treas. Reg. § 1.482-7, the Notice would make clear how reimbursement of intangible development costs (IDCs) under a CSA interacts with the capitalization of SREs. Under the Notice, Treas. Reg. § 1.482-7(j)(3)(i) would provide that CST payments do not give rise to gross income to the extent that they do not exceed the payor’s share of IDCs that are capitalized as SREs or are deductible expenses, and instead reduce the amount of such IDCs. CST payments in excess of the payor’s reasonably anticipated benefit (RAB) share of IDCs that are SREs subject to capitalization or are deductible will be treated as income.
Whether SREs are amortized over five years or 15 years depends on where the research is conducted rather than on who is paying the costs. Thus, to the extent that CST payments by a foreign subsidiary are allocable to capitalizable costs of research conducted in the United States, the foreign subsidiary amortizes those costs over five years.
The Notice provides a few examples of how cost-sharing arrangements are treated under the new section 174.
In the first, U.S. parent incurs $100,000 of IDCs in the United States and the foreign subsidiary incurs $100,000 of IDCs outside of the United States. All of the IDCs are SREs subject to capitalization and amortization. The foreign subsidiary’s RAB share is 60%. As a result, the foreign subsidiary’s share of the IDCs is $120,000 (60% x ($100,000 + $100,000)), so it must make a $20,000 CST payment.
U.S. parent has no gross income from receiving the CST payment. Instead, it reduces its SREs subject to capitalization from $100,000 to $80,000. The foreign subsidiary has $120,000 of SREs, $100,000 of which are subject to 15-year amortization and $20,000 of which are subject to five-year amortization.
The second example illustrates a situation where the payments made under the CSA exceed the foreign participant’s share of SREs and deductible IDCs and thus give rise to gross income. U.S. parent incurs $100,000 of IDCs, $5,000 of which must be capitalized over five years, $5,000 of which are deductible and $90,000 of which are an arm’s-length rental charge for use of the parent’s facility in the United States. The foreign subsidiary also bears $100,000 of IDCs, and the foreign subsidiary’s RAB share is 60%. As a result, the foreign subsidiary’s share of the IDCs is $120,000 (60% x ($100,000 + $100,000)), so it must make a $20,000 CST payment. Under the Notice, the CST payment is treated as reducing pro rata the $10,000 of capitalizable and deductible IDCs of the U.S. parent up to the foreign subsidiary’s RAB share of those IDCs—i.e., by $6,000 ($10,000 x 60%). The capitalizable amount is reduced by $3,000 ($6,000 x ($5,000 / ($5,000 + $5,000))), and the deductible amount is reduced by $3,000 ($6,000 x ($5,000 / ($5,000 + $5,000))). The remaining $14,000 of the CST payment is treated as income.
Transfers and Dispositions
Section 174(d) provides that “no deduction” is allowed for SREs on account of an abandonment, retirement or other disposition of the related intangibles, and that amortization continues after one of those events.
Notice 2023-63 interprets section 174(d) very broadly so as to limit not only a loss deduction under section 165(a) for abandonment of a failed project or sale of the IP at a loss, but also to prevent recovery of costs to reduce gain realized on a sale under section 1001. Specifically, section 7.02 of the Notice provides that, except in a case where the taxpayer ceases to exist, no recovery of unamortized research expenses is allowed on account of a disposition of the intangibles. This “no recovery” rule also applies to a sale of intangibles as part of an “applicable asset acquisition” under section 1060.
The example in section 7.05(1) involves a company that sells intangibles with $100,000 of capitalized R&D at a gain. No recovery of basis is allowed for determining gain under section 1001. Instead, the capitalized costs continue to be amortized by the transferor over the relevant amortization period, irrespective of the disposition.
One might well ask whether this interpretation of section 174(d) is consistent with the statutory text or even the 16th Amendment’s definition of “income.” If Corp. X spends $100 on R&D producing an item of intangible property and sells the item for $80, has Corp. X realized any “income”? Nowhere does section 174(d) eliminate basis or suspend the application of sections 1001 and 1012 which determine basis and the amount of gain or loss. In the analogous context of sales of inventory, the courts have long recognized that cost of goods sold (COGS) is not a “deduction” (a matter of legislative grace), but is subtracted from gross receipts in arriving at gross income. See, e.g., Max Sobel Wholesale Liquors v. Commissioner, 69 T.C. 477, aff’d, 630 F.2d 670 (9th Cir. 1980) (Section 162(c)(2) bar on deductions for illegal payments and bribes did not apply to COGS); Patients Mut. Assistance Collective Corp v.
Commissioner, 151 T.C. 176 (2018), aff’d, 995 F.3d 671 (9th Cir. 2021) (same for costs of goods sold from a business subject to § 280E).
Section 7 also provides rules for non-recognition transactions. In the case of a section 381 transaction, the acquiring corporation steps into the shoes of the transferor corporation for purposes of amortizing SREs. In the case of a tax-free transfer that is not a section 381 transaction, however, the Notice seems to indicate that the “no recovery” rule would apply and cause the transferor to continue to amortize the R&D expenses. See section 7.05(d). For example, if one corporation transferred intangibles to another corporation in a section 351 transaction, it would seem that the transferor corporation would retain the SREs, notwithstanding that the transferee acquired the income-producing asset. This result is in contrast to the approach previously taken under section 59(e) and similar provisions (Philadelphia & Reading Corp v. United States, 602 F.2d 338 (Ct. Cl. 1979); PLR 201033014; PLR 200812015).
Recovery of R&D costs is available on a disposition by a corporation that ceases to exist in a transaction that is not a section 381 transaction, subject to an anti-abuse rule. See section 7.04(2). For example, if a C corporation sold all of its assets and then liquidated in a section 331 liquidation, under the Notice, the SREs would generally be recovered in the corporation’s final taxable year.
Comments are requested on the application of section 174(d) to partnerships, but not on the basic outlines of the guidance laid out above. Nonetheless, we expect comments will be forthcoming on all aspects of the section 174(d) guidance.
Mechanics of the Amortization Periods
Section 174(a)(2)(B) provides that SREs are amortized ratably over the applicable period beginning with the “midpoint” of the taxable year in which the SREs are incurred.
Section 3 of the Notice generally defines the midpoint as the first day of the seventh month of the taxable year in which SREs are paid or incurred. If the taxpayer has a short taxable year, the midpoint at which amortization begins is the middle month of the year. Note that since the five-year period or 15-year period is defined as either 60 months or 180 months, a short taxable year does not accelerate amortization of the costs.
Example: A calendar year taxpayer incorporated on October 17, 2022, and incurred $60,000 in SREs attributable to domestic research in its 2022 short year. Since the taxpayer’s short year has three months (October, November and December), the midpoint month is November; thus section 174 amortization begins in November and ends at the end of the calendar year, resulting in two months of amortization in 2022. As a result, the taxpayer amortizes $2,000 of SREs in 2022 ($60,000 / 60 x 2 months), $12,000 in each of 2023 – 2026 ($60,000/60 x 12 months), and the remaining $10,000 in 2027 ($60,000 /60 x 10 months).
Determining Section 174 Costs and Software Development Costs
Section 4 of the Notice provides guidance on how to determine expenses that are within the scope of section 174. Under the Notice, SREs include expenditures that satisfy the requirements under Treas. Reg. § 1.174-2 or that are paid in connection with the development of any computer software (as defined in section 5 of the Notice).
The Notice provides a non-exhaustive list of examples of the types of costs that are SREs:
- labor costs (including all elements of compensation other than severance compensation);
- materials and supplies costs;
- cost recovery allowances (including depreciation, amortization or depletion allowances with respect to property used in the performance of SRE activities or in the direct support of SRE activities);
- patent protection costs;
- certain operational and management costs (that are incurred in the performance of SRE activities or in the direct support of SRE activities); and
- travel costs related to the performance of SRE activities or the direct support of SRE activities.
By contrast, specific costs are excluded from being treated as SREs under the Notice, such as G&A costs that only indirectly support or benefit SRE activities, interest expense, costs to input content into a website or for website hosting, costs to register a domain name or trademark, costs listed in Treas. Reg. § 1.174-2(a)(6)(i) – (vii) and amounts representing amortization of SREs incurred in tax years beginning before January 1, 2022 (through elective capitalization under former section 174 rules or section 59(e)).
To determine SREs for a taxable year, taxpayers must allocate costs to SRE activities on the basis of a “cause-and-effect relationship” between the costs and the SRE activities, or another relationship that reasonably relates the costs to the benefits provided to the SRE activities. Taxpayers may use different allocation methods for different types of costs but must consistently apply the same methods for other tax purposes. Examples of allocation methods are provided in section 4.03(4) of the Notice.
Software Development Costs
Section 5 of the Notice provides additional guidance on the definition of “software development” for purposes of section 174(c)(3). The Notice draws a distinction between work done before and after software (or updates or enhancements) is released commercially. Accordingly, section 5.03 of the Notice defines software development for purposes of section 174(c)(3) to include planning the development of computer software, designing computer software, building a model of the computer software, writing source code, certain testing of computer software and production of product master(s) in the case of software developed for sale or license to others. Development of software includes development of updates and enhancements that add new functionality or materially increase speed or efficiency of a program. See section 5.02(2).
By contrast, training on use of a program, maintenance that does not give rise to upgrades or enhancements (such as debugging), data conversion and installation activities are all excluded from the definition of “software development” for under the Notice. Activities that occur after software is ready for sale or license to customers or otherwise placed in service (such as marketing, routine maintenance and customer support) are also not “software development” activities per the Notice.