One of the more significant issues that taxpayers and tax practitioners have faced in recent months is the Tax Cuts and Jobs Act’s (TCJA) amendment to Section 174, requiring capitalization of previously deductible R&D and software development expenses. This has raised a number of U.S. tax questions. Moreover, the House Republicans recently proposed legislation to restore R&D expensing, with an option to make a Section 59(e) election on a late basis for taxpayers who have counted on R&D capitalization being in place during 2022 and future years. See Build It in America Act, H.R. 3938, Section 101(b)(2) (Sec. 174(f)(2) (transition rules)). However, there is still uncertainty as to whether legislation to restore R&D expensing will be enacted.
One tax impact of new Section 174 is that the related expenses are charged to a capital account and give rise to basis. See Section 174(a)(2)(A) (providing that the taxpayer “shall charge such expenditures to the capital account”). Where such basis goes and how it is recovered in dispositions of related IP is not entirely clear. As discussed below, IRS rulings and case law have had to wrestle with the treatment of capitalized expenses under Section 59(e) and analogous provisions. Moreover, Section 174(d) provides a special rule for treatment of R&D expenses on a disposition of the asset, providing that amortization shall continue.
These technical interpretive questions are discussed below. However, even assuming that capitalized R&D expense is treated the same as any other basis in the IP asset and fully recoverable on a disposition, a number of practical questions and issues will arise that may catch practitioners by surprise, who, by force of habit, have gotten used to IP being a zero-basis asset.
Practical Issues Stemming from Recovery of Capitalized Costs
The treatment of self-created IP as having a zero basis is so engrained that the author has only started to process that most IP now has a positive basis (at least barring retroactive legislation). This raises a number of tax planning issues, even assuming basis recovery works the way it “ought to,” especially (but not solely) on a disposition of IP. A summary of some of these issues are discussed below:
- On an asset sale involving some but not all of the taxpayer’s IP, basis will have to be allocated between the sold IP and retained IP on some basis. Compare Preamble on Treas. Reg. § 1.59-1(e), TD 9168 (noting that taxpayers capitalizing R&D under Section 59(e) have the burden of maintaining records sufficient to allocate the basis to the IP sold.
- To recover basis, the IP must be transferred in a transaction characterized as a sale rather than a license. For corporations without a capital gains preference, the potential for basis recovery brings an added significance to whether a licensing transaction conveys “all substantial rights” to the IP to allow recovery of costs.
- Certain statutory rules may defer recovery of basis, such as Section 453.
- Distributions of IP (or proceeds from the sale of IP) may create less current earnings and profits due to the IP having basis. For example, if a CFC distributed self-created IP to its US parent company in a § 301 distribution, there now may be less § 311(b) gain to include as GILTI or subpart F income.
- A taxpayer making a “covered asset acquisition” under § 901(m) may find that capitalization of R&D expense means that a target has somewhat less of a basis difference in its assets before the acquisition than it otherwise would have.
- US taxpayers allocating and apportioning interest expenses may benefit from R&D expense being capitalized into the basis of IP assets. Compare Prop. Reg. § 1.861-9(k)(2), REG-101657-20 (Nov. 12, 2020), allowing taxpayers to elect to capitalize research expenditures solely for purposes of interest expense apportionment under section 861.
- In testing whether a foreign corporation is a PFIC under the tax book value method, R&D expense would create tax basis in IP assets. The interaction with § 1298(e)(1) remains to be seen.
As can be seen from the foregoing examples, capitalization of R&D will create new issues and dimensions to consider in taxation of a range of not infrequent transactions and tax planning areas.
Technical Questions around Recovery of Capitalized Costs under § 174
Apart from the practical considerations above, a few different issues arise as to how capitalized R&E costs should be treated on a disposition. Similar questions have arisen, of course, in the context of electively capitalized costs under Section 59(e) and Section 174(b). Although it would seem to be common sense that the unamortized expense is charged to the basis of the related IP, the statutory language has a number of twists and turns. It is notable that in the similar area of § 59(e) and § 616(b), it has taken private letter rulings and in one case, litigation, to reach this logical result.
This issue can be analyzed through two different fact patterns: (1) a taxable sale of the IP and (2) a tax-free transfer, such as under Section 351, Section 368 or Section 721.
Gain on sale of an asset is determined under §§ 1001 and 1011 as the difference between amount realized and the adjusted basis of the property sold. Section 1016(a)(1) provides for adjustments to basis of property for expenses properly chargeable to the capital account. Section 1016(a)(2) through 1016(a)(38) then provides various special rules, and reductions to basis for recovery of capitalized costs (e.g., through depreciation).
With respect to elective capitalization of R&D under former Sections 174(b) and 59(e), the statutory language in this regard was not exactly comprehensive.
For an election to defer expenses under old Section 174(b), former section 174(b)(1) (flush language) provided that the expenses deferred would be charged to the capital account for determining basis of the property under Section 1016(a)(1). Section 1016(a)(14) then provided for downward adjustments to basis for recovery of deferred expenses “resulting in a reduction of the taxpayers’ taxes … but not less than the amounts allowable under such section for the taxable year and prior years.” Treas. Reg. § 1.1016-5(j) further provides that deferred expenses under Section 174(b) were treated as an adjustment to the basis of property to which they relate. Thus, research expenses deferred under old section 174 were treated similarly to depreciation of tangible property.
By contrast, Section 59(e) itself does not state what happens to capitalized expenses. Treas. Reg. § 1.1016-5(j) does not address Section 59(e) elections. Section 1016(a)(20), however, provides for a reduction of basis for “amounts allowed as deductions under Section 59(e),” a result that would only be logical if the Section 59(e) expenses were added to basis when capitalized in the first instance.
The IRS and Treasury provided regulations and administrative guidance to clarify that Section 59(e) capitalized expenses were treated as adjustments to basis for determining gain or loss on a sale of IP. In PLR 200117006 (Jan. 17, 2001), the IRS ruled that, where a taxpayer sold Technology as to which it had deferred expenses under Section 59(e), the deferred expenses not previously amortized would be treated as adjustments to the basis of Technology sold. Although the § 1016 regulations do not refer to Section 59(e), the IRS reasoned that expenses deferred and capitalized under Section 174(b) and Section 59(e) should be treated in a similar manner and Section 59(e) was omitted from the Section 1016 regulations because it was enacted subsequently. Later, in 2005, the Section 59(e) regulations confirmed this result. See Treas. Reg. § 1.59-1(b)(2).
The TCJA’s mandatory capitalization rules have their own statutory framework with respect to recovery of basis. First, like Section 59(e), current Section 174 does not explicitly address how capitalized expenses are treated. Instead, Section 174(a)(2)(A) merely states that capitalized expenses shall be “charged to the capital account”—what capital account is unstated. Moreover, no conforming changes were made to Section 1016(a)(14), which literally would imply that basis is not adjusted downward for amortized expense.
This all would seem to be yet another TCJA “slip of the pen.” Notably, the House’s Build It in America Act, H.R. 3938, would correct this issue by modifying Section 1016(a)(14) to explicitly refer to capitalized expenses under post-TCJA Section 174. See Build It in America Act, §§ 174(e)(2) and 174A(j). Absent legislation, however, the question remains as to how much the tune can be read from gaps in the notes.
The TCJA added Section 174(d), a bar on claiming a deduction for capitalized expenses on a disposition of IP. This provision reads, in relevant part, as follows:
“if any property with respect to which specified research or experimental expenditures are paid or incurred is disposed, retired, or abandoned …, no deduction shall be allowed with respect to such expenditures on account of such disposition” and “such amortization deduction shall continue ….” (emphasis added).
Naturally, absent such a provision, taxpayers could to some extent work around the deferred expense treatment by identifying failed projects for abandonment or other disposition. Such an abandonment loss would give rise to a deduction under Section 165, which Section 174(d) generally seems intended to disallow. Compare § 197(f)(1) (disallowing losses on certain sales of § 197 intangibles). The TCJA legislative history states, however, that in the case of a disposition of IP subject to capitalization, “any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.” See H.R. Conference Report 115-466 (Dec. 15, 2017), at p. 425 (emphasis added). This would seem to be a case where the legislative history and text of the statute are at odds in terms of the goals to be accomplished.
Tax-Free Transfers of IP
The other issue is how capitalized expenses are treated if the assets are transferred tax free, e.g., in a tax-free Section 351 incorporation transaction. Some code sections explicitly provide that the transferee in this situation steps into the shoes of the transferor. See Section 197(f)(2). Other areas, such as Section 59(e), do not explicitly address the issue.
In Philadelphia & Reading Corp v. United States, 602 F.2d 338 (Ct. Cl. 1979), the Court of Claims addressed how deferred mining development expenses capitalized under Section 616(b) were treated in a case where the taxpayer incurring the expenses transferred the mine to a subsidiary in a transaction governed by Section 351. Section 616(b), like Section 59(e) or post-TCJA Section 174, did not explicitly address the issue. The Court of Claims took a policy-based and logical approach, concluding that a Section 351 transfer involved continued ownership of the same investment in modified form and should be treated as continued ownership of the mine as to which the deferred expenses were incurred. The court noted that due to reduction in basis for recovery of the expenses, the transferee did not obtain a double benefit. It also reasoned that it would be illogical to treat the deferred expenses as charged to a separate capital account, severed from the basis of the underlying mine, and rejected that position in holding that the capitalized expenses traveled with the mine to the transferee.
Many of the same points stressed by the court in Philadelphia & Reading could also be applied to expenses capitalized under Section 174. In fact, in several PLRs involving tax-free spin-offs and section 351 transactions, the IRS has followed Philadelphia & Reading in the case of capitalized expenses under Section 59(e), which like the statute addressed there and in Section 174 was silent on how capitalized expenses should be treated on a tax-free transfer. See PLR 200812015 (transfer of Business A and Business B intangibles in a tax-free spin-off under Section 355) and PLR 201033014 (same).
Treatment of capitalized costs under new Section 174 is a second-level issue stemming from capitalization that will become more prevalent the longer it persists in the Code. Pending passage of the legislative fix, tax practitioners should consider the implications of capitalized expenses in structuring transfers of IP both from a technical and practical level.