On September 8, 2023, the Department of Treasury (the Treasury) and the Internal Revenue Service (the IRS) released Notice 2023-63 (the Notice), which sets forth the Treasury and the IRS’s intent to issue proposed regulations addressing the application of Section 174.1 In 2017, legislation commonly referred to as the Tax Cuts and Jobs Act amended Section 174 to eliminate the option for taxpayers to deduct R&E expenditures and instead to require taxpayers to capitalize and amortize “specified research or experimental” (SRE) expenditures generally over five years for U.S. expenditures and 15 years for non-U.S. expenditures, for tax years beginning after December 31, 2021.
The requirement to capitalize and amortize SRE expenditures has had a significant and often surprising impact on emerging growth and technology companies in research intensive industries, causing such companies to recognize taxable income earlier, and in larger amounts, when compared to book income. In addition, the changes to Section 174 can impact the qualified small business stock (QSBS) eligibility of such companies by increasing their “gross assets,” which generally cannot exceed $50 million at the time of a stock issuance for such stock to qualify as QSBS.2
The Notice provides much needed guidance relating, among others, to the definition of SRE expenditures, the treatment of costs or expenditures incurred by a research provider by contract, the application of Section 174 in the context of a disposition, retirement, or abandonment of property or otherwise in connection with a dissolution of a corporate taxpayer, and the treatment of SRE expenditures under the Section 482 rules applicable to cost sharing arrangements. The Treasury and the IRS have requested written comments on the interim guidance by November 24, 2023. While the Notice is effective for any tax year ending after September 8, 2023, taxpayers can elect to rely on the guidance provided for tax years beginning after December 31, 2021 if the guidance is consistently applied.
Capitalization and amortization of SRE expenditures
Scope of SRE expenditures
The Notice defines SRE expenditures as (i) R&E expenditures that satisfy the requirements of Treasury Regulations Section 1.174-2 and (ii) R&E expenditures that are paid or incurred in connection with the development of computer software, even if they don’t fulfill the requirements of Treasury Regulations Section 1.174-2. The Notice provides a number of illustrative examples of SRE expenditures, including (i) labor costs (including compensation other than severance) of employees and independent contractors who perform, supervise, or directly support SRE activities, (ii) materials, supplies, and non-depreciable tools used or consumed in SRE activities, (iii) depreciation, amortization, or depletion allowances for property used in SRE activities, (iv) costs of obtaining a patent (including attorney’s fees), (v) certain operational costs relating to facilities, equipment, and assets used in performance of SRE activities; and (vi) travel costs for the performance or direct support of SRE activities. Such costs must be allocated among SRE activities on the basis of a cause-and-effect relationship between the costs and the SRE activity, although another relationship can be used if it “reasonably relates the costs to the benefits provided to the SRE activities.” In addition, the basis for allocation can differ among various types of SRE costs so long as the method for each type is applied consistently.
The Notice further clarifies that certain costs, including, among others, G&A costs that indirectly support SRE activities (e.g., salaries of payroll, HR, and accounting personnel), interest on debt taken to finance SRE activities, and costs for website hosting or to register an Internet domain name or trademark, are not to be considered as SRE expenditures.
Wilson Sonsini observation: The explicit exclusion of G&A costs is a helpful clarification in determining what costs are considered SRE expenditures.
Scope of software development
Section 174(c)(3) provides that R&E expenditures include amounts paid or incurred in connection with the development of software. The Notice provides that for this purpose, software development includes planning the development of software (including identification and documentation of requirements), designing and modelling a computer program, writing source code, revising and testing computer software, and producing the product master for software developed for sale or licensing to others. However, at the point at which software is either (i) placed in service for use by the taxpayer in its trade or business or (ii) is ready for sale or third-party licensing, software development ceases, and costs are no longer capitalized under Section 174. Further, in the case of software developed for self-use, any training, maintenance, data conversion, and installation activities are not considered software development, and accordingly any associated costs are not capitalized under Section 174. Finally, costs related to marketing, maintenance, distribution, or customer support activities performed with respect to software developed for third-party use that occurs after such software is ready for licensing or sale, are not software development costs required to be capitalized under Section 174.
Wilson Sonsini observation: Since SRE expenditures are tied to the time at which software is placed in service or is ready for license or sale, clearly documenting this point in time will be important to determine which costs are subject to capitalization under Section 174.
Scope of SRE expenditures under services agreements or other research contracts
The Notice clarifies that costs incurred by a service provider, e.g., under a services agreement or as a contractor, to perform research services with respect to an “SRE product” or develop an “SRE product” for a recipient party are not required to be capitalized under Section 174 unless either (i) the research provider has financial risk if the research fails, or (ii) the research provider has a right to use the SRE product in its trade or business or otherwise exploit the SRE product through sale, lease, or license, unless that right is subject to approval from an entity that is not related to the research provider (as specially defined). An SRE product is defined as a pilot model, process, formula, invention, technique, patent, computer software, or similar property (or a component thereof) that is subject to protection under applicable domestic or foreign law but, importantly, specifically excludes “mere know-how” gained by the service provider in the course of providing services. Accordingly, a research provider that develops and retains know-how (but does not retain an SRE product) is not required to capitalize related costs under Section 174.
Wilson Sonsini observation: This clarification provides helpful guidance to taxpayers that provide services to others under research contracts and/or services arrangements.
Treatment of unamortized SRE expenditures in the event of disposition, retirement, or abandonment of property
The Notice reaffirms the position under the existing regulations that no deduction will be allowed with respect to the capitalized SRE expenditures if the property for which such expenditures were made, is disposed of, retired, or abandoned within the amortization period. Instead, the taxpayer must continue to amortize the expenditures over the remaining amortization period.
If a corporation ceases to exist in a transaction covered under Section 381(a) of the Code (e.g., a tax-free liquidation under Section 332 or a tax-free asset reorganization under Section 368(a)), the Notice provides that the acquiror is required to continue amortizing the unamortized SRE expenditures over the remainder of the five-year amortization period. However, if the transferor corporation ceases to exist in another type of transaction (e.g., a taxable liquidation or winddown of the corporation), the corporation will be allowed to deduct the unamortized SRE expenditures in its final tax year, unless a principal purpose of the transaction is to claim a deduction for SRE expenditures.
Wilson Sonsini observation: While a corporation that sells all of its assets and liquidates in a taxable transaction can generally recover the remaining amortization deductions, a corporation that sells all its assets, including the property giving rise to the SRE expenditures, but that does not liquidate, cannot make such recovery.
Short taxable years
Under Section 174, the amortization of SRE expenditures begins from the midpoint of the tax year in which the expenditures were incurred. The Notice clarified that the midpoint of a tax year generally means the first day of the seventh month of such tax year. However, for a short tax year, the midpoint is determined by the number of months in the short tax year, and the same month will not be counted twice in successive short tax years.
Treatment of SRE expenditures under cost sharing arrangements
Certain companies may have previously entered into a “cost sharing arrangement” to allocate research and development costs between related entities. The current regulations under Section 482 provide only for the allocation of deductible costs. The Notice announced the intent to expand the scope of the Section 482 regulations to include capitalized SRE expenditures as a category of allocable costs for applicable cost sharing arrangements.
If you have any questions about the impact of R&E expenditure capitalization under Section 174 or the guidance set forth in the Notice, please contact Myra Sutanto Shen, Greg Broome, Dave Strong, Derek Wallace, Jonathan Zhu, or any member of the tax practice at Wilson Sonsini.
Anjali Krishnan contributed to the preparation of this report.
[1] All “Section” or “Treasury Regulations Section” references are to sections of the Internal Revenue Code, 1986, as amended (the Code) and the Income Tax Treasury Regulations, respectively, as of September 15, 2023.
[2] For more information about QSBS, please see Wilson Sonsini Alert: “Understanding Section 1202: The Qualified Small Business Stock Exemption.”
