IRS provides guidance on Section 174 expenditures

Notice 2023-63 provides interim guidance regarding specified research or experimental expenditures (SRE) under Section 174 and announces the intention of the Internal Revenue Service (IRS) to issue proposed regulations consistent with this guidance to be effective for tax years ending after Sept. 8, 2023.

Guidance is also provided regarding the treatment of SREs under Section 460 for long-term contracts and the application of Section 482 to cost-sharing arrangements involving SREs.

The notice specifically provides guidance, definitions and clarifications regarding several key items involving SREs. These include:

  • The Section 174 requirements to capitalize and amortize SREs and the treatment of short taxable years
  • Scope of whether expenditures are SRE expenditures under Section 174 and subject to capitalization and amortization
  • Determination of whether certain activities constitute software development for purposes of Section 174
  • Whether costs paid for research performed under contract are SRE under Section 174
  • How to treat unamortized SRE expenditures when the property is disposed of, retired or abandoned in certain transactions
  • How to apply the percentage-of-completion method (PCM) to account for income from long-term contracts under Section 460 when allocable contract costs include SRE expenditures
  • Update to Section 482 regulations addressing cost-sharing transaction payments between controlled parties in a cost-sharing arrangement when there are costs required to be charged to a capital account

Several specific definitions include:

  • Foreign research is any research conducted outside the US, Puerto Rico or any US territory or possession, and foreign research is determined by where the SRE activities are performed.
  • Amortization begins at the midpoint of the taxable year in which the SRE are paid or incurred. The midpoint is the first day of the seventh month.
  • Amortization for a short taxable year is determined based on the number of months in the short taxable year. The midpoint of a short taxable year is the first day of the midpoint month.
  • Examples of costs that are defined as SRE include but are not limited to:
    • Labor costs of employees and contractors who perform, supervise or directly support SRE activities
    • Materials and supplies including tools and equipment used or consumed in the performance or support of SRE activities
    • Cost-recovery allowances, such as amortization, depreciation or depletion for property used in the performance or support of SRE activities
    • Costs of obtaining a patent, including attorney costs
    • Certain operation and management costs, such as rent; utilities; insurance; taxes; repairs and maintenance; security; and other similar overhead costs with respect to facilities or equipment used in the performance or support of SRE activities
    • Travel costs for the performance or support of SRE activities
  • Examples of costs that are not treated as SRE expenditures include:
    • General and administrative service departments that only indirectly support or benefit SRE activities, such as payroll, human resources and accounting
    • Interest on debt to finance SRE activities
    • Activities associated with software that are not defined as software development
    • Costs incurred to input content into a website
    • Website hosting costs paid to an internet service provider
    • Costs to register an internet domain or trademark
    • Costs already excluded in the regulations from being research or experimental expenditures (ordinary quality control testing; efficiency surveys; management studies; consumer surveys; advertising or promotions; acquisition of third-party patent, model, production or process; or research in connection with literary, historical or similar projects)
    • Amortization of SRE expenditures
    • Amortization of research or experimental expenditures paid or incurred in taxable years beginning before Jan. 1, 2022
  • Examples of activities that are treated as software development (including upgrades and enhancements) for purposes of Section 174:
    • Planning the development of software, including the identification and documentation of software requirements
    • Designing the computer software
    • Building a model of the computer software
    • Writing source code and converting to machine-readable code
    • Testing the computer software and making necessary modifications to address defects identified during testing
    • Production of the product master if developed to be sold or licensed

Mazars’ insight

Taxpayers and practitioners have long awaited this guidance from the IRS regarding many nuances of the new Section 174 that went into effect for tax years beginning after Dec. 31, 2021.

With this notice announcing the intention to issue proposed regulations, there is now welcome clarity regarding many items, such as the treatment of short years, what constitutes software development and how to recapture unamortized expenses when the SRE has been disposed, retired or abandoned.

Although this new guidance is effective for tax years beginning after Sept. 8, 2023, taxpayers should have already implemented the change in method for Section 174 expenditures and already be accounting for the tax treatment of SRE by charging to a capital account for all of these expenditures.

If a change was not implemented on the tax return for the first tax year beginning after Dec. 31, 2021, a change in accounting method will need to be filed with the subsequent tax year’s tax return.

Please contact your Mazars professional for additional information.

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.

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