On September 8, 2023, the IRS and Treasury unveiled Notice 2023-63, outlining future regulations about the amortization of research and experimental (R&E) costs. This proposed guidance focuses on:

1. Capitalizing and amortizing R&E expenses as per the 2017 Tax Cuts and Jobs Act (TCJA).

2. The relationship between §174 and the tax handling of long-term contracts.

3. Correct treatment of cost-sharing agreements concerning R&E expenses.

These guidelines would be effective for tax years ending post-September 8, 2023. Taxpayers can utilize the Notice's provisions for tax years concluding after December 31, 2021, with certain conditions.

Historical Context

Before the TCJA amendment, §174(a) permitted taxpayers to either instantly deduct R&E expenses or defer them for at least 60 months. However, TCJA revised this to mandate a capitalization and 60-month (or 180-month for foreign research) amortization period. These changes, effective post-December 31, 2021, can be burdensome for companies with significant R&E costs. Some bipartisan support exists for a reversion to the previous §174(a) standard.

Key Points from the Notice

• Defining R&E Costs: §174(a) includes costs related to a taxpayer’s business activities, including experimental ones, as well as software development costs.

• Software Development: Costs involved in computer software development, including enhancements, fall under §174.

• Contract-based Research: The Notice also addresses R&E activities performed under contract and the associated costs.

• Midpoint Convention: Amortization of R&E expenses begins at the year's midpoint.

• Short Tax Years: The Notice offers guidance about the midpoint in a short tax year.

• Handling Property: The treatment of unamortized R&E expenses related to property that's disposed of, retired, or abandoned is clarified.

Our Thoughts

The Notice illuminates many aspects of §174, particularly related to M&A deals and intra-group restructuring. Notably, there's a lack of guidance on §174's intersection with partnerships, potentially impacting taxpayers investing in flow-through structures. While the modeling of the new §174 rules might be complex, Unicorn Tax Advisors can offer expertise.

Long-Term Contracts and §460

Section 460 mandates the use of the percentage-of-completion method (PCM) for long-term contract income accounting. Current regulations include R&E expenditures in revenue recognition. The Notice suggests that these expenditures will be considered incurred based on their amortization and deduction as per §174(a)(2)(B).

Cost-Sharing Regulations

Under US transfer pricing regulations, taxpayers can share intangible property development costs through a cost-sharing agreement. The Notice suggests new regulations to allocate cost-sharing payments properly.

Our Thoughts

Taxpayers involved in transfer pricing agreements related to R&E activities should understand the implications of the anticipated rules. Given the complexity of the regulations under §482 and their interplay with §174's R&E rules, it's recommended to consult with experts like Unicorn Tax Advisors.