IRS Drops Last - Minute Guidance on §174 Research Amortization
On Friday, September 8, 2023, the Internal Revenue Service (IRS) published an advance copy of Notice 2023-63. This notice provides a roadmap for future guidance on the capitalization and amortization of the costs of research or experimentation and software development under Internal Revenue Code (IRC) § 174. Before diving into the guidance itself, it is important to state that the notice also sets the date after which any future guidance will be applicable. Though taxpayers can rely on the rules provided in the notice for earlier tax years, it will not be required for tax years ending on or before September 8, 2023. To reiterate, the rules in this notice are not mandatory for the 2022 calendar tax year or for any tax year ending on or before September 8, 2023.
The primary purpose of this guidance is to provide clarity to taxpayers on the requirement in § 174(a) of the Internal Revenue Code to capitalize and amortize specified research or experimental expenditures (SREs). This notice provides extensive guidance on the treatment of short taxable years, cost-capturing techniques, software development, contract research, and certain dispositions. To a more limited extent, it also provides guidance on issues relating to long-term contracts and cost-sharing arrangements. The notice closes with a request for comments, both in general and on specific issues, and a promise of additional procedural guidance to implement the changes in the notice.
General § 174 Rules
Under the new version of § 174 as modified by the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers are required to capitalize and amortize SREs over five years or fifteen years, based on the location of the research.[1] In general, Notice 2023-63 uses terms as they are defined in the existing § 174 regulations.[2] The notice also coins the new term SRE expenditures, which are either traditional research or experimental expenditures under regulation § 1.174-2 or expenditures paid or incurred in connection with the development of any computer software.[3] SRE activities are then defined as software development activities or research or experimental activities,[4] i.e., the activities generating the costs classified as SRE expenditures. (Software development is defined in the notice; the TCJA changes did not codify Rev. Proc. 2000-50.[5]) The notice then provides non-exhaustive examples of costs that are SRE expenditures and costs that are not SRE expenditures.
Examples of SRE Expenditures:
- Labor costs (full-time, part-time, contract employees, and independent contractors), including all elements of compensation except severance pay.
- Materials and supplies costs.
- Depreciation, amortization, or depletion allowances for assets used in SRE activities.
- Patent costs.
- Certain operation and management costs (rent, utilities, etc.).
- Certain travel costs.
Examples of Non-SRE Expenditures:
- General and administrative service department costs that only indirectly support SRE activities.
- Interest on SRE activity debt.
- Costs for activities excluded from the definition of software development.
- Costs for inputting content into a website or the periodic costs of hosting a website.
- Costs for registering domain names or trademarks.
- Costs for activities otherwise excluded from § 174, such as efficiency surveys, consumer surveys, management studies, historical studies, etc.
- Amortization under either current or prior § 174.
After identification, the SRE expenditures must be allocated to SRE activities based on a cause-and-effect relationship that reasonably relates the costs to the benefits provided by the SRE activities.[6] These methods may include labor hours for researchers or square footage devoted to SRE activities for occupancy costs.[7] The SRE expenditures are then capitalized and amortized beginning at the midpoint of the year, i.e., generally the first day of the seventh month, regardless of whether the property to which the SRE expenditures relate was disposed of before the midpoint.[8] For short years, the amortization is based on the number of months in the year with specific rules provides for how to include partial months, especially in consecutive short years.[9]
Finally, the notice requires consistent treatment for SRE expenditures under subtitle A of the Code.[10] Thus, a cost cannot both be capitalized under § 263A and under § 174. The notice is silent on how the consistency requirement, or revised § 280C, is impacted by qualified research expenses under § 41 that are not capitalized under § 174, such as costs eligible for the R&D credit under the substantially all rule of § 41(b)(2)(B).[11]
While this notice is fairly descriptive in terms of what costs should be included, future guidance should more clearly develop the relationship between these examples and the nexus standards for determining whether a cost is incidental to development as described in Rev. Rul. 67-401 and its progeny. It is currently unclear whether the notice treats all compensation (except for severance pay) as labor costs or whether there must be a nexus between the pay and labor in an SRE activity. The latter approach is more consistent with how the IRS has sometimes treated compensation in research credit claims.
Software Development
Though we have previously noted that Notice 2023-63 does not codify Rev. Proc. 2000-50 to define software development, its definition of computer software closely tracks the definition in the revenue procedure with some modernization. Computer software includes not only new computer software, but also upgrades or enhancements that result in additional functionality or significant improvements in speed or efficiency and the incidental and ancillary rights necessary to acquire title, ownership, or the right to use the software.[12] Computer software includes software for sale, lease, or license to others and internal use software.[13]
The following activities are treated as software development:
- Planning the development of computer software, including identifying and documenting software requirements.
- Designing computer software.
- Building a model of computer software.
- Writing and converting source code into machine-readable code.
- Testing and modifying the software to address defects (up to specific milestones).
- Production of product master(s) for software developed for sale or licensing to others.
Activities that are not treated as software development include:
- Purchasing, installing, configuring pre-coded parameters, and reengineering the business for compatibility with purchased software.
- In the case of software developed for internal use: Training, post-implementation maintenance that doesn’t lead to upgrades, data conversion (except activities to facilitate data access or conversion).
- In the case of software developed for sale or licensing to others, post-completion activities such as marketing, promotional efforts, certain maintenance activities, distribution activities (e.g., remote access), and customer support.
Generally speaking, internal use software-related activities cease capitalization when placed in service and for software for sale or license to others when technological feasibility has been established, product masters produced, and the software is ready for sale.[14]
Though the notice applies to software development even if it would not have been subject to old § 174,[15] the rules seem to incorporate guidance derived from old § 174. In Yellow Freight Sys. v. United States, the Federal Claims Court stated:[16]
The Joint Committee explains that Congress enacted the research credit provision to encourage additional research and development believing that the nation’s edge in those areas had declined during the preceding years. Blue Book at 19. Plaintiff cites to the Blue Book for the proposition that Congress intended expenditures for development of computer software deductible under Revenue Proc. 69-21 to qualify for the research credit under § 44F. Blue Book at 124. Defendant cites to another passage, which states:
“For this purpose, the cost of developing computer software means costs incurred in developing new or significantly improved programs or routines that cause computers to perform desired tasks (as distinguished from other software costs where the operational feasibility of the program or routine is not seriously in doubt.)” Id.
Under Revenue Proc. 69-21 cited by plaintiff, “all the costs properly attributable to the development of software by the taxpayer” would be eligible for the research credit. Defendant defines the “costs properly attributable to the development of software” as those utilized in “developing new or significantly improved programs” only. Thus, in order [**16] for a research credit to be available, new or significantly improved programs must have been produced by plaintiff.
This creates a confusing interpretive issue. The notice introduces standards developed to identify software development costs eligible for old § 174 (and the research credit) while not explicitly requiring the resolution of uncertainty and a process of experimentation. Going further, the technological feasibility requirement that applies only to software for sale or license to others seems to suggest that even the resolution of uncertainty is still a necessary step to identify when software must be capitalized. A taxpayer-friendly way of viewing this is that they need everything but a process of experimentation before having to capitalize software development under new § 174. Whether Treasury agrees and further develops this line-of-thought remains to be seen. Another area of confusion relates to dual-purpose research.
Should taxpayers capitalize the costs of research, such as efficiency surveys or financial modeling or research, prior to the determination of whether to develop software based on that research? Perhaps a whether or which-type analysis should apply? Determining whether otherwise noncapitalizable research results in an idea that can be turned into software should not be capitalizable, but any research or planning after the point in time at which the decision to develop software has been made should be capitalized?
Contract Research
For the last two years, different Treasury officials have consistently maintained in informal comments that generally only one taxpayer in a contract research situation should have capitalizable costs in a contract research situation, at least absent a cost-sharing arrangement. It is not yet clear how well the notice tracks with this desire.
The notice introduces new terminology to handle contract research. The research provider is the taxpayer hired to do the research, while the research recipient is the company that hires the research provider.[17] The research recipient capitalizes costs using the traditional principles of the existing § 174 regulations.[18] A research provider generally only capitalizes if they are at financial risk for the cost of the research, but still must capitalize if they own the resulting intellectual property.[19] These rules seem designed to prevent a situation where no taxpayer capitalizes SREs, i.e., the situation described in Private Letter Ruling 9449003,[20] perhaps at the risk of double-capitalization.
Other Issues
The notice also addresses the following issues:
- As a general rule, basis recovery is not accelerated when a research project is sold or otherwise disposed of. [21] The taxpayer continues to amortize the SRE expenditures. This also applies in the § 351 context.[22]
- If a corporation ceases to exist in a § 381(a) transaction, the acquirer continues amortization using a step-in-the-shoes approach. If a corporation ceases to exist in a transaction not described in § 381(a), the remaining adjusted basis of the SRE expenditures is deducted.[23]
- In a taxpayer-friendly move, it appears Treasury will not be consistent with LAFA 20205301f, and the § 460 Percentage of Completion Method (PCM) will include only the amortization, not the fully capitalized amount, in computing the PCM.
- Treasury intends to issue guidance addressing cost-sharing arrangements under § 482 to provide that Cost Sharing Transaction (CST) payments owed to a controlled participant reduce the category of Intangible Development Costs (IDCs) borne by that participant that are required to be capitalized and also the category of IDCs borne by that participant that are deductible. The guidance would further provide that CST payments in excess of the payor’s Reasonably Anticipated Benefit (RAB) share in excess of the total amount of IDCs described above will be treated as income.
Request for Comments and Future Procedural Guidance
The IRS requested specific comments in a number of areas. This request for comments ranges from all of the areas directly addressed in the notice to issues around partnership dispositions to AMT to small businesses and start-ups to the reduced credit election. It is important to note that the IRS recognizes that § 280C(c) may provide that there is a reduction SRE expenditures only in the amount of the excess of the research credit over 10% of the qualified research expenditure amortization. Comments will be due November 24, 2023, suggesting that proposed regulations will likely not be available until 2024. Finally, the IRS provides that taxpayers may rely on the automatic change provisions in Rev. Proc. 2023-24 until such time as they issue procedural guidance specific to the notice.
State Conformity
As a final note, many states have decoupled from the federal treatment of §174 costs under the TCJA. For example, recently Georgia enacted Senate Bill 56 (S.B. 56) to update its conformity to the Internal Revenue Code. Georgia’s conformity is based on the IRC “as amended, provided for in federal law enacted on or before January 1, 2023.” This change applies to tax years beginning on or after January 1, 2022. Despite the general conformity to the Internal Revenue Code, S.B. 56 decouples Georgia from the federal treatment of R&E expenditures. Under the Tax Cuts & Jobs Act (TCJA) of 2017, the Internal Revenue Code required taxpayers to capitalize and amortize their specified research or experimental expenditures starting in 2022. Georgia will maintain the pre-TCJA treatment of R&E expenditures, which generally permits expensing in the year paid or incurred. Expensing treatment is generally more favorable for taxpayers.
[1] See generally Notice 2023-63, section 3.
[2] Notice 2023-63, section 4.02(1).
[3] Notice 2023-63, section 4.02(2) & (3).
[4] Notice 20223-63, section 4.02(4).
[5] Compare Notice 2023-63, section 2.01(3) with section 5.03.
[6] Notice 2023-63, section 4.0.3(3).
[7] Id.
[8] See generally Notice 2023-63, section 3.
[9] Notice 2023-63, section 3.06.
[10] Notice 2023-63,
[11] Cf. Notice 2023-63, section 1.
[12] Notice 2023-63, section 5.02(1) & (2).
[13] Notice 2023-63, section 5.02(1).
[14] Notice 2023-63, section 5.03(5).
[15] Notice 2023-63, section 4.01(3)(b).
[16] Yellow Freight Sys. v. United States, 24 Cl. Ct. 804, 809, 1991 U.S. Cl. Ct. LEXIS 594, *15-16, 92-1 U.S. Tax Cas. (CCH) P50,029, 70 A.F.T.R.2d (RIA) 92-5669 (Cl. Ct. December 30, 1991).
[17] Notice 2023-63, section 6.02(1) & (2).
[18] Notice 2023-63, section 6.02(3).
[19] Notice 2023-63, section 6.02(4).
[20] P.L.R. 9449003 (Aug. 25, 1994).
[21] Notice 2023-63, section 7.02.
[22] Notice 2023-63, section 7.05(1)(d).
[23] Notice 2023-63, section 7.04.
