IRS Notice 2023-63: Clarification on Section 174 Rules

The Internal Revenue Service (IRS) issued Notice 2023-63 to provide interim guidance on the treatment of specified research or experimental (SRE) expenditures. This guidance was necessary after the Tax Cuts and Jobs Act of 2017 (TCJA) made changes to Internal Revenue Code Section 174. The notice clarifies new rules that require the capitalization and amortization of these costs, a departure from previous tax practice, and provides a framework for businesses to follow until formal regulations are released.

Background on Section 174 Changes

Prior to the TCJA, businesses could elect to immediately deduct research and experimentation costs in the year they were incurred. This long-standing rule was altered for taxable years beginning after December 31, 2021. The TCJA eliminated the option for immediate expensing and instead mandated that all SRE expenditures must be capitalized and amortized.

This means businesses must now treat these costs as an asset and deduct them over a period of years. The amortization period depends on where the research activities take place. For research conducted within the United States, costs must be amortized over a five-year period. For research conducted outside of the United States, a fifteen-year amortization period applies. This shift from immediate deduction to mandatory amortization created uncertainty that prompted the IRS to issue clarifying guidance.

Key Provisions of Notice 2023-63

Notice 2023-63 provides clarity on several aspects of the new Section 174 rules. The guidance addresses the scope of SRE expenditures, the treatment of software development costs, and rules for handling property that is sold or retired.

Scope of SRE Expenditures

The notice provides a broad definition of what constitutes an SRE expenditure. It specifies that SRE expenditures include not only direct research costs, such as wages for researchers and supplies, but also many indirect costs. These can include rent, utilities, insurance, and depreciation for facilities and equipment used for research, as well as certain overhead expenses. The guidance also outlines costs that are excluded from the definition, such as general and administrative service department costs that only indirectly support research activities, quality control testing, and management studies.

Software Development Costs

One of the most significant clarifications relates to software development. The TCJA specified that costs incurred in connection with software development are treated as SRE expenditures. The notice elaborates on this, providing examples of activities that fall under this definition. These activities include planning, designing, coding, and testing the software up until the point it is either placed in service for internal use or is ready for sale to customers.

Disposition, Retirement, or Abandonment

A point clarified by the notice is the treatment of unamortized SRE expenditures when the underlying property is disposed of, retired, or abandoned. The notice states that taxpayers cannot immediately write off the remaining unamortized balance. Instead, the taxpayer must continue to amortize the costs over the remainder of the five-year or fifteen-year period, even after the associated property is no longer in service. This rule impacts the calculation of gain or loss on such transactions.

Interaction with Long-Term Contracts

The notice also addresses the interaction between the new Section 174 rules and the accounting methods for long-term contracts under Section 460. For businesses that use methods like the percentage-of-completion method, the guidance clarifies how SRE expenditures fit into this framework. Under the notice, only the amortization amount for that specific year is considered a cost allocable to the contract, not the entire SRE expenditure.

Short Taxable Years

Finally, the notice provides rules for handling amortization in a short taxable year, which is a tax year of less than 12 months. The guidance explains that the amortization deduction for a short taxable year must be prorated. The deduction is calculated based on the number of months in the short taxable year, following the same principle as the mid-month convention used for the regular amortization calculation.

Accounting Method Change Procedures

To comply with the mandatory capitalization rules, many taxpayers must change their method of accounting. The IRS has established procedures for obtaining automatic consent for this change. For the first taxable year beginning after December 31, 2021, the IRS provided a simplified option. Instead of filing a full Form 3115, Application for Change in Accounting Method, taxpayers could attach a statement with the required information to their tax return.

For taxpayers making the change in a later year, the process requires filing a Form 3115 to get automatic consent. The change applies only to expenditures paid or incurred in taxable years beginning after December 31, 2021.

Implications for Taxpayers

The mandatory amortization of research expenditures has financial consequences for businesses. By deferring deductions over five or fifteen years instead of taking them immediately, companies face several impacts.

• An increase in taxable income compared to the prior law, which leads to a higher current tax liability.
• A direct effect on cash flow management, as a larger tax bill leaves less cash available for operations, investment, and innovation. Businesses must adjust their quarterly estimated tax payments to avoid underpayment penalties.
• A need to implement robust internal cost accounting systems to meticulously track and segregate all costs that fall under the definition of SRE expenditures, including both direct and indirect costs.
• The creation of book-tax differences, which occur when SREs are capitalized for tax purposes but may be expensed for financial reporting. These differences must be tracked, leading to deferred tax assets or liabilities on the company’s balance sheet.