Optimizing R&D Taxation in the US Market

Optimizing R&D Taxation in the US Market. Businesses are still grappling with the recent alteration to the Section 174 capitalization tax law, which mandates that R&D expenses be capitalized and amortized for tax years starting after December 31, 2021. Under this change, research costs incurred within the country must be spread over five years, while those for foreign R&D are spread over fifteen.

This change in tax legislation has increased financial pressure on many companies
involved in R&D. Former Section 174 allowed taxpayers to:

Elect to deduct research or experimental expenditures paid or incurred in connection with a trade or business as currently deductible expenses.
Capitalize and amortize such expenditures over a period of not less than 60 months, OR
Charge such expenditures to capital account.

The IRS issued Notice 2023-63, which offers substantial guidance on how to implement the Section 174 capitalization requirements after December 31,2021. This notice provides details on the wide array of R&D costs covered by Section 174 and addresses potential issues related to double capitalization.

“(1) Requirement to capitalize and amortize SRE expenditures. Section 13206(a) of the TCJA amended former § 174 for amounts paid or incurred in taxable years beginning after December 31, 2021. For such amounts, § 174(a)(1) disallows deductions for SRE expenditures, except as provided in § 174(a)(2).

Section 174(a) (2) requires taxpayers to charge SRE expenditures to capital account and allows amortization deductions of such capitalized expenditures ratably over the applicable § 174 amortization period, beginning with the midpoint of the taxable year in which such expenditures are paid or incurred”.

What does this all mean for business?

For example, consider a company with $2 million in revenue in, $1 million in qualified research and development costs, and $1 million in other deductible expenses. Under the previous system, the company would have no profit and would owe no income taxes.

However, with the recent alterations to Section 174, the company can now only deduct $100,000 from its research costs. Consequently, the company (or its owners) would owe federal income taxes on $900,000 of taxable income.

What are SRE Expenditures?

The IRS defines SRE Expenditures as research and development cost in an experimental or laboratory sense, which includes all costs that are incident to the developing or improvement of a product. Additionally, SRE Expenditures, such as labor cost of employees and independent contractors, directly relates to research activities. Some Cost of Materials and Supplies, Patent Cost ant etc. must be capitalized and amortized under Section 174 over 5 or 15 years.

Notice 2023-63 also provides list of SRE Expenditures that are excluded from amortization rules, such as General and Administrative Services ( like human services, accounting services), Interest on Debt, Some Website costs, Quality Control Testing, etc. Taxpayers incurring SRE Expenditures should review their internal accounting procedures to ensure they properly differentiate between ordinary and necessary expenses under IRS Section 162 and Section 174.

Notice 2023-23 includes a few important regulations that must be considered by any taxpayer having SRE Expenditures:

Accounting method changes
Amortization for short-tax year
Software used in SRE Activities
Disposition, retirement, or abandoned
Merges, acquisitions, and dissolutions
Cost Sharing Arrangements
Research Credit

SMAR GLOBAL company accepted the challenge. We held a series of consultations with our fellow accountants and businessmen, on the basis of which we were able to build the right strategy for our partners. Our development today includes a list of recommendations and techniques for companies that are looking for a competent approach and optimal solutions to this problem at the international level! And our team is happy to help you!