Research and experimental (R&E) expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be immediately deductible for tax purposes under the 2017 Tax Cuts and Jobs Act (TCJA). R&E expenditures are now required to be capitalized and amortized over a period of five years for research conducted within the US or 15 years for research conducted overseas.
Previous rules allowed an immediate deduction, but under the new mandatory capitalization rules amortization of R&E expenditures now begins from the midpoint of the taxable year in which the expenses are paid or incurred, resulting in a negative year 1 tax and cash flow impact.
For example, a company invests $25 million in qualified R&E in 2022. Prior to the TCJA amendment, the business could have immediately deducted the entire $25 million on its 2022 tax return. Under the new rules, the company will be entitled to deduct amortization expense of $2,500,000 in 2022, calculated by dividing $25 million by five years, and then applying the midpoint convention. The example’s decrease of $22.5 million in year 1 deductions demonstrates the gravity of the new rules for those investing heavily in technology and/or software development.
Overseas R&E Activities
R&E expenditures incurred for actions abroad are subject to an amortization period of 15 years. Outsourcing R&E and software development overseas is common. The new rules may impact taxpayers currently incurring these costs abroad significantly more than their counterparts conducting R&E activities in the US. The tax impacts of the longer 15-year recovery period should be carefully reviewed when looking at the cost savings from moving R&E activities internationally.
Impact on Financial Reporting under ASC 740
Taxpayers need to keep in mind the mandatory capitalization rules’ impact on their tax provisions. In general, the addback of R&E expenditures in situations where the amounts are deducted currently for financial reporting purposes will create a new deferred tax asset. Although the book/tax disparity in the treatment of R&E expenditures is considered a temporary difference (the R&E amounts will ultimately be deducted for tax purposes), the ancillary effects of the new rules may have other tax impacts, such as on the calculation of Global Intangible Low-Taxed Income (GILTI) inclusions and Foreign-Derived Intangible Income (FDII) deductions, which typically give rise to permanent differences that increase or decrease a company’s effective tax rate. If there is an increase in taxable income, the US valuation allowance assessment for deferred tax assets might also be affected. Additionally, changes to both GILTI and FDII amounts must be accounted for in valuation allowance assessments since they impact profitability projections.
The resulting increase in taxable income from the new mandatory capitalization rules for R&E expenditures will probably affect the computation of quarterly estimated tax payments and extension payments owed for the 2022 tax year. Taxpayers with net operating loss carryforwards should also bear in mind the new rules’ tax implications, as more net operating losses (NOLs) may be used than anticipated in 2022 and beyond. They may end up in a taxable position if the deferral of the R&E expenditures is material (or if NOLs are limited under Section 382 or the TCJA). In such cases, businesses might look at other tax planning opportunities, such as conducting an R&E tax credit study or looking at their eligibility for the FDII deduction, which might lower their overall tax liability.
Navigating the complexity of the changes to the tax treatment of R&E expenditures can be difficult. The team at MarksNelson can help guide you through the process, documentation, and efforts to reduce overall tax liability.