Democratic leaders announced today that a deal has been reached to fund pending infrastructure and budget reconciliation measures. There does not appear to be an agreement on the specific tax measures that will be included, however, it is hoped that the continued deductibility of research and experimentation (R&E) expenses will be included.
Treatment of R&E expenditure under section 174
Section 174 allows taxpayers to currently deduct, or elect to amortize, R&E expenses paid or incurred in tax years beginning before January 1, 2022. R&E expenses eligible for the purposes of the section 174 include those paid or incurred for research carried out by the taxpayer as well as research carried out by certain third parties on behalf of the taxpayer. An impending change to section 174, brought about by the Tax Cuts and Employment Act 2017 (TCJA), subjects R&E costs to mandatory capitalization and amortization over five years (15 years for the foreign research) for tax years beginning after December 31, 2021.
Legislative Consideration to Extend the Deductibility of R&E Expenses
According to the Biden administration’s green paper, released on May 28, 2021, which declared its intention to “encourage R&E”, various policies could be implemented to achieve this goal. Democrats on the Ways and Means Committee initially took an approach proposed by Rep. John Larson (D-Conn.) In February 2021 as part of a bipartisan effort to retain deductibility of R&E costs. In a letter to the House, Representative Larson urged the House to temporarily extend the immediate deductibility of R&E costs under section 174, explaining that “a four-year deferral of the requirement [to capitalize and amortize R&E costs] would result in a relatively minor revenue charge over the 10-year budget period, as most expenses would have been amortized over the period under current law. Rather than extend the pre-TCJA law and permanently allow a full deduction of R&E expenses for the current year, the Ways and Means Committee proposed the four-year extension for the expenditure. immediate of these costs advocated by Representative Larson. The four-year extension amounts to a compromise that is likely attributable to the directive in the budget reconciliation rules to assess an element of cost to the federal government within the prospective ten-year budget window. The cost of a permanent extension has been estimated to be around $ 124 billion, while the four-year extension is less expensive. Specifically, the Joint Committee on Taxation estimates that the approach proposed by the Ways and Means Committee would cost the federal government $ 125.2 billion over the next four years, but only $ 4 billion overall. the ten-year budget window.
The tax policy that underlies a taxpayer’s ability to expense R&E costs in full for the current tax year is that it would encourage investment in technology and innovation, and stimulate investment in technology and innovation. economy by promoting job creation. Studies support the conclusion that deductible R&E costs lead to increased investment in research, leading to trademarks, copyrights, patents and industrial innovations. R&E activities in the United States have directly led to the development of jets, satellites, semiconductors, the Internet, MRIs and breakthrough drugs to treat cancer, heart disease, and more. and other diseases. According to the Tax Foundation, the treatment of deductions for R&E costs would increase long-run GDP by 0.1%, capital stock by 0.2%, wages by 0.1%, and lead to around 19,500 additional full-time equivalent jobs. Representative Larson cited a recent Ernst & Young economic study supporting the proposition that a four-year delay in the requirement to capitalize and amortize R&E costs would promote job growth. The study specifically found that a four-year extension would result in an additional investment of $ 50 billion in R&E and support, on average, 167,000 jobs per year. In light of the economic impact of the COVID-19 pandemic on the number of jobs in the United States, this favorable impact on job growth could not be more timely. In addition, according to Representative Larson, the temporary nature of the proposed extension is expected to affect taxpayer behavior and lead to an acceleration in R&E costs within the four-year period.
Maintain historical deduction for R&E expenses
Requiring the capitalization and amortization of R&E costs, rather than allowing an immediate deduction for the current year, also runs counter to the historical tax treatment of these expenses from a national and international perspective. R&E expenses have currently been deductible since 1954, with the aim of removing uncertainty about the tax treatment of R&E expenses and to encourage taxpayers to engage in research activities. The mandatory capitalization and depreciation of R&E expenses would mark the first time that R&E expenses have not been deducted immediately in almost 70 years. The trend in OECD countries to allow immediate expensing of such expenditures or a more generous treatment in the form of “super-deductions” worth more than 100% of the value of the research and development investment is perhaps -be more meaningful.
Legislative considerations for treating domestic and foreign R&E expenditure differently
For the United States to remain competitive in the global R&E environment, the immediate expensing of R&E costs, or a close corollary thereof, is a necessity. Interestingly, as a result of the changes made by the TCJA, there appears to be a divergence in the benefit accorded to firms performing R&E expenditures, with more favorable treatment accorded to firms performing R&E expenditures over United States. Under the TCJA, while domestic R&E expenses must be capitalized and amortized over five years for tax years beginning after December 31, 2021, overseas R&E expenses must be amortized over fifteen years. As legislative proposals progress in the Senate, it will be interesting to monitor the evolution of this difference in treatment, especially with so many references to rebuilding our national infrastructure. Depending on the underlying cost, there are a number of alternatives to consider, including deferring changes to the TCJA specifically for national R&E spending, thus strengthening the Administration’s ‘build back better’ initiative. .
Accounting Policy Considerations Implied by the Imminent Change to Section 174
The impending change to section 174 also has implications for a taxpayer’s accounting method. For amounts paid or incurred in tax years beginning after December 31, 2021, any amount paid or incurred in connection with the development of any software will be treated as an R&E expense for the purposes of section 174. Under of the Rev. Proc. 2000-50, software development costs can be either (i) treated as expenses and deducted in the year paid / incurred, or (ii) amortized and prorated over a period of at least 60 months from from the date of completion of development or 36 months from the date the software was put into service. The TCJA provides that the change to a five-year amortization period constitutes a change in accounting policy. If the provisions of the TCJA come into effect, the changes to section 174 will be treated as a change in accounting policy for purposes initiated by the taxpayer with the consent of the IRS. This change in methodology could impact taxpayers in the context of the review, and the approach the Service will take to address this issue is unclear.
As of this point, the bill is being assessed by the Senate, where members of the Senate Finance Committee previously issued a bill reorienting the FDII deduction with the apparent aim of bolstering activity. of R&E. While the Senate can go ahead with its initial proposal, negotiation and final enactment will likely depend on minimizing the overall cost of the package. From a cost perspective, the Ways and Means Committee’s approach would appear favorable. Taxpayers should be aware of the uncertainty surrounding section 174 and watch what is sure to be an interesting negotiating process. However, according to the recent proposal of the Ways and Means Committee, R&E expenses would remain immediately deductible in full for the current tax year.