New R&D Expense Amortization May Hurt Cash Flows, Valuations

August 7, 2018

Research and development, which is the lifeblood that keeps many companies competitive, will soon lose some of its advantageous tax treatment and that change may crimp cash flows and depress valuations.

A new provision in President Donald J. Trump’s tax reform law requires R&D expenses to be amortized over five years instead of all at once starting in 2022. R&D conducted outside of the U.S. must be amortized over 15 years.

Currently, companies can claim a tax deduction for all of their R&D expenses in the same year the cost was incurred, which gives them an immediate benefit and encourages reinvestment.

While the change was meant to incentivize long-term R&D projects and bolster federal revenue coffers, critics warn that it effectively inflates the cost of investing in research and diminishes cash flow.

“Requiring amortization for research will hit the bottom line hard for innovative companies – and will discourage both basic and applied research,” former U.S. Rep. Rick Lazio, a Republican from New York, wrote in an opinion piece published in The Hill.  “It eats into the seed corn of future improvements and inventions that will continue to propel strong economic growth for our country.”

One chief financial officer who is already worrying about the change is Andrew Brown of online textbook rental company Chegg Inc. The Santa Clara, California-based firm spent $82 million on R&D last year as it invested in new technology and new products.

“This gives me much anxiety,” Brown told The Wall Street Journal. “This will be a major change.”

$120 Billion Crunch

For decades, R&D has received more generous tax treatment than almost any other category of business expenses. In addition to deducting those expenses immediately, many businesses also qualify for large R&D tax credits.

Those powerful incentives entice companies to plow billions of additional dollars into R&D and experimentation, which leads to innovation, new knowledge and economic growth, according to the Tax Foundation.

The R&D amortization change is expected to raise $120 billion in federal revenue over the next decade, according to estimates by The Joint Committee on Taxation. Download their report here, and see the bottom of page 3 for the R&D amortization estimate.

That illustrates the scope of the impact on companies who might otherwise have reinvested that money and will see their cash flows diminished, the Tax Foundation says.

Some experts say it’s likely that lawmakers amend or eliminate the R&D amortization provision before the change kicks in.

“Many of my former colleagues will consider the amortization of R&D as a placeholder that will never see the light of day,” Lazio wrote in The Hill.

The Tax Foundation also thinks the provision will be changed.

“One straightforward option for lawmakers would be to simply cancel the scheduled requirement…and allow businesses to continue deducting their research costs immediately,” Scott Greenberg, a senior analyst at the Tax Foundation’s Center for Federal Tax Policy, wrote in March.

What You Should Do

Executives should call their congressional representatives and share their views on how the R&D amortization change will impact their business, and whether they wish to see it modified or eliminated before 2022.

In the meantime, taxpayers should evaluate the impact of the new rules and study their own programs to make sure they can isolate and break out R&D costs. They may need to tweak their financial reporting systems, or file additional tax schedules such as those used to track net operating loss (NOL) carryforwards.

These things are another hidden cost of the new amortization rule and the complexities that go along with it, according to The Wall Street Journal.

As 2022 draws near, companies may be surprised to find it necessary to set aside cash or obtain a new or larger bank loan to cover higher tax obligations when the new rules take effect.

Diminished cash flow as a result of five or 15 year write-offs, along with higher debt costs, could, in turn, hurt the overall valuation of a company.

Companies who outsource R&D to locations outside the U.S. may want to review the cost benefit of a future write-off over 10 more years, after which, the offshore savings may start to evaporate.

That’s especially true if a company happens to be an acquisition target, or is trying to raise new funding or new corporate debt. It’s possible that some companies will see borrowing costs tick upward if lenders require a higher interest rate in exchange for modified debt covenants or larger loans to cover the decrease in cash flow.

Companies that are expensing R&D costs should also be sure that they are taking advantage of all the relevant R&D tax credits they are eligible for, which can help offset the impact of the looming 5-year amortization change. R&D credits can carry forward for 20 years, making them a great offset against future obligations.

Lastly, companies who invest significant amounts domestically or internationally should lobby their congressional representatives now, before the rule takes effect in 2022.

To Recap

The sweeping changes in Trump’s tax reform law include a provision that will require companies to amortize R&D expenses over five years, instead of in the year incurred, starting in 2022.

This extended write off period may squeeze cash flows and diminish valuations, especially for companies that might be acquired. It could also increase borrowing costs.

Companies should call their congressional representatives and express their views on the change. They should also review their R&D programs and expenses, make sure they are taking advantage of R&D tax credits and consider accelerating R&D projects before the new rule takes effect.

Learn more information on the R&D tax credit.