Will You Be Able to Immediately Expense R&D Costs in the Future?|
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At a glance
- The main takeaway: The tax legislation passed in 2017 removed the immediate expensing of R&D costs beginning January 1, 2022.
- What this means for you: With the end of 2021 fast approaching, businesses that incur foreign and domestic R&D costs need to understand how this change may affect their tax situation if Congress does not remove the provision.
- Next steps: Call your Congressional representative to ask for the amortization provision to be removed completely and contact Aprio for help with understanding what it means from a tax standpoint.
The full story:
Like many aspects of life, tax code changes are inevitable in the United States — and some of those changes have a greater impact than others. Many of the current proposals in the House and Senate have received a lot of press, but there is one proposal that has not risen to the forefront.
Tax deductibility of R&D expenses
Under current tax law, research and development (R&D) costs are fully deductible in the year incurred; software development costs are included in the definition of R&D.
In the 2017 tax legislation, Congress included a provision stating that R&D expenses for all taxpayers must be amortized over five years for domestic costs and over 15 years for nondomestic costs, starting with the years following December 31, 2021. Since the 2017 legislation did not apply until 2022, many taxpayers and practitioners have not focused on the change, but the end of 2021 is only a few months away.
How does this change affect your company?
Assume your U.S. company has a 100% foreign subsidiary that performs R&D; for U.S. purposes, those costs will have to be capitalized for income taxes and expensed over 15 years, while the foreign subsidiary will continue to recognize income as earned.
While an income tax expense on a financial statement may not change due to the accounting for deferred income taxes, we expect that companies will have to use cash to pay taxes that otherwise would be used to perform more R&D. The impact of this change might not be visible on a company’s financial statement; rather the footnotes to the financial statement will disclose the impact of the change on cash flow.
Will the public and private markets value companies differently because of this change? In leveraged and unleveraged M&A deals, there has always been an assumption that these costs are fully and immediately deductible to obtain a tax benefit.
Let’s look at an example and assume the following to see the impact of this change hypothetically:
- A company has taxable income of $10 million under the current tax
- The company incurs $4 million per year for R&D costs with 50% domestic and 50% foreign
- Under current tax law, those costs are fully deductible
- Starting with the 2022 tax year:
- The company spends $2 million on domestic R&D — of this amount, $400,000 will be deducted from taxable income and the remaining amount, or $1.6 million, will be expensed over the following four years
- The company spends $2 million on foreign R&D — of this amount, $133,333 will be deducted from taxable income and the remaining $1.867 million will be expensed over the following 14 years
If we consider a federal corporate tax rate change from 21% to 28%, that represents a 29% increase — and if your company has an R&D profile like the one below, your total increase in tax will be 77%.
The bottom line
With bipartisan support, the House originally included a provision to remove the five-year amortization set to begin in 2022; they did not address foreign R&D costs, which would still have to be expensed by companies over 15 years. In the Democratic version of the provision released on September 13, the R&D amortization requirement was not removed but delayed until tax years beginning after December 31, 2025.
While you should applaud the House for adding this delay, we strongly suggest you contact your Congressional representatives and ask for the domestic and foreign amortization provisions to be removed completely, especially for small businesses.
If you have any questions about the provision and how it affects your business, schedule a free consultation with our team today.