Winter is Coming for Technology Companies Conducting R&D
Brace yourselves—winter is coming soon for companies conducting R&D in the U.S. and the battle will be harder fought for those performing R&D abroad, thanks to the Tax Cuts and Jobs Act (TCJA). Like the final outcome of the epic battles in HBO’s Game of Thrones, the journey to realize the full financial benefits of R&D tax credits will now require patience over many seasons and will be wrought with new plot twists.
While this was passed into law back in 2017, there are components that don’t come into effect for a few more years. However, action needs to be taken now to understand and prepare for these changes because not all of them are favorable, particularly for companies engaged in R&D activities. Software development companies should take special note, as they will be particularly affected.
Old v. New
Under the old rules, companies could expense research and experimental (R&E) costs immediately or choose to capitalize the expenses in accordance with Internal Revenue Code (IRC) Section 174 and amortize them over no fewer than five years. Most all companies today expense these costs as incurred to obtain an immediate tax deduction.
Under the TCJA, for tax years beginning after Dec. 31, 2021, R&E expenditures incurred must be capitalized and amortized ratably over a five-year period, beginning with the midpoint of the tax year they are incurred in. This is only for R&E expenditures incurred in the U.S.—if you’re spending money on R&D overseas, that amortization period jumps up to a staggering 15 years.
R&E Defined and the Impact to Software Developers
IRC Section 174(b) now defines R&E expenses as “specified research or experimental expenditures… which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.” Before TCJA amended the language, software developers could use Rev Proc 2000-50, which allowed for full expensing of software development costs. However, because TCJA amended the language of IRC Section 174 to read as ‘specified research and experimental expenditures’ and added a new special rule under IRC Section 174(c)(3) that any amount paid or incurred for software development is now ‘specified R&E expenditure’, software development costs will also have to be capitalized and amortized appropriately.
Consequences of TCJA
There are a few implications of this new capitalization rule:
- Businesses must file a Form 3115 – Change in Accounting Method to begin capitalizing and amortizing R&E costs arising in tax years beginning after Dec. 31, 2021.
- Businesses can no longer take an immediate deduction for R&E expenses and receive an immediate tax benefit from them.
- There will be added administrative burden to keep track of R&E expenses and their various amortization schedules in compliance with the TCJA.
However, as a result of these changes, the Research and Development Tax Credit becomes more valuable than ever. In addition to the capitalization rule, the TCJA also limits Net Operating Loss (NOL) deductions arising in tax years after Dec. 31, 2017 to 80 percent of taxable income. While NOLs now have an indefinite carryforward, the carryback provision was eliminated.
This means that companies need to be searching high and low for additional tax savings opportunities, and the R&D credit can provide them. If your company has R&E expenditures, you should already be taking advantage of the R&D tax credit, as these credits can offset actual income tax due. If you aren’t yet taking advantage of the R&D tax credit, Aprio can help you with you maximize your benefits from both the federal and state R&D credits.
What You Need to Do Now
There are several steps that you should consider and take immediate action towards:
- Consider when this law change goes into effect, will you be better off on-shoring your R&E? If so, be careful to not lock your off-shore R&E past Dec. 31, 2021. The result would be a five year versus a 15-year write off of R&E in the future, plus the on-shore R&E will increase your federal and state(s) R&D credit.
- Contact your Congressional representatives at Democracy.io to amend this provision. Simply enter your address and the website will pull a list of your representatives. We’ve even included some language you can utilize below, if you’d like. This will only take you 30 seconds.
I’m writing to voice my displeasure at the new Research and Experimentation capitalization rules under IRC §174 as a result of the Tax Cuts and Jobs Act. The rules I am most concerned with will require our company to capitalize all domestic R&D activities over five years and non-U.S. activities over 15 years. R&D is the lifeblood of the American economy and these new rules will have many negative consequences, including creating an increased administrative burden and compliance costs on businesses, and serving to discourage R&D activities and investment.
R&D should always be encouraged and never disincentivized. The Tax Foundation has determined that canceling these amortization rules would result in a .15 percent larger economy, .26 percent larger capital stock, .12 percent higher wages, and 30,600 full-time equivalent jobs. I implore you to help eliminate this change and restore the old rules so that the United States can continue to be a vanguard of innovation.
Some have suggested that if a software company is sold prior to this rule going into effect, the rule will not impact it. At Aprio, we have a different perspective, as we look at valuations of public and private technology companies. When this rule goes into effect, it will likely reduce the valuation of companies engaged in R&E. Any knowledgeable buyer will consider this rule’s impact as 2021 draws closer.
R&D tax credits still represent an attractive means to recapture costs to fund innovation. However to avoid the dragon’s fire of the Tax Cuts and Jobs Act, businesses must be prepared to act quickly and be in it for the long haul to gain the full benefit of this tax credit.
If you ever have any questions regarding the new amortization rules or R&D tax credits, please reach out to Carli McDonald, Partner-in-Charge of Aprio’s R&D Tax Credit Services group.