The Tax Cuts and Jobs Act of 2017 (TCJA) brought the most comprehensive update of US tax law since the 1986 tax reform passed under President Reagan. The heart of the TCJA was a permanent reduction in the corporate tax rate from around 35% to 21%. The TCJA was also seen as beneficial to the Research and Development (R&D) tax credit, as the credit remains permanent while a significant number of other credits and deductions have been eliminated to pay for the lowered tax rates. In addition, the reduction in corporate tax rates resulted in a welcome increase in the value of the reduced R&D tax credit.
However, the law buried a change in the treatment of tax deductions in accordance with Section 174 from tax years beginning after December 31, 2021. Prior to the TCJA, Section 174 offered taxpayers the ability to record R&D expenses immediately as an expense pursuant to Section 174 (a) or, pursuant to Section 174 (b), to choose to treat these expenses as deferred expenses and the costs over a period of time to be settled for at least 60 months, starting with the month in which the taxpayer realizes benefits from these expenses for the first time. This allowed taxpayers’ tax planning options to either use the deductions in the current year or to defer them depending on their facts and circumstances. In addition, Section 174 (f) (2) taxpayers could choose to write off expenses over a 10 year period under Section 59 (e) that would otherwise be eligible as a Section 174 (a) deduction.
For tax years beginning after December 31, 2021, the new legislation in the TCJA removes the option to currently deduct R&D expenses and requires taxpayers to debit them to a capital account and amortize them over five tax years from the mid-tax year in which the stated research or experimental expenses are paid for or incurred (Section 174 (a)). Changed Section 174 also requires expanded amortization in cases of retired, abandoned, or sold property for which certain research or experimental expenses are paid or incurred, thereby denying immediate deduction in the event of retirement, abandonment, or sale. As an additional blow to foreign research, the payback period is extended to 15 tax years.
Taxpayers who have used Revenue Procedure 2000-50 to either incur software development costs or to amortize them over 36 months are also unlucky. The new language in section 174 (c) (3) states that any amount paid or incurred in connection with the development of software will be treated as research or testing and will be forced into the five year payback period.
With changes coming in 2022, taxpayers should start developing tax planning strategies to minimize the negative impact of the new depreciation rules. In previous years, many taxpayers were able to incur costs incurred under either Section 162 for normal and necessary business expenses or Section 174 (a) without major tax consequences. From 2022 onwards, due to the new timing differences, taxpayers will have to pay close attention to the characterization of the expenditure between the two code sections. To the extent that costs for the R&D tax credit under Section 41 cannot be taken into account, they should also be checked if they can also be excluded for Section 174 based on the definitions in Treasury Regulation 1.174-2 in order to include these amounts in the Year to be offset in accordance with Section 41, Section 162.
In addition, the amended Section 174 may affect organizations that have never previously used the research and development tax credit due to net operating losses (NOLs) or funding issues. These taxpayers will now be forced to determine whether their costs incurred should be amortized and not recognized as an expense.
Due to the late entry into force of the amendments to Section 174, taxpayers still have a short window of opportunity to continue using the current spending on research or experimental spending under Section 174 (a). As a result, taxpayers with planned R&D activities should consider accelerating this spending to before 2022. While the taxpayer pays for these expenses a year earlier, in many cases the immediate deduction can provide a significant time value of the money saved. Consider the following table that illustrates the treatment of the $ 50,000 expenses incurred in 2021 and 2022 under Section 174:
Taxpayers should also reconsider the division of R&D activities in the US and overseas. While offshore locations are often touted for cheaper labor compared to the US, the changes in Section 174 provide compelling reasons to relocate R&D activities. Carrying out R&D activities in the US will reduce the payback period from 15 years to five years. Moving operations to the US also allows the spending to be eligible for the research and development tax credit, adding to the funds available for future discoveries.
While taxpayers and tax advisors continue to focus on tax compliance compliance for the 2020 tax year, it would be wise for them to consider the impact of the upcoming changes to Section 174. Taxpayers should be ready to deal with a higher taxable income of 90% in 2022. Expenses according to § 174 will be deferred for tax purposes in future years compared to the previous full expense allowance. To the extent that it makes economic sense to accelerate R&D spending by 2021, these costs would be treated preferentially for most taxpayers than in 2022.
There are currently legislative proposals in Congress to amend the upcoming onerous changes to the rules in Section 174. A Senate bill dated March 16, 2021, The American Innovation and Jobs Act, by Sens. Margaret Hassan (DN.H.), Todd Young (R-Ind.), Catherine Cortez Masto (D-Nev.) Was introduced. Rob Portman (R-Ohio) and Ben Sasse (R-Neb) would allow companies to file for full research and development tax credit immediately within one year under Section 174. This would repeal a provision in the Tax Cuts and Employment Act of 2017 that provided for it.From 2022, companies will have to spread research and development deductions over a five-year period. This bill is a great opportunity to demonstrate non-partisanship.
A similar bill was passed in the House of Representatives on February 24th by Representatives from John Larson (D-Conn.), Ron Estes (R-Kan.), Jimmy Panetta (D-Calif.) And Darin LaHood (R-Ill.) .), Suzan DelBene (D-Wash.), And Jodey Arrington (R-Texas). Legislators on both sides want to reach an agreement on R&D spending, and it would be helpful if an agreement could be reached before the last minute dash that comes with a year-end deal. Everyone recognizes the benefits of successfully resolving this problem, as successfully resolving this problem can continue to contribute to an economic recovery once the economy emerges from the pandemic.
An important lesson to be learned from the 2020/2021 Covid-19 pandemic is the need to reassess the U.S. supply chain so that we are not overly dependent on one country. One of the best weapons to do this is to catalyze the growth of U.S. R&D in STEM and manufacturing. Since research and development is the most effective way to invest in and strengthen future economic growth, this legislation should be welcomed by all. One of the best weapons to achieve that independence is to catalyze the growth of U.S. R&D in STEM and manufacturing. Strengthening research and development will encourage the development of breakthrough technologies and skills that will fuel future economic growth. This legislation should be welcomed by all.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Yair Holtzman is a partner and head of the Tax Credit and Research Incentive Practice at Anchin Block & Anchin LLP.
Gleb Gorkhover is Senior Manager of R&D Tax Credits and Incentives at Anchin Block & Anchin LLP.
Bloomberg Tax Insights articles are written by seasoned practitioners, academics and policy makers to discuss developments and current tax issues. To make a contribution, please contact us at TaxInsights@bloombergindustry.com.