IRS Releases Interim Guidance on Amortization Section 174 Expenses

The Internal Revenue Services has released interim guidance to clarify the application of IRC Section 174 after the amendments made by the Tax Cuts and Jobs Act (TCJA). The TCJA requires taxpayers to capitalize Section 174 research and experimental expenditures (including software development costs) for tax years beginning after January 1, 2022 and amortize domestic expenditures over five years (15 years for qualified foreign expenditures).

Notice 2023-63, released on September 8, 2023, provides guidance on proposed regulations that address:

1. The capitalization and amortization of specified research or experimental (SRE) expenses under Section 174 and clarification on the midpoint for a short tax year;
2. The definition of SRE expenditures and software expenditures;
3. The treatment of SRE expenses under IRC Section 460;
4. The application of IRC Section 482 to cost sharing arrangements involving SRE expenditures;
5. The treatment of costs incurred for research performed under contract, and whether such costs qualify as SRE expenditures under Section 174; and
6. The treatment of costs under Section 174 in the event of disposition, retirement, or abandonment of property.

SRE Expenditures

The notice defines allowable SRE expenditures to include labor costs; materials and supplies; cost recovery allowances; patent costs; certain operation costs; management costs; and travel costs. It includes examples to illustrate cost sharing arrangements involving allowable SRE expenditures. The notice also outlines costs that are excluded from being treated as SRE expenditures, including:

• General and administrative service department costs
• Interest on debt financing for SRE activities
• Costs for activities related to computer software described in section 5.05 of the notice
• Costs related to website hosting and inputting content into website
• Certain specific activities listed in Treas. Reg. § 1.174-2(a)(6)(i)-(vii)
• Amortization amounts for specific expenditures

Allocation Methods

Notice 2023-63 walks through allocation methods to determine total SRE expenditures for a taxable year based on a reasonable relationship that links the costs to the SRE activities. For example, a company might determine that the manufacturing or accounting departments are not SRE activities, as they do not, or only indirectly, support or benefit SRE activities. The company might then allocate the costs directly linked to SRE activities on the basis of total labor hours spent on such activities or on the relative square footage of each department.

Allocation methods can vary based on the type of costs and activities but must be consistent. The methodology for allocation ratios must be based on the cause-and-effect relationship between the cost and the SRE activities or another relationship that reasonably relates the costs to the benefits provided to the SRE activities. For example, a company might allocate facility cost recovery allowances by the ratio of the square footage of the area used to conduct or directly support SRE activity to the total square footage of the facility.

Expenditures that are defined as SRE expenditures must be treated as SRE expenditures for all other purposes. These expenditures may not be treated as ordinary and necessary expenses under IRC Section 162 or capitalized under IRC Section 195, IRC Section 263(a), IRC Section 263A, or IRC Section 471. The amortization deductions arising from such SRE expenditures must also be allocated and apportioned consistent with the rules under Treas. Reg. §1.861-8 and Treas. Reg. §1.861-17.

Software Development

The notice includes the definition of “software development activities” under IRC Section 174(c)(3). The term “computer software” under the notice generally means any computer program or routine that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine.

Computer software generally includes system software, programming software, application software, embedded software, and all forms and media in which the software is contained. Computer software also generally includes computer programs of all classes. The notice also defines upgrades and enhancements, activities that are treated as software development, software development activities related to purchased computer software, and computer software developed for sale or licensing to others.

Activities Excluded from Software Development

The notice also lists two broad categories of activities that are not treated as software development:

1. computer software developed by a taxpayer for use in its trade or business and
2. computer software developed for sale or licensing to others.

Computer software that is developed, upgraded, or enhanced by the taxpayer in its trade or business includes several activities. These include:

• Training employees and other stakeholders that will use the software;
• Maintenance activities after the software is placed in service that do not give rise to upgrades and enhancements (for example, maintenance to debug, diagnose, and fix programming errors);
• Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion; and
• The installation of the software and other activities relating to placing the computer software in service.

Computer software that is developed, upgraded, or enhanced for sale or licensing to others also includes several activities that are not treated as software development. These include:

• Activities that occur after the software (or upgrades and enhancements to such software) is ready for sale or licensing to others (for example, marketing and promotional activities);
• Maintenance activities that do not give rise to upgrades and enhancements;
• Distribution activities (for example, making the software available via remote access); and
• Customer support activities.

Costs Paid or Incurred for Research under Contract

The notice clarifies the treatment of costs paid or incurred for research under contract. For the purposes of the proposed rules, a research provider is the party that contracts to perform research services or develop SRE product for a research recipient. A provider may incur SRE expenditures under the contract if the provider both bears financial risk under the terms of the contract and has a right to use the SRE product in its own trade or business or otherwise exploit through sale, lease, or license.

Impact of Corporate Cessation on SRE Property

The notice provides rules on the disposition, retirement, or abandonment of SRE property, depending on whether the cessation occurs in a transaction described in IRC Section 381(a). If a corporation ceases to exist for Federal income tax purposes in a transaction or series of transactions described in Section 381(a), the acquiring corporation will continue to amortize the distributor or transferor corporation’s unamortized SRE expenditures over the remainder of the distributor or transferor corporation’s applicable Section 174 amortization period beginning with the month of transfer. If a corporation ceases to exist for Federal income tax purposes in a transaction or series of transactions to which Section 381(a) does not apply, the corporation is allowed a deduction equal to the unamortized SRE expenditures in its final taxable year.

Effective Date

This notice applies to tax years ending after September 8, 2023, so it is not binding for taxpayers with tax years ending prior to that date. However, it is important to note that even if this guidance is not relied upon to determine Section 174 costs for tax years ending prior to September 8, 2023, the Section 174 amortization requirement still applies to all 2022 tax returns. Until the Treasury Department and IRS issue finalized regulations, taxpayers may rely on the interim guidance in the notice. The Treasury Department and IRS also intend to issue guidance providing procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with the notice. Until then, taxpayers may rely on Section 7.02 of Rev. Proc. 2023-24 to change their methods of accounting under Section 174 to comply with the notice. Notice 2023-63 does not change the rules for determining eligibility for, or computation of, the research credit under IRC Section 41.

The IRS is seeking comments on specific issues and issues not addressed in this Notice by November 23, 2023.

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