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TAX CLINIC

and apportionment rules for R&E ex-
Amended Sec. 174 requires capitalization of penditures under Regs. Sec. 1.861-17.
R&E expenditures and software development Cost sharing
costs and recovery through amortization Issues may arise under amended Sec.
over a five-year period (15 years for foreign 174 with respect to certain cost-sharing
arrangements subject to Sec. 482, for
research) for costs incurred in tax years example, between a U.S. parent that
beginning after 2021. incurs U.S.-based R&E expenses and a
controlled foreign corporation (CFC)
that reimburses the parent for the
amortization over a five-year period (15 ■ The extent to which overhead costs CFC’s share of the cost-shared R&E
years for foreign research) for costs in- are considered Sec. 174 expenditures; expenditures. In a typical cost-sharing
curred in tax years beginning after 2021. and arrangement, the CFC reimbursement
The current deduction under Rev. Proc. ■ How domestic and foreign research would reduce the R&E expenditures
2000-50 and the annual election under activities are distinguished from one reported by the U.S. parent such that the
Sec. 59(e) to recover R&E expenditures another for purposes of determining U.S. parent would report its income and
over 10 years no longer are available for whether the costs are amortized over expenses on a net basis. However, the
Sec. 174 costs that are required to be five or 15 years. proper treatment is uncertain if the U.S.
capitalized and amortized. parent must capitalize and amortize the
Research credit gross amount of the R&E expenditures
Identifying Sec. 174 costs The TCJA also amended Sec. 41, the over five years because the cost-sharing
Under prior Sec. 174, taxpayers expens- research credit, to define “qualified regulations could be read to require
ing R&E expenditures had less need to research” as research for which expen- a taxpayer to recognize income if the
distinguish these costs from expenses ditures may be treated as “specified reimbursement received exceeds the
deductible under Sec. 162. The new research or experimental expenditures” amount of R&E expenditures that are
capitalization and amortization regime under Sec. 174. Accordingly, how Sec. deducted.
requires taxpayers to identify and deter- 174 costs are defined also has implica- That is, if the gross basis of the
mine the proper amount of their Sec. tions for the research credit under U.S. parent’s R&E expenditures is the
174 costs. Sec. 41. amount amortized, then the U.S. parent
To correctly determine Sec. 174 may need to recognize income equal to
expenditures, taxpayers must resolve a International impact the amount of reimbursed expenditures
number of technical issues that currently A change in characterization of R&E in year 1 that exceeds the amortiza-
are not addressed in regulations or other expenditures, as well as the increase in tion expense, causing a disparity in
IRS and Treasury guidance, including: taxable income as a result of R&E capi- the amount of income and expense
■ The definition or scope of R&E talization, may affect a taxpayer’s Sec. recognized. If, on the other hand,
activities; 250 foreign-derived intangible income amortization is based on the net basis
■ How software development costs are deduction, Sec. 951A global intangible of the U.S. R&E expenditures, then the
defined (e.g., whether they include low-taxed income profile, Sec. 59A base- U.S. parent recognizes no reimburse-
installation of acquired software); erosion and anti-abuse tax (if the R&E ment income in the transaction. It is
■ Whether Sec. 174 is an activity-based expenditures are made to related foreign uncertain which outcome the IRS would
test, ownership-based test, or both; affiliates), and, as a positive effect, may deem acceptable.
■ Whether Sec. 174 requires the decrease the amount of business interest
taxpayer to be at risk for the disallowed under Sec. 163(j). R&E char- Accounting method issues
development; acterization and capitalization changes In addition to resolving technical issues,
■ Whether a contractor performing also may affect the allocation and ap- guidance is needed from the IRS and
R&E services for a client has portionment of expenses under Sec. Treasury to provide the procedural rules
Sec. 174 expenditures where the 861, including, in particular, under Regs. to effect an accounting method change
contractor is not at risk and has no Sec. 1.861-8, dealing with computation to begin capitalizing and amortizing Sec.
ownership rights in the resulting of taxable income from U.S. and other 174 costs. The TCJA provides that the
intellectual property; sources and activities, and the allocation change in method of accounting from

8 July 2022 The Tax Adviser