Section 174 marks a recent addition to the tax code, applicable from the tax year 2022 onward. It introduces changes to the calculation of profits for corporate taxes.
This regulation holds implications for all startups, mainly those already generating revenue, including global startups. Notably, it can lead to a scenario where startups with revenue but no tangible profits may face a substantial tax obligation.
The critical shift introduced by Section 174 is that R&D expenses are no longer immediately deducted; they are spread out over a specified period (5 years for the U.S. and 15 years for international operations).
As of tax years commencing in 2022 or later, taxpayers are obligated to capitalise and amortise research and experimental (R&E) expenses over either five or 15 years. This alteration carries significant implications for a diverse array of companies, influencing both financial statements and tax returns. Given the ongoing struggle to reverse this legislative change, businesses are advised to identify affected costs and evaluate the resulting impacts proactively.
For federal income tax purposes, Section 174 encompasses a comprehensive range of costs incurred by companies in the course of developing or enhancing a product or process. These expenditures typically relate to activities aimed at resolving "uncertainty" and involve questions regarding capability, methodology, or the appropriateness of design.
In practical terms, this definition is expansive and encompasses diverse expenses.
Direct costs under Section 174 may encompass:
Indirect costs under Section 174 may encompass the following:
Also, check out Inkle’s Free Online Section 174 Tax Calculator: https://www.inkle.io/tools/section174-tax-calculator
A diverse array of companies is poised to be affected by the requirement to capitalise and amortise Section 174 expenditures. This includes businesses that:
The Tax Cuts and Jobs Act (TCJA) amended Section 174 concerning the federal income tax treatment of research & experimental (R&E) expenditures incurred for tax years starting post-December 31, 2021. Previously, companies could deduct such costs for federal income tax purposes or use alternative recovery methods.
However, the new regulations necessitate capitalisation and dictate a recovery period of 5 years for domestic R&E/15 years for foreign R&E. Notably, the updated rules explicitly categorise software development costs as R&E expenditures, subjecting them to the same capitalisation and recovery guidelines.
Despite anticipating a legislative change to reinstate R&E expensing, Congress still needed to enact a deferred capitalisation provision. While negotiations may resume, companies must evaluate the repercussions of these rules on their financial statements.
The rules introduce new and substantial book-tax differences and associated deferred tax assets. Effective tax rates may be affected, particularly concerning other tax calculations.
Given legislative challenges, companies should be prepared to account for this change in tax compliance, planning, and payment considerations.
Companies will be tasked with establishing a method to identify and track all research and experimental (R&E) expenditures falling under Section 174. This undertaking is likely significant due to these provisions' broad and subjective nature.
As mentioned earlier, many costs traditionally not classified as "R&E" may now be subject to Section 174 capitalisation. Even companies that initially believe they have a roadmap for cost identification through historical Research Tax Credit (RTC) computations or financial statement reporting methods (such as ASC 740 or tracking software development expenses) may discover that these starting points do not offer a comprehensive approach to account for all R&E costs subject to capitalisation.
Additionally, with limited near-term guidance expected from the Treasury and the IRS, companies will need to navigate several technical considerations.
However, identifying these costs is only the beginning, as the mandated capitalisation and amortisation under Section 174 can influence various other tax computations.
In brief, Section 174 applies to any taxpaying entity that incurs qualifying research and development (R&D) costs, irrespective of industry or business size. Specifically, various types of businesses are affected, including:
Various categories of expenses can fall under Section 174 capitalisation:
Section 174 does not allow deductions for all research and development (R&D) expenses. For instance, costs related to land or depreciable properties are not deductible.
Furthermore, costs associated with research conducted post the commencement of commercial production, marketing research, quality control, and funded research (including research supported by grants, contracts, or any external funding) are generally excluded from Section 174 deductions.
For tax purposes, meeting the following four-part test outlined by the Internal Revenue Service is necessary to qualify for the R&D credit:
To determine conformity to Section 174, companies need to consult the specific state in which they are filing. States adhere to either a rolling or static basis of conformity to the Internal Revenue Code (IRC). In states with rolling conformity, any changes to the federal tax code are automatically adopted as they occur.
Examples of states following this approach include Illinois, New Jersey, New York, and Pennsylvania.
Conversely, states with static conformity adopt the federal tax code as of a specific date.
Static conformity states include Florida, Georgia, Virginia, and North Carolina. Some states practice selective conformity, adopting specific sections of the IRC. Notable examples include Arkansas, Colorado, and Oregon.
It's important to note that the degree of conformity can vary among states and may be subject to specific additions/exceptions based on each state's individual tax laws.
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