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Will Companies Expense R&D Again?

Services: Tax

The Tax Cuts and Jobs Act (“TCJA”) passed in late 2017 brought with it many tax benefits, including a reduction in the corporate tax rate from a top rate of 35% to a flat 21%. Along with that, however, came less advantageous tax treatment of other items, in an effort to pay for the rate reduction. One of those was a deduction that has existed since 1954, the ability to expense research & development (“R&D”) expenses under Section 174. Often times popular tax benefits get removed as a way to pay for tax cuts made by Congress. Some are intended only for a time being, with the intention of allowing the benefit in later legislation since it is so popular with both parties. The same was expected for this benefit, however, the requirement to capitalize R&D expenses and amortize them over 5 years for U.S. expenses and 15 years for foreign expenses began as of January 1, 2022. Now, over mid-way through the initial year of its implementation, the legislation remains unchanged. The Biden administration’s “Build Back Better” legislation would have delayed the effective date until years beginning after December 31, 2025; but with that tabled, companies continue to wait and see if a provision to bring back the expensing of R&D will succeed in being attached to any other bill.

Innovation keeps the U.S. competitive with other countries. Congress typically agrees on the need to provide tax incentives to foster innovation, so provisions like this one tend to be points of negotiation. Whether agreement will be made before the end of 2022 that this provision should be delayed or repealed is unknown at this time, so companies are being forced to plan for its tax impact. The requirement to capitalize these expenses creates a cash flow mismatch, with the cash flowing out in one year but the tax benefit not being allowed in full for many years. As a result, companies are having to project the tax effect of this and report accordingly in their quarterly financials, and potentially pay in federal and state estimated taxes during the year.

This is especially problematic for companies who receive advance payments for services to be provided over several years. The IRS allows a one-year deferral of revenue when continuing performance obligations exist for those advance payments. However, in the second tax year, the remainder is required to be included in income regardless of whether there are services still to be performed. A drug development company receiving upfront payments, for example, would usually quickly spend down that revenue as R&D. Although timing of the spending may not match the revenue earned perfectly for tax purposes, expensing along the way allows for a much closer match. With the requirement to capitalize and amortize these expenses over 5 or 15 years, the cash tax difference of these two scenarios could be significant. Similar issues can arise with software development companies, as software development costs are included in this change, requiring them to be capitalized as well. In addition, net operating loss (“NOL”) carryforwards are limited to 80% of taxable income, so in the past where companies could use NOLs to cover the shortfall, that is limited. The R&D tax credit can help mitigate the cash tax impact, but again, requires planning and careful documentation.

At this point of the year, it is difficult to know if legislation providing relief will pass before the end of the year, particularly with mid-term elections in the fall. Companies should work with their tax advisors to plan accordingly in order to avoid potential penalties and interest on payments due if legislation doesn’t materialize, which certainly is not guaranteed.