An olive branch or shot across the bow? IRS issues Notice 2023-63 providing welcome substantive Section 174 guidance

The long wait for substantive guidance under Section 174 ended late last week with the release by the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) of Notice 2023-63 (Notice).¹ Taxpayers may rely on interim guidance provided in the Notice pending issuance of forthcoming proposed regulations, which are expected to be consistent with the interim guidance provided in Sections 3 through 9 of the Notice. In addition to providing helpful clarification and explanation of the rules regarding capitalization and amortization of specified research and experimental (SRE) expenditures under Section 174 (including guidance on software development costs, contract research and treatment upon disposition), the Notice also updates certain provisions under Sections 460 and 482 to account for the change in treatment of SRE expenditures from being immediately deductible to capitalized and amortized. Although the Notice provides taxpayers with flexibility in a number of instances when evaluating the treatment of SRE expenditures, there is some risk such flexibility may be interpreted as ambiguity. For this reason, it will be important to review how and whether positions taken in the Notice may change when subsequent regulations are released.

This Alert summarizes the various guidance provided in the Notice and highlights provisions important to taxpayers considering implementation of these new rules on their current year tax returns, as well as in the future.

Background and Overview

As enacted in 1954, former Section 174 was meant to provide clarity to taxpayers regarding the treatment of otherwise capitalizable research or experimental (R&E) expenditures with no determinable useful life. Former Section 174 permitted taxpayers a choice between an election to deduct R&E expenditures currently, to capitalize and amortize R&E expenditures over a period of not less than five years, or to charge R&E expenditures to a capital account. R&E expenditures under former Section 174 are defined in Treas. Reg. §1.174-2. While the regulations under former Section 174 addressed costs paid by a taxpayer for research or experimentation carried on by a third party on behalf of the taxpayer, they did not address the treatment of expenditures paid by a contractor for research or experimentation carried on for another person or organization (contract research).

Prior to the Tax Cuts and Jobs Act (TCJA), software development costs were permitted similar, albeit slightly different, treatment to R&E expenditures. Specifically, Rev. Proc. 2000-50 allowed taxpayers to treat software development costs as currently deductible expenses or as capital expenditures amortizable over a period of either 60 months or 36 months. However, Rev. Proc. 2000-50 does not define what activities constitute software development or further describe software development activities.

The TCJA amended Section 174 to require taxpayers to charge SRE expenditures to a capital account. SRE expenditures are then amortizable over the applicable Section 174 amortization period (applicable period), beginning with the midpoint of the taxable year in which the SRE expenditures are paid or incurred. Further, the TCJA amended the scope of Section 174 to include software development costs. SRE expenditures may not be recovered upon the disposition, retirement or abandonment of property with respect to which the SRE expenditures are paid or incurred. Rather, if such property is disposed of, retired or abandoned before the SRE expenditures are fully amortized, the taxpayer must continue to amortize the SRE expenditures over the applicable period. These amendments apply to amounts paid or incurred in connection with a taxpayer’s trade or business in any taxable year beginning after December 31, 2021.

The IRS issued Rev. Procs. 2023-8 and 2023-11 in late December 2022 to provide procedural guidance for complying with Section 174 (now incorporated into Section 7.02 Rev. Proc. 2023-24). However, many substantive questions regarding the application of Section 174 remained. The Notice provides guidance with respect to many of these outstanding issues.

Scope and Applicability

Guidance provided in the Notice may be relied on by taxpayers for expenditures paid or incurred in taxable years beginning after December 31, 2021, provided the taxpayer applies Sections 3 through 9 in their entirety and applies the rules consistently. However, taxpayers may not rely on the rules in Section 7 with respect to SRE expenditures paid or incurred related to property that is contributed to, distributed from or transferred from a partnership. Prior to issuance of procedural guidance specific to the Notice, taxpayers may rely on Section 7.02 of Rev. Proc. 2023-24 to change methods of accounting to comply with the Notice.

While the Notice addresses expenditures that may be treated as SRE expenditures under Section 41(d)(1)(A) and Treas. Reg. §1.41-4(a)(2)(i), it does not impact the rules for determining eligibility for or computation of the research credit, and particularly, it does not change the rules regarding “research with respect to computer software” or the definitions of qualified research or qualified research expenditures for purposes of the research credit under Section 41.

The Notice obsoletes Section 5 of Rev. Proc. 2000-50.

Capitalization and Amortization of SRE Expenditures

Section 3 of the Notice provides definitional and procedural clarifications regarding the capitalization and amortization of SRE expenditures, including the application of these provisions to short taxable years. Under Section 174, taxpayers must capitalize SRE expenditures and amortize them ratably over the applicable period, beginning with the midpoint of the taxable year in which the expenditures are paid or incurred. The Notice defines “midpoint” to mean the first day of the seventh month of the taxable year in which the SRE expenditures are paid or incurred.

Under the Notice, the amortization deduction for a short taxable year is based on the number of months in the short taxable year. With regard to short taxable years that include part of a month, the entire month is included in the number of months in the taxable year. If part of the same month is included in two successive short taxable years, the month is included in the first short taxable year and not the second. The midpoint of a short taxable year is the first day of the midpoint month. The midpoint month for a short taxable year with an even number of months is determined by dividing the number of months in the year by two and then adding one. The midpoint month for a short taxable year with an odd number of months is the month for which there is an equal number of months before and after such month. Section 3.07 of the Notice provides a helpful example that demonstrates the application of these provisions to a taxpayer with a short taxable year.

The applicable period is five years for domestic research and 15 years for foreign research. Section 3.03 of the Notice defines foreign research as any research conducted outside of the United States, the Commonwealth of Puerto Rico, or any U.S. territory or other possession of the United States. Under the Notice, taxpayers determine whether SRE expenditures are attributable to foreign research based on where the corresponding SRE activities are performed.

Scope of Section 174

Section 4 of the Notice clarifies the scope of Section 174 by defining SRE expenditures. The Notice incorporates all defined terms provided in Treas. Reg. §1.174-2.

Definitions

Under the Notice, “SRE expenditures” must (1) be paid or incurred by the taxpayer during the taxable year in connection with the taxpayer’s trade or business, and (2) either (a) satisfy the requirements under Treas. Reg. §1.174-2 to be R&E expenditures, or (b) be paid or incurred in connection with the development of computer software. The Notice defines “SRE activities” to mean software development activities or R&E activities described in Treas. Reg. §1.174-2 (i.e., activities in the experimental or laboratory sense intended to discover information that would eliminate uncertainty concerning the development or improvement or appropriate design of a product or a component or subcomponent of a product). R&E expenditures under Treas. Reg. §1.174-2 include all costs incident to those SRE activities. Thus, SRE expenditures under the Notice incorporate any R&E expenditures under former Section 174 and add computer software development costs, regardless of whether such costs satisfy the requirements under former Section 174.

The Notice further provides a non-exhaustive list of the types of costs that are considered incident to SRE expenditures, including: labor costs (i.e., all elements of compensation other than severance); materials and supplies costs (cross-referencing Treas. Reg. §1.162-3); cost recovery allowances (with respect to property used in the performance of SRE activities); patent costs, certain operation and management costs (used in the performance of SRE activities or in direct support of such activities) and travel costs. The Notice also identifies a number of costs that are neither permitted nor required to be treated as SRE expenditures, including: general and administrative costs that only indirectly support or benefit SRE activities; interest on debt to finance SRE activities; costs paid or incurred for activities identified in the Notice as not constituting software development; costs to input content into a website; costs for website hosting that involve the payment of a specified; periodic fee to an Internet service provided in return for hosting a website on its server(s) connected to the Internet; costs to register an Internet domain name or trademark; costs excluded under Treas. Reg. §1.174-2(a)(6)(i)-(vii); and, amounts representing amortization of SRE expenditures or R&E expenditures under former Section 174.

Allocations

Under the Notice, a taxpayer must determine total SRE expenditures for a taxable year by allocating costs to SRE activities on the basis of a cause-and-effect relationship between the costs and the SRE activities, or another relationship that reasonably relates the costs to the benefits provided to the SRE activities. The allocation method may differ among types of costs, but the method used for each type of cost must be applied consistently. Further, SRE expenditures must be treated consistently for purposes of all provisions under subtitle A (i.e., SRE expenditures may not be treated as deductible Section 162 expenses, or capitalized under Sections 195, 263(a), 263A or 471). Similar to the direction provided with respect to the application of the midpoint determination to short taxable years, Section 4.03(4) provides a comprehensive example for taxpayers to understand how to properly allocate costs to SRE activities. Based on the example, reasonable allocation methods for various types of costs may include:

• Allocating labor costs based on a ratio of total time spent performing, supervising, or directly supporting SRE activities to total time spent performing all services for the taxpayer;
• Allocating facility cost recovery allowances based on a ratio of square footage used to conduct or directly support SRE activities to total square footage of facility;
• Allocating equipment cost recovery allowances based on a ratio of use for SRE activities to total use;
• Allocating materials and supplies costs based on a ratio of use for SRE activities to total use or a ratio of the department’s time spent on SRE activities to total department time; and,
• Allocating utilities based on a ratio of the department’s time spent on SRE activities to total department time.

Software Development

Computer Software

The Notice defines “computer software” similarly to the definition provided in Rev. Proc. 2000-50. Specifically, for purposes of the Notice, “computer software” is defined broadly to mean any computer program or routine (i.e., any sequence of code) 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. The code may be stored on a computing device, affixed to a tangible medium, or accessed remotely via a private computer network or the Internet. The Notice provides an extensive list of examples.

Notably, computer software under the Notice includes a computer program, a group of programs, and upgrades and enhancements. Upgrades and enhancements are defined as modifications to existing computer software that result in additional functionality (enabling the software to perform tasks that it was previously incapable of performing), or materially increase the speed or efficiency of the software.

Further, computer software includes software developed for use by the taxpayer in its trade or business or for sale or licensing to others.

Computer software does not include any data or information base described in Treas. Reg. §1.197-2(b)(4) (e.g., customer lists, client files) unless the database or item is in the public domain and is incidental to a computer program. Additionally, computer software does not include any procedures that are external to the computer’s operation.

Software Development Activities

The Notice provides that software development activities include (but are not limited to) planning the development of the computer software (or upgrades/enhancements to such software), including identification and documentation of software requirements; designing computer software (or upgrades/enhancements to such software); building a model of computer software (or upgrades/enhancements to such software); writing source code and converting it to machine-readable code; and testing the computer software (or upgrades/enhancements to such software) and making necessary modifications to address defects identified during testing up until a certain point in time (the point in time differs based on the intended use of the software).

For computer software developed by a taxpayer for use in its trade or business, software development activities do not include training employees and other stakeholders that will use the computer software; maintenance activities after the computer software is placed in service that do not give rise to upgrades/enhancements (e.g., corrective maintenance to debug, diagnose, and fix programming errors); data conversion activities (except activities to develop computer software that facilitate access to existing data or data conversion); or installation and other activities related to placing the computer software into service.

In the case of computer software developed for sale or licensing to others, activities that occur after the software is ready for sale or licensing, such as marketing and promotional activities, maintenance activities that do not give rise to upgrades/enhancements, distribution activities, and customer support activities are not treated as software development activities.

The purchase and installation of purchased computer software are not software development activities.

Contract Research

As anticipated, the Notice also addresses costs incurred in connection with contract research in Section 6. In particular, Section 6.04 clarifies the treatment of costs paid or incurred by research providers (i.e., the party that contracts to either perform research with respect to an SRE product or develop an SRE product for the research recipient). It is not surprising that to the extent the research provider bears financial risk under the terms of the contract, costs paid or incurred by the research provider that are incident to the SRE activities performed by the research provider under the contract are SRE expenditures to the research provider. The Notice goes further to provide that even without financial risk under the terms of the contract, if the research provider has the right to use any resulting SRE product in its trade/business or otherwise capitalize on any resulting SRE product through a sale, lease, or license, then costs paid or incurred by the research provider that are incident to the SRE activities performed by the research provider under the contract are SRE expenditures of the research provider for which no deduction is allowed except as provided in Section 174(a)(2), irrespective of whether the research recipient is required to treat its costs as SRE expenditures. A potentially significant exception is that a research provider will not be treated as having a right to use the SRE product in its trade/business or otherwise capitalize on the SRE product through sale, lease, or license if such right is available to the research provider only upon obtaining approval from another party to the research arrangement that is not related to the research provider within the meaning of Sections 267 or 707.

Disposition, Retirement, or Abandonment of Property

Section 7 addresses the treatment of unamortized SRE expenditures in the case that property with respect to which such expenditures are paid or incurred is disposed of, retired, or abandoned in certain transactions during the applicable period. Under the Notice, unamortized SRE expenditures must generally continue to be amortized over the applicable period, regardless of whether the corresponding property has been disposed of, retired or abandoned. For example, under the Notice, SRE expenditures are amortized over the applicable period even if the SRE expenditures relate to property that is disposed of, retired or abandoned prior to the midpoint of the year in which the SRE expenditures are incurred. Unamortized SRE expenditures refers to the amount of any SRE expenditures paid or incurred by a corporation or its predecessor, less the amount of any amortization deductions previously allowed to the corporation or its predecessor under Section 174.

Transactions in Which a Corporation Ceases to Exist

Under the Notice, if a corporation ceases to exist in a transaction described in Section 381(a), the acquiring corporation continues to amortize the distributor or transferor corporation’s unamortized SRE expenditures over the remainder of the distributor or transferor corporation’s applicable period, beginning with the month of transfer (i.e., no acceleration of SRE expenditure recovery). However, if a corporation ceases to exist in a transaction not described in Section 381(a), the corporation is allowed a deduction equal to its unamortized SRE expenditures in its final taxable year. Importantly, unlike any other section in the Notice, Section 7.04(2)(b) explicitly provides an anti-abuse exception for certain transactions not described in Section 381(a). The anti-abuse exception provides that the exception allowing for accelerated recovery of unamortized SRE expenditures does not apply if a principal purpose of the transaction is to claim a deduction for the unamortized SRE expenditures.

Examples illustrating these rules further clarify that the general rule requiring unamortized SRE expenditures to continue to be amortized over the applicable period following the disposition, retirement or abandonment of related property applies equally to a sale of property, an applicable asset acquisition within the meaning of Section 1060(c), and an asset exchange described in Section 351.

Long-Term Contracts under Section 460

The Notice provides proposed revisions to regulations under Section 460 to clarify application of the percentage-of-completion method (PCM) to long-term contracts for which the allocable contract costs include SRE expenditures. The Section 460 regulations generally provide that allocable contact costs include R&E expenditures, thereby increasing the portion of a contract considered completed and the percentage of the contract price required to be reported. Because Section 174 no longer permits a current deduction for such expenditures, these provisions may result in a mismatch of contract price and contract costs that is inconsistent with the intent of the PCM. Thus, the Notice proposes to amend existing Section 460 regulations to reflect the change in treatment of SRE expenditures under Section 174 to provide that costs allocable to a long-term contract using the PCM include amortization of SRE expenditures (rather than amounts capitalized) and that SRE expenditure amortization is treated as incurred for purposes of the PCM at the time at which they are deducted.

Cost-Sharing Regulations

The Notice also provides proposed revisions to the cost sharing regulations under Treas. Reg. §1.482-7 to similarly reflect the change in treatment of SRE expenditures under Section 174 from immediately deductible expenses to being charged to a capital account and amortized. Specifically, the Notice proposes to amend Treas. Reg. §1.482-7(j)(3)(i), which addresses cost sharing transaction payments between controlled participants in a cost sharing arrangement that are made to ensure each controlled participant’s share of intangible development costs (IDCs) is in proportion to its share of reasonably anticipated benefits from exploitation of the developed intangibles. The proposed revisions would refer to IDCs that are chargeable to capital account, in addition to those that are deductible, in order to account for the changes to Section 174. Three examples illustrate application of these proposed amendments.

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