On September 8, 2023, the Department of Treasury (Treasury Department) and the Internal Revenue Service (IRS) released Notice 2023-63 (the Notice). The Notice announces that the Treasury Department and the IRS intend to issue proposed regulations addressing the capitalization and amortization of specified research or experimental (SRE) expenditures under Internal Revenue Code (IRC) Section 174. Taxpayers may rely on the interim guidance included in the Notice prior to the publication date of the proposed regulations for the treatment of SRE expenditures under Section 174.
Background on Section 174
The Tax Cuts and Jobs Act (TCJA) amended former Section 174 for certain amounts paid or incurred in taxable years beginning after December 31, 2021. Taxpayers are required to capitalize and amortize research and experimental (R&E) expenditures over a 5-year period for U.S. costs or a 15-year period for foreign costs, beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. Additionally, any amounts paid or incurred in connection with the development of software must be treated as R&E expenses subject to capitalization.
The Treasury Department and IRS issued Rev. Proc. 2023-8 and Rev. Proc. 2023-11 in December of 2022. This guidance allows taxpayers to obtain automatic consent to change methods of accounting to comply with Section 174 as amended by the TCJA. Taxpayers must make this change in method of accounting on a cut-off basis during the first taxable year beginning after December 31, 2021. Any changes made subsequent to the taxpayer’s first taxable year beginning after December 31, 2021, will require a modified Section 481(a) adjustment. The guidance also allows taxpayers to file a statement in lieu of filing Form 3115, Application for Change in Accounting Method, depending on the time of filing.
SRE Expenditures Defined
The interim guidance in the Notice provides taxpayers with clarity in determining whether expenditures are SRE expenditures subject to capitalization and amortization under Section 174. The term SRE expenditures means R&E expenditures paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business. This also includes expenditures that are paid or incurred with the development of computer software, consistent with the amendments to Section 174 by the TCJA.
SRE activities include software development activities or R&D activities, 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.
The Notice provides examples of SRE expenditures, including:
- Labor costs – including full-time, part-time, contract employees and independent contractors who perform, supervise or directly support SRE activities (includes all elements of compensation other than severance compensation)
- Materials and supplies costs – costs of materials and supplies, including tools and equipment that are not depreciable under Section 168, which are used or consumed in the performance of SRE activities
- Cost recovery allowances – depreciation, amortization or depletion allowances with respect to property used in the performance of SRE activities or in the direct support of SRE activities
Other costs to be treated as SRE expenditures include patent costs, certain operation and management costs and travel costs.
The Notice also provides examples of costs that are not treated as SRE expenditures, including:
- Costs paid or incurred by general and administrative service departments or functions that only indirectly support or benefit SRE activities
- Interest on debt to finance SRE activities
- Costs to input content into a website
- Costs for website hosting
- Costs to register an Internet domain name or trademark
- Amounts representing amortization of SRE expenditures
Allocation Method for SRE
To determine total SRE expenditures for a taxable year, taxpayers must allocate 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 used for one type of costs may be different than the allocation method used for another type of cost. Once an allocation method is determined, it must be applied on a consistent basis.
The interim guidance in the Notice provides taxpayers with clarity in determining whether certain activities constitute software development for purposes of Section 174. The term computer software generally means 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 through a private computer network or the Internet (i.e., cloud computing).
Computer software generally includes system software, programming software, application software, embedded software and all forms and media in which the software is contained, whether written, magnetic or otherwise. It also generally includes computer programs of all classes, such as operating systems, executive systems, software monitors, compilers and translators, assembly routines and utility programs as well as application programs.
Computer software includes a computer program, a group of programs, and upgrades and enhancements. It also includes any incidental and ancillary rights that are necessary to effect the acquisition of the title to, the ownership of or the right to use the computer software, and that are used only in connection with that specific computer software. Computer software includes software developed for use by the taxpayer in its trade or business or for sale or licensing to others. The term upgrades and enhancements generally mean modifications to existing computer software that result in additional functionality, or materially increase speed or efficiency of the software.
Activities that are treated as software development for purposes of Section 174 generally include:
- Planning the development of the computer software, including identification and documentation of the software requirements
- Designing the computer software
- Building a model of the computer software
- Writing source code and converting it to machine-readable code
- Testing the computer software and making necessary modifications to address defects identified during testing, but only up until the point in time that:
- The computer software is placed in service
- The computer software is ready for sale or licensing to others
- Production of the product master
The following activities associated with software development projects are not treated as software development for purposes of Section 174:
- 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 and enhancements
- Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion
- Installing the computer software and other activities relating to placing the computer software in service
Purchased Computer Software
The purchase and installation of purchased computer software, including the configuration of pre-coded parameters to make such software compatible with the business and reengineering the business to make it compatible with the purchased software, and any planning designing, modeling, testing or deployment activities with respect to the purchase and installation of such software, are not activities that constitute software development for purposes of Section 174.
Other Items in The Notice
The Notice also provides interim guidance related to research performed under contract, the disposition, retirement, or abandonment of property, long-term contracts under Section 460 and cost sharing regulations under Section 482.
What Does This Mean for Taxpayers?
Taxpayers may rely on Notice 2023-63 for tax years beginning after December 31, 2021, provided the taxpayer relies on and consistently applies all the guidance contained within. Alternatively, taxpayers may choose not to apply the Notice until the forthcoming proposed regulations are effective.
The Treasury and IRS also anticipate issuing updated procedures that will address situations in which taxpayers have, prior to the issuance of Notice 2023-63, changed methods of accounting to comply with Section 174 as amended by the TCJA, but whose treatment of SRE expenditures is not entirely consistent with the Notice.
If you have any questions on the Notice released by the IRS please contact your BSSF advisor.
About the Author
Carrie Small, CPA, MST, is a Tax Principal at Brown Schultz Sheridan & Fritz (BSSF). She is a leader within the BSSF Insurance Practice, which provides a full range of audit, tax and advisory services to insurance companies across the country. Within the practice, Carrie specializes in providing tax compliance, tax provision and tax consulting services to insurance entities.