Ending a prolonged wait for guidance on the revisions made to IRC §174 by the Tax Cuts and Jobs Act in 2017, which took effect in 2022, the IRS has released Notice 2023-63.[1] This Notice provides guidance related to the newly required amortization of research and experimentation costs.

The History of the Research and Experimental Expense Amortization Provision

Most commentators have viewed the amortization of research expenses provision, added to the law as part of the Tax Cuts and Jobs Act, as a measure that was always expected to be repealed before taking effect. Why, you might ask, would Congress enact a provision that perhaps none of those voting for the bill actually wanted to see implemented? The answer is simple: budget scoring and Senate rules regarding budget reconciliation bills.

Certain members of the House and Senate who generally supported the Tax Cuts and Jobs Act were nevertheless concerned about voting for a bill with too high a cost. This provision served as a revenue-raiser, reducing the overall cost of the bill. When combined with other revenue-raisers—most of which were intended to take effect—it brought the overall projected cost of the law down to a level that at least 51 Senators could accept.

Additionally, under the rules of the U.S. Senate, most bills must receive support from 60 Senators to come before the Senate for a vote. Thus, opponents of a bill that has the support of a majority, but fewer than 60 Senators, can block the bill from becoming law simply by preventing it from coming to a vote.

However, the annual federal budget is an exception; it must be passed. Concerns that the 60-vote rule could create a crisis led to a special set of rules for what is known as the budget reconciliation process. Only a simple majority of the Senate, the same number needed to pass the bill, must consent to allowing the bill to go to a vote. One of the limitations on such a bill is that it must not result in a net increase in the deficit outside of a 10-year budget window. This provision, which would remain in effect permanently, served to offset the cost of provisions in the TCJA that were projected to have costs outside of that 10-year window.

But how could those voting for the bill be certain the provision would not take effect? Legislators supporting the bill were assured that the vast majority of those who would vote against the Tax Cuts and Jobs Act also opposed this change in the law and would not want the provision to become effective. Thus, it was anticipated that at some point within the next five years—before the provision took effect in 2022—it would be repealed, either as part of a later reconciliation package or through a bill that garnered enough support to clear the 60-vote hurdle in the Senate

As 2021 began, it seemed that a repeal was imminent. Although a different party now controlled the Senate, the repeal of the Section 174 provision initially made it into a reconciliation package—the proposed Build Back Better Act (BBBA). However, the BBBA faced opposition not only from minority party Republicans but also from certain Democrats, with one major concern being the cost of the bill.

Eventually, the BBBA evolved into the much less expensive Inflation Reduction Act (IRA). One way the bill’s cost was reduced was by removing the repeal of Section 174 from its language. This move, much like with the TCJA, brought the cost of the IRA down to a level where it garnered enough support to be brought to a vote.

While additional attempts were made to pass a provision repealing the TCJA changes to Section 174, no package that could secure 60 votes in the Senate was ever finalized. Increased Congressional concern over budget deficits made it difficult to pass a bill that would be scored as increasing the deficit. Moreover, those who had opposed the TCJA had other provisions they wanted included if they were to allow a bill that increased the deficit to come to a vote in the Senate.

During this period, the IRS seemed to operate under the assumption that Congress would eventually repeal the provision, which was virtually universally opposed on Capitol Hill. This optimistic approach persisted even as 2022 ended without such a repeal being enacted, apparently in the hope that Congress would retroactively repeal the provision in 2023. However, as Congress failed to pass such a provision and even the extended due date for the first returns subject to this change approached, the IRS finally conceded and issued the guidance.

Scope of the Guidance

The Notice outlines this guidance and explains how it will interact with rules related to the credit for increasing research activities under IRC §41:

The guidance in this notice does not apply for purposes of determining whether an expenditure paid or incurred for taxable years beginning before January 1, 2022, is a research or experimental expenditure under § 174 as in effect for taxable years beginning before January 1, 2022 (former § 174). This notice provides guidance regarding expenditures that are treated as SRE expenditures under § 174 and, therefore, affects expenditures that may be treated as SRE expenditures for purposes of § 41(d)(1)(A) and § 1.41-4(a)(2)(i). However, this notice is not intended to change the rules for determining eligibility for or computation of the research credit under § 41 and the regulations thereunder, including rules for “research with respect to computer software,” and the definitions of “qualified research” and “qualified research expenses.”[2]

The Notice also details the changes made by the TCJA to the treatment of specified research or experimental (SRE) expenditures:

Section 13206(a) of the TCJA amended former § 174 for amounts paid or incurred in taxable years beginning after December 31, 2021. For such amounts, § 174(a)(1) disallows deductions for SRE expenditures, except as provided in § 174(a)(2). Section 174(a)(2) requires taxpayers to charge SRE expenditures to capital account and allows amortization deductions of such capitalized expenditures ratably over the applicable § 174 amortization period, beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. As used in this notice, the term “applicable § 174 amortization period” refers to a 5-year (60-month) period in the case of SRE expenditures attributable to domestic research or a 15-year (180-month) period in the case of SRE expenditures attributable to foreign research, as defined in section 3.03 of this notice.[3]

The law defines SRE Expenditures as follows:

Section 174(b), as amended by section 13206(a) of the TCJA, defines “SRE expenditures” to mean, with respect to any taxable year beginning after December 31, 2021, research or experimental expenditures that are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business. See Snow v. Commissioner, 416 U.S. 500 (1974) (“in connection with” a trade or business is broader than “in carrying on” a trade or business).[4]

The law also amended the treatment of software development costs, subjecting them to the same amortization periods and rules.

Section 13206(a) of the TCJA added new § 174(c)(3) to require that any amount paid or incurred in connection with the development of any software in taxable years beginning after December 31, 2021, be treated as a research or experimental expenditure (and thus an SRE expenditure to the extent paid or incurred by the taxpayer during the taxable year in connection with the taxpayer’s trade or business).[5]

The law also included a provision to prevent taxpayers from immediately writing off costs related to property that is being amortized under Section 174:

Section 13206(a) of the TCJA added new § 174(d) to provide that deductions of SRE expenditures may not be taken on account of the disposition, retirement, or abandonment of property with respect to which such SRE expenditures are paid or incurred. If such property is disposed of, retired, or abandoned during the applicable § 174 amortization period, § 174(d) requires that the amortization deductions for such SRE expenditures continue over that period.[6]

The law specifies that this will necessitate a change in the method of accounting for such costs by the taxpayer:

Section 13206(b) of the TCJA requires taxpayers to apply the provisions of § 174, as amended by section 13206(a) of the TCJA, as a change in method of accounting for purposes of § 481, initiated by the taxpayer and made with the consent of the Secretary of the Treasury or her delegate, and applied on a cutoff basis to SRE expenditures paid or incurred in taxable years beginning after December 31, 2021. Thus, no adjustments under § 481(a) are permitted or required with respect to research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2022.[7]

The IRS has previously outlined the method for obtaining this automatic consent to change in accounting method, as described in the Notice:

On December 12, 2022, the Treasury Department and the IRS issued Rev. Proc. 2023-8, 2023-3 I.R.B. 407, to provide procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with § 174, as amended by the TCJA. On December 29, 2022, the Treasury Department and the IRS issued Rev. Proc. 2023-11, 2023-3 I.R.B. 417, to modify and supersede Rev. Proc. 2023-8. The change in method of accounting provided by Rev. Proc. 2023- 11 was subsequently included in section 7.02 of Rev. Proc. 2023-24, 2023-28 I.R.B. 1207. Section 7.02 of Rev. Proc. 2023-24 implements the requirement imposed by § 13206(b) of the TCJA that a taxpayer must make this change in method of accounting on a cutoff basis if the change was made during the taxpayer’s first taxable year beginning after December 31, 2021. However, section 7.02 of Rev. Proc 2023-24 provides that a taxpayer making the change for a taxable year subsequent to the taxpayer’s first taxable year beginning after December 31, 2021, is required to make that change with a modified § 481(a) adjustment that takes into account only SRE expenditures paid or incurred in taxable years beginning after December 31, 2021. Section 7.02(7) of Rev. Proc. 2023-24 also provides that a taxpayer that changes its method of accounting for SRE expenditures under the revenue procedure will receive limited audit protection. Specifically, audit protection will not apply for expenditures paid or incurred in taxable years beginning before January 1, 2022. Audit protection also will not apply for expenditures paid or incurred in taxable years beginning after December 31, 2021, if a change in method of accounting is made for the taxable year immediately subsequent to the first taxable year beginning after December 31, 2021. See section 10.02 of this notice for additional procedural guidance the Treasury Department and IRS intend to issue.[8]

Capitalization and Amortization of SRE Expenditures

The Notice announces that the IRS plans to issue proposed regulations in the future. These proposed regulations are expected to be consistent with the preliminary guidance provided in this Notice.

The Treasury Department and the IRS intend to propose rules in forthcoming proposed regulations consistent with the interim guidance provided in this section 3, which provides taxpayers with clarity regarding the requirement in § 174(a) to capitalize and amortize SRE expenditures and the treatment of short taxable years.[9]

The Notice outlines the general capitalization requirements under the revisions to IRC §174 as follows:

Taxpayers are required to capitalize SRE expenditures (as defined in section 4.02(2) of this notice) and amortize such expenditures ratably over the applicable § 174 amortization period beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.[10]

Foreign research, which is subject to a longer amortization period, is defined as follows:

The term foreign research means any research conducted outside the United States, the Commonwealth of Puerto Rico, or any U.S. territory or other possession of the United States. See §§ 174(a)(2)(B) and 41(d)(4)(F).[11]

The Notice also details how specific items of SRE are to be categorized as foreign research:

Taxpayers must look to where the SRE activities (as defined in section 4.02(4) of this notice) are performed to determine whether the corresponding SRE expenditures are attributable to foreign research for purposes of section 3.02 of this notice.[12]

The Notice also defines midpoint for purposes of the amortization rules.

Except as provided in section 3.06 of this notice, for purposes of determining when amortization begins under § 174(a)(2)(B) and section 3.02 of this notice, the term midpoint means the first day of the seventh month of the taxable year in which the SRE expenditures are paid or incurred. See section 7.03 of this notice for interim guidance with respect to SRE expenditures that relate to property disposed of before the midpoint of the taxable year in which such SRE expenditures are paid or incurred.[13]

Special rules for short taxable years are discussed in the Notice, starting with an overview of general rules for such years.

The amortization deduction for a short taxable year is based on the number of months in the short taxable year. If a short taxable year includes part of a month, the entire month is included in the number of months in the taxable year, but the same month may not be counted more than once. If a taxpayer has two successive short taxable years and the first short taxable year ends in the same month that the second short taxable year begins, the taxpayer should include that month in the first short taxable year and not in the second short taxable year.[14]

The Notice also addresses how the midpoint rule applies to such years:

The midpoint of a short taxable year is the first day of the midpoint month. In the case of a short taxable year with an even number of months (as determined under section 3.06(1) of this notice), the midpoint month is determined by dividing the number of months in the short taxable year by two and then adding one (for example, for a short taxable year consisting of ten months, the midpoint month is the sixth month of the short taxable year ((10 / 2) + 1 = 6)). In the case of a short taxable year with an odd number of months (as determined under section 3.06(1) of this notice), the midpoint month is the month for which there are an equal number of months before and after such month (for example, for a short taxable year consisting of seven months, the mid-point month is the fourth month of the short taxable year).[15]

The Notice provides the following example of applying the above short year rule:

Example

Facts. Taxpayer is a calendar-year taxpayer that incorporated and began operations on October 17, 2022. In 2022, Taxpayer paid or incurred $60,000 in SRE expenditures that were not attributable to foreign research. Taxpayer has no short taxable years after its initial taxable year.

Analysis. Taxpayer has a short taxable year that begins on October 17, 2022, and ends on December 31, 2022, and thus is treated as having a three-month taxable year under section 3.06(1) of this notice. The midpoint month is November, and thus November 1, 2022, will be treated as the midpoint under section 3.06(2) of this notice. In 2022, Taxpayer amortizes $2,000 of SRE expenditures ($60,000 / 60 months × 2 months). In taxable years 2023 through 2026, each a full 12-month taxable year, Taxpayer amortizes $12,000 ($60,000 / 60 months × 12 months) each year, or $48,000 total. In 2027, Taxpayer amortizes the remaining $10,000 ($60,000 / 60 months × 10 months).[16]

Scope of Section 174

The next section of the Notice discusses the scope of IRC §174, as revised by the Tax Cuts and Jobs Act. The IRS states that this is to provide “taxpayers with clarity in determining whether expenditures are SRE expenditures subject to capitalization and amortization under §174.”

Terms Used in Section 174

Terms used in the Notice carry the same meaning as they do in existing Treasury Regulation §1.174-2, unless the Notice specifies otherwise. For example, the term “product” is defined as it is in Treasury Regulation §1.174-2(a)(3). In the existing regulation, that term has the following meaning:

For purposes of this section, the term product includes any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license.[17]

SRE expenditures are defined in the Notice as follows:

The term SRE expenditures means, with respect to any taxable year beginning after December 31, 2021, research or experimental expenditures (as defined in section 4.02(3) of this notice), which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.[18]

Research or experimental expenditures are defined as expenditures that:

(a) satisfy the requirements under § 1.174-2 to be research or experimental expenditures, or

(b) are paid or incurred in connection with the development of any computer software (as provided in section 5 of this notice), regardless of whether such expenditures are research or experimental expenditures under § 1.174-2.[19]

This section of the Notice cautions that Section 6 of the Notice addresses issues related to whether expenditures paid or incurred pursuant to a contract are considered research or experimental expenditures.

Reg. §1.174-2(a)(1) defines research or experimental expenditure broadly as follows:

The term research or experimental expenditures, as used in section 174, means expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.[20]

The subsection goes on to give costs that automatically would be included as such costs.

The term generally includes all such costs incident to the development or improvement of a product. The term includes the costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application.[21]

The regulation goes on to provide information on the nature of such expenditures

Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.[22]

The provision clarifies that it is the nature of the activity, rather than the success or failure of the product, that determines whether such expenditures qualify.

Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174.[23]

Finally, the provision concludes by stating that the commencement of production does not preclude the incurrence of additional §174 costs. As long as uncertainty regarding the development or improvement of the product remains, §174 costs will continue to be incurred.

Costs may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated.[24]

Additionally, Treasury Regulation §1.174(a)(6) provides a list of expenditures that are excluded from being considered research or experimental expenditures.

The ordinary testing or inspection of materials or products for quality control (quality control testing);
Efficiency surveys;
Management studies;
Consumer surveys;
Advertising or promotions;
The acquisition of another’s patent, model, production or process; or
Research in connection with literary, historical, or similar projects.[25]

SRE activities means

Software development activities described in section 5.03 of this notice, or
Research or experimental activities described in § 1.174-2 (that is, 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).[26]

Identification and Allocation of SRE Expenditures

The Notice provides the following summary of what are SRE expenditure requirements:

As provided in section 4.02(2) and (3) of this notice, SRE expenditures include expenditures that satisfy the requirements under § 1.174-2 or are paid or incurred in connection with the development of any computer software, regardless of whether such software expenditures satisfy the requirements under § 1.174-2.[27]

A summary of the provisions related to SRE expenditures in Treasury Regulation §1.174-2 is provided next.

Section 1.174-2(a)(1) and (5) provide that research or experimental expenditures under § 1.174-2 include all costs incident to the development or improvement of a product, a component of a product, or subcomponent of a product, as applicable (that is, research or experimental expenditures under § 1.174-2 include all costs incident to SRE activities described in section 4.02(4)(b) of this notice).[28]

The Notice provides a non-exhaustive list of costs incidental to SRE activities and describes the nature of that list as follows:

Section 4.03(1) of this notice provides a nonexhaustive list of examples of the types of costs that are incident to SRE activities described in section 4.02(4)(b) of this notice or paid or incurred in connection with software development activities described in sections 4.02(4)(a) and 5.03 of this notice. In other words, section 4.03(1) of this notice provides a non-exhaustive list of examples of the types of costs that are SRE expenditures.[29]

The costs included in that list are provided below:

Labor costs. Labor costs of full-time, part-time, and contract employees and independent contractors who perform, supervise, or directly support SRE activities. Labor costs include all elements of compensation other than severance compensation, such as basic compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan.
Materials and supplies costs. Costs of materials and supplies, including tools and equipment that are not depreciable under § 168, which are used or consumed in the performance of SRE activities or in the direct support of SRE activities. For example, a cost described in § 1.162-3, relating to the cost of a material or supply, may be an SRE expenditure.
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, including property placed in service in a taxable year that begins on or before December 31, 2021. For example, depreciation with respect to a test bed used in the performance of SRE activities, or allocable depreciation with respect to a facility in which SRE activities, or services that directly support SRE activities, are performed.
Patent costs. Costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application.
Certain operation and management costs. Rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs with respect to facilities, equipment and other assets used in the performance of SRE activities or in the direct support of SRE activities.
Travel costs. Travel costs for the performance of SRE activities or the direct support of SRE activities.[30]

The Notice also includes a list of costs that are neither required nor permitted to be treated as SRE expenditures:

Section 4.03(2) of this notice provides a list of costs that are not permitted or required to be treated as SRE expenditures, regardless of whether they may be incident to SRE activities described in section 4.02(4) of this notice.[31]

The costs that are not to be treated as SRE expenditures are listed below:

Costs paid or incurred by general and administrative service departments (or functions) that only indirectly support or benefit SRE activities (for example, services of payroll personnel in preparing salary checks of research personnel, services of human resources personnel who hire research personnel, or services of accounting personnel who account for research expenses);
Interest on debt to finance SRE activities;
Costs paid or incurred for activities described in section 5.05 of this notice (activities not treated as 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 provider in return for hosting a website on its server(s) connected to the Internet;
Costs to register an Internet domain name or trademark;
Costs listed in § 1.174-2(a)(6)(i)-(vii) (the list from the existing regulation discussed earlier in this article);
Amounts representing amortization of SRE expenditures; and
Amounts representing amortization of research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2022.[32]

Although a cost might appear in the example SRE expenditure list discussed in this section of the Notice, not all such expenditures will necessarily be treated as SRE expenditures that must be capitalized. Instead, a method must be adopted to reasonably allocate such costs between those that qualify as SRE expenditures and those that do not.

To determine total SRE expenditures for a taxable year, taxpayers must allocate costs, including the types of costs described in section 4.03(1) of this notice, 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.[33]

While a taxpayer is permitted to use different methods for different costs, the methods employed must be reasonable and applied consistently.

The allocation method used for one type of cost may be different than the allocation method used for another type of cost. However, the allocation method used for each type of cost must be applied on a consistent basis. For example, a taxpayer that consistently allocates labor costs described in section 4.03(1)(a) of this notice to SRE activities by multiplying such labor costs by the ratio of the total time the person or people actually spent performing, supervising, or directly supporting SRE activities during the taxable year to the total time the person or people spent performing all services for the taxpayer during the taxable year, meets the requirements in this section 4.03(3). Similarly, a taxpayer that consistently allocates facility cost recovery allowances described in section 4.03(1)(c) of this notice to SRE activities by multiplying such cost recovery allowances by the ratio of the square footage of the area used to conduct or directly support SRE activities to the total square footage of the facility, meets the requirement of this section 4.03(3).[34]

The Notice cautions that even though a method may be deemed reasonable for allocation under this rule, it does not necessarily mean that the same form of allocation would be considered appropriate for other provisions of the IRC.

An allocation method for a particular type of cost that meets the requirements of this section 4.03(3) may not be appropriate for purposes of allocating that same type of cost under other sections of the Code.[35]

The IRS provides a comprehensive example of applying the allocation rules to numerous expenses in Section 4.03(4) of the Notice. Advisers should consider reviewing this example in detail when looking to apply these rules.

Consistency Requirement

The Notice addresses the requirement for consistent treatment of costs as being SRE for all provisions of the IRC. The Notice provides:

SRE expenditures must be treated consistently for purposes of all provisions under subtitle A of the Code (subtitle A). Thus, expenditures that are defined as SRE expenditures under section 4.02(2) of this notice must be treated as SRE expenditures for all purposes under subtitle A. Such expenditures may not be treated as ordinary and necessary expenses under § 162 or capitalized under § 195, § 263(a), § 263A, or § 471. The amortization deductions arising from such SRE expenditures must also be allocated and apportioned consistent with the rules under §§ 1.861-8 and 1.861-17.[36]

Although not explicitly stated, it should be clear that by imposing this consistency requirement, the IRS is signaling its position that it will not allow a taxpayer to treat an expenditure as an SRE expenditure for purposes of IRC §41 (the credit for increasing research activities) while simultaneously deducting that expense as an ordinary and necessary business expense under IRC §162.

Software Development Expenditures

The IRS plans to issue proposed regulations defining which software development expenditures must be amortized under IRC §174, regardless of whether or not they would otherwise qualify as research and experimental expenditures.

Defined Terms

Section 5 of the Notice provides the following definitions related to software development:

(1) Computer software. The term computer software generally means any computer program or routine (that is, 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 (for example, a disk or DVD), or accessed remotely via a private computer network or the Internet, for example, via 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. Computer software also generally includes computer programs of all classes, for example, 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 (as defined in section 5.02(2) of this notice). Computer software 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. Computer software does not include any data or information base described in § 1.197-2(b)(4) unless the database or item is in the public domain and is incidental to a computer program. For example, customer lists or client files are not included in computer software unless such items are in the public domain and incidental to a computer program. Additionally, computer software does not include any procedures that are external to the computer’s operation.

(2) Upgrades and enhancements. The term upgrades and enhancements generally means 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 speed or efficiency of the software.[37]

Activities Treated as Software Development

A non-exclusive list of activities treated as software development for the purposes of IRC §174 is provided in the Notice.

Planning the development of the computer software (or the upgrades and enhancements to such software), including identification and documentation of the software requirements;
Designing the computer software (or the upgrades and enhancements to such software);
Building a model of the computer software (or the upgrades and enhancements to such software);
Writing source code and converting it to machine-readable code;
Testing the computer software (or the upgrades and enhancements to such software) and making necessary modifications to address defects identified during testing, but only up until the point in time that:
- In the case of computer software developed for use by the taxpayer in its trade or business, the computer software is placed in service; and
- In the case of computer software developed for sale or licensing to others, technological feasibility has been established, product masters(s) have been produced, and the computer software is ready for sale or licensing to others; and
In the case of computer software developed for sale or licensing to others (or the upgrades and enhancements to such software), production of the product master(s).[38]

Special Rules Related to Purchased Software

The Notice outlines special treatments that apply to purchased software:

In the case of upgrades and enhancements to purchased computer software, the principles set forth in section 5.03 of this notice apply. However, 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 § 174.[39]

Activities Not Treated as Software Development

The Notice provides a list of items not considered software development for the purposes of IRC §174.

Computer software developed by a taxpayer for use in its trade or business. In the case of computer software that is developed for use by the taxpayer in its trade or business (or upgrades and enhancements to such software):
- 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 (for example, corrective maintenance to debug, diagnose, and fix programming errors);
- Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion; and
- Installing the computer software and other activities relating to placing the computer software in service.[40]
Computer software developed for sale or licensing to others. In the case of computer software that is developed for sale or licensing to others (or upgrades and enhancements to such software), activities that occur after such software (or upgrades and enhancements to such software) is ready for sale or licensing to others, such as marketing and promotional activities, maintenance activities that do not give rise to upgrades and enhancements, distribution activities (for example, making the software available via remote access), and customer support activities.[41]

Research Performed Under Contract

Section 6 of the Notice offers guidance on determining when costs paid or incurred for research performed under contract qualify as SRE expenditures.

Definitions

Section 6 provides the following definitions related to research performed under contracts:

Research provider. The term research provider means the party that contracts with a research recipient (as defined in section 6.02(2) of this notice) to:
- perform research services for the research recipient with respect to an SRE product, or
- develop an SRE product (as defined in section 6.02(4) of this notice) that the research recipient acquires from the research provider.
Research recipient. The term research recipient means the party that contracts with the research provider to:
- perform research services for the research recipient with respect to an SRE product, or
- develop an SRE product that the research recipient acquires from the research provider.
Financial risk. The term financial risk means the risk that the research provider may suffer a financial loss related to the failure of the research to produce the desired SRE product.
SRE product. The term SRE product means any pilot model, process, formula, invention, technique, patent, computer software, or similar property (or a component thereof) that is subject to protection under applicable domestic or foreign law. For example, mere know-how gained by a research provider through the performance of research services for a research recipient that is not subject to protection under applicable domestic or foreign law does not give rise to an SRE product in the hands of the research provider.[42]

Treatment of Costs Paid or Incurred by a Research Recipient

The Notice provides the following details on the treatment of costs paid or incurred by a research recipient:

The treatment of costs paid or incurred by the research recipient is governed by the principles set forth in § 1.174-2(a)(10) and (b)(3).[43]

Treasury Reg. §1.174-2(a)(10) provides:

(10) Amounts paid to others for research or experimentation. The provisions of this section apply not only to costs paid or incurred by the taxpayer for research or experimentation undertaken directly by him but also to expenditures paid or incurred for research or experimentation carried on in his behalf by another person or organization (such as a research institute, foundation, engineering company, or similar contractor). However, any expenditures for research or experimentation carried on in the taxpayer's behalf by another person are not expenditures to which section 174 relates, to the extent that they represent expenditures for the acquisition or improvement of land or depreciable property, used in connection with the research or experimentation, to which the taxpayer acquires rights of ownership.[44]

While Treasury Reg. §1.174-2(b)(3) reads:

(3) Amounts paid to others for research or experimentation resulting in depreciable property. If expenditures for research or experimentation are incurred in connection with the construction or manufacture of depreciable property by another, they are deductible under section 174(a) only if made upon the taxpayer's order and at his risk. No deduction will be allowed (i) if the taxpayer purchases another's product under a performance guarantee (whether express, implied, or imposed by local law) unless the guarantee is limited, to engineering specifications or otherwise, in such a way that economic utility is not taken into account; or (ii) for any part of the purchase price of a product in regular production. For example, if a taxpayer orders a specially-built automatic milling machine under a guarantee that the machine will be capable of producing a given number of units per hour, no portion of the expenditure is deductible since none of it is made at the taxpayer's risk. Similarly, no deductible expense is incurred if a taxpayer enters into a contract for the construction of a new type of chemical processing plant under a turn-key contract guaranteeing a given annual production and a given consumption of raw material and fuel per unit. On the other hand, if the contract contained no guarantee of quality of production and of quantity of units in relation to consumption of raw material and fuel, and if real doubt existed as to the capabilities of the process, expenses for research or experimentation under the contract are at the taxpayer's risk and are deductible under section 174(a). However, see subparagraph (4) of this paragraph.[45]

Treatment of Costs Paid or Incurred by Research Provider

The Notice offers the following guidance related to costs incurred by a research provider:

If the research provider bears financial risk under the terms of the contract with the research recipient, then costs paid or incurred by the research provider that are incident to the SRE activities (see section 4.03 of this notice) performed by the research provider under the contract are SRE expenditures. However, even if the research provider does not bear financial risk under the terms of the contract with the research recipient, if the research provider has a right to use any resulting SRE product in the trade or business of the research provider or otherwise exploit any resulting SRE product through 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 § 174(a)(2), regardless of whether the research recipient is required to treat its costs as SRE expenditures under section 6.03 of this notice. For purposes of the preceding sentence, a research provider will not be treated as having a right to use the SRE product in the trade or business of the research provider or otherwise exploit 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 § 267 or § 707.[46]

Example Related to Contract Research

The Notice provides the following example to illustrate the principles related to contract research:

Example

(1) Facts. Company C engages Company D, a contractor located in the United States, to develop an SRE product for use in Company C’s trade or business. The activities undertaken by Company D are undertaken upon Company C’s order, and Company D makes no performance guarantees with respect to the SRE product. Company C will pay Company D a fixed sum of $25,000 plus an amount equivalent to Company D’s actual expenditures. Company D does not have any right to use or otherwise exploit any resulting SRE product. In 2023, Company D incurs $125,000 of expenditures to successfully develop the product in the United States, and Company C pays to Company D $150,000 pursuant to the terms of the contract.

(2) Analysis. Under section 6.04 of this notice, Company D may not treat the $125,000 of expenditures it incurs to develop the SRE product on behalf of Company C as SRE expenditures under § 174 because (i) Company D does not bear financial risk, and (ii) Company D does not have any right to use or otherwise exploit any resulting SRE product. Under section 6.03 of this notice, the $150,000 paid by Company C is an amount paid to another party for research or experimentation undertaken on Company C’s behalf under § 1.174-2(a)(10) and (b)(3) and is thus an SRE expenditure under section 4.02(2) of this notice. The applicable § 174 amortization period is 5 years (60 months) because the research is performed by Company D in the United States. Company C’s location is not relevant for determination of the applicable § 174 amortization period.[47]

Disposition, Retirement, or Abandonment of Property

Section 7 offers guidance on the treatment of unamortized SRE expenditures if property, with respect to which such expenditures are paid or incurred, is disposed of, retired, or abandoned during the §174 amortization period.

General Rule

The Notice provides a general rule that applies to such situations, except in cases where a corporation that incurred the expenses ceases to exist.

Except as provided in section 7.04 of this notice, if any property with respect to which SRE expenditures are paid or incurred is disposed of, retired, or abandoned during the applicable § 174 amortization period, no recovery is allowed with respect to the unamortized SRE expenditures on account of such disposition, retirement, or abandonment, and the taxpayer that disposed of, retired, or abandoned such property continues to amortize such expenditures under § 174 over the remainder of the applicable § 174 amortization period. For purposes of this section 7, the term unamortized SRE expenditures means the amount of any SRE expenditures paid or incurred by the corporation (or its predecessor), less the amount of any amortization deductions previously allowed to the corporation (or its predecessor) under § 174.[48]

The fact that the property is disposed of prior to the midpoint of the year in which the costs were incurred does not alter the results.

An amortization deduction is allowed under § 174 for SRE expenditures even if such expenditures relate to property that is disposed of, retired, or abandoned prior to the midpoint of the taxable year in which such expenditures are paid or incurred. Accordingly, such expenditures are subject to the rules in sections 7.02 and 7.04 of this notice.[49]

Transactions in Which the Corporation Ceases to Exist

The Notice outlines two separate treatments if a corporation ceases to exist: one for transactions subject to IRC §381(a), where attributes carry over to the successor corporation, and another for transactions not subject to that provision.

Transactions Subject to IRC §381(a)

The Notice provides for a “step in the shoes” treatment for the successor corporation when the transaction is subject to IRC §381(a), with the successor corporation continuing to amortize the remaining balance of the costs over the remaining term.

If a corporation ceases to exist for Federal income tax purposes in a transaction or series of transactions described in § 381(a), the acquiring corporation will continue to amortize the distributor or transferor corporation’s unamortized SRE expenditures over the remainder of the distributor or transferor corporation’s applicable § 174 amortization period beginning with the month of transfer.[50]

Other Transactions Where the Corporation Ceases to Exist

In most other transactions where the corporation ceases to exist, the corporation is granted a deduction for the unamortized balance in its final year.

Except as provided in section 7.04(2)(b), if a corporation ceases to exist for Federal income tax purposes in a transaction or series of transactions to which § 381(a) does not apply, the corporation is allowed a deduction equal to the unamortized SRE expenditures in its final taxable year.[51]

However, in a section entitled “Anti-abuse Exception,” the Notice stipulates that the immediate deduction provision will not apply if a principal purpose of the transaction is to claim a deduction for unamortized SRE expenses.

Section 7.04(2)(a) of this notice does not apply if a principal purpose of the transaction(s) described in section 7.04(2)(a) of this notice is to claim a deduction for the unamortized SRE expenditures.[52]

Generally, the IRS would consider a transaction to have a principal purpose of claiming a deduction for unamortized SRE expenditures if there is no other significant business reason for the transaction and it’s clear that the transaction would not have occurred but for the existence of the deduction rule.

Long Term Contracts Under IRC §460

Section 8 of the Notice addresses issues arising from the changes under IRC §174 as they relate to long-term contracts, as defined in IRC §460. Specifically, the guidance pertains to the application of the percentage-of-completion method (PCM) in such circumstances.

Background and Why This Has Become an Issue

The IRS provides a background discussion to elucidate the nature of the problem arising from the change in IRC §174 as it relates to those using PCM accounting for long-term contracts under IRC §460.

Section 460(a) generally requires use of the PCM to account for taxable income from a long-term contract. Section 1.460-4(b)(2)(i) provides that under the PCM, the portion of the contract price a taxpayer must report in a tax year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs. This ratio represents the portion of a contract considered completed for purposes of the PCM. Under the PCM, a taxpayer generally deducts allocable contract costs as they are incurred. As provided by § 1.460-4(b)(2)(iv), an increase in the percentage of the contract price to be reported is matched by deduction of the incurred costs that cause the increase. Under the current § 460 regulations in § 1.460- 5(b)(2)(vi), allocable contract costs include research or experimental expenses, other than independent research and development expenses. Thus, when these expenses are incurred, they increase the portion of a contract considered completed and the percentage of the contract price required to be reported. The current § 460 regulations were drafted when a taxpayer could deduct currently research or experimental expenses under former § 174. Section 174(a), as amended by the TCJA, requires that SRE expenditures be charged to capital account and deducted over the applicable § 174 amortization period. As a result, the current § 460 regulations provide that incurred research or experimental expenses increase the percentage of the contract price required to be reported, although § 174(a) prevents a corresponding current deduction of incurred SRE expenditures. The resulting mismatch of contract price and contract costs is inconsistent with the contemplated operation of the PCM.[53]

Revised Treatment of §174 Costs Under PCM

To address the mismatch between the contract price and contract costs triggered under the current §460 regulations following the capitalization of costs under the new IRC §174, the Notice provides the following guidance:

The Treasury Department and the IRS anticipate issuing proposed regulations that would amend the existing § 460 regulations, including § 1.460-5(b)(2)(vi), to provide that the costs allocable to a long term contract accounted for using the PCM include amortization of SRE expenditures under § 174(a)(2)(B), rather than the capitalized amount of such expenditures, and that such amortization is treated as incurred for purposes of determining the percentage of contract completion as deducted. The amendments would not apply to expenditures previously capitalized under § 59(e)(2)(B) or under former § 174(b), or to independent research and development expenditures, as defined in § 460(c)(5), which are not allocable contract costs. Research or experimental expenditures that are not independent research and development expenditures, however, would remain subject to allocation under § 460(c)(1) regardless of whether they are SRE expenditures.[54]

Cost Sharing Regulations (Reg. §1.482-7)

Another set of regulations impacted by the change in the treatment of §174 expenses pertains to regulations under IRC §482.

Background

As with long-term contracts, the Notice begins by providing the background to the impacted regulation.

Section 1.482-7(j)(3)(i) addresses cost sharing transaction payments (CST Payments) between controlled participants in a cost sharing arrangement (CSA) that are made to ensure that 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 (RAB share). Section 1.482-7(j)(3)(i) generally provides that CST Payments reduce deductible IDCs borne by the controlled participant to which the CST Payments are owed. Any amount of CST Payment in excess of such deductible IDCs is treated as in consideration for the use of land and tangible property furnished for purposes of the CSA by the controlled participant to which the CST Payment is owed. CST Payments generally are considered the payor’s costs of developing intangibles at the location where such development is conducted. See also § 1.482-7(j)(3)(iii), Example 1.[55]

Updated Guidance

The Notice provides the following updated guidance in this area:

(1) The Treasury Department and the IRS anticipate issuing proposed regulations that would replace the second through fourth sentences of § 1.482-7(j)(3)(i) with rules providing that CST Payments owed to a controlled participant reduce:

(a) The amount of the category of IDCs borne directly by that participant that are-36- required to be charged to capital account, and

(b) The amount of the category of IDCs borne directly by that participant that are not described in section 9.03(1)(a) of this notice and that are deductible.

(2) CST Payments not in excess of the payor’s RAB share of the total amount of the IDCs in both categories described in section 9.03(1)(a) and (b) of this notice reduce the amount of each such category of IDCs in the same proportion that the total amount of the IDCs in each category bears to the total amount of IDCs in both categories. CST Payments in excess of the payor’s RAB share of the total amount of IDCs in both categories described in section 9.03(1)(a) and (b) of this notice will be treated as income.[56]

Applicability Dates

The Notice provides information on the applicability dates of this guidance in Section 10 of the Notice.

It is anticipated that the forthcoming proposed regulations will provide that rules consistent with the rules described in sections 3 through 9 of this notice would apply for taxable years ending after September 8, 2023. Except as otherwise provided in this section 10.01, prior to the publication date of the forthcoming proposed regulations in the Federal Register, a taxpayer may choose to rely on the rules described in sections 3 through 9 of this notice, including for expenditures paid or incurred in taxable years beginning after December 31, 2021, provided the taxpayer relies on all the rules in sections 3 through 9 of this notice and applies them in a consistent manner. However, taxpayers may not rely on the rules in section 7 of this notice for SRE expenditures paid or incurred with respect to property that is contributed to, distributed from, or transferred from a partnership.[57]

The IRS also plans to release additional guidance, offering taxpayers—a number of whom have already filed their 2022 income tax returns—a method to change their accounting method to align with the guidance in this Notice.

The Treasury Department and IRS intend to issue guidance in the Internal Revenue Bulletin (see § 601.601(d) of the Procedural Rules) to provide procedures for taxpayers to obtain automatic consent to change methods of accounting to comply with this notice. Until the issuance of such procedural guidance, taxpayers may rely on section 7.02 of Rev. Proc. 2023- 24 to change their methods of accounting under § 174 to comply with this notice. The Treasury Department and IRS anticipate issuing updated procedures that will address situations in which taxpayers have, prior to the issuance of this notice, changed methods of accounting to comply with § 174 as amended by the TCJA but whose treatment of SRE expenditures is not entirely consistent with this notice. Unless specifically authorized by the Commissioner of Internal Revenue or by statute, a taxpayer may not request, or otherwise make, a retroactive change in method of accounting by filing an amended return. See Rev. Rul. 90-38, 1990-1 C.B. 57; Rev. Rul. 2023-8, 2023-18 I.R.B. 801.[58]

[1] Notice 2023-63, September 8, 2023, https://www.irs.gov/pub/irs-drop/n-23-63.pdf (retrieved September 8, 2023)

[2] Notice 2023-63, September 8, 2023

[3] Notice 2023-63, September 8, 2023

[4] Notice 2023-63, September 8, 2023

[5] Notice 2023-63, September 8, 2023

[6] Notice 2023-63, September 8, 2023

[7] Notice 2023-63, September 8, 2023

[8] Notice 2023-63, September 8, 2023

[9] Notice 2023-63, September 8, 2023

[10] Notice 2023-63, September 8, 2023

[11] Notice 2023-63, September 8, 2023

[12] Notice 2023-63, September 8, 2023