The change in tax treatment of research and experimental expenditures under Internal Revenue Code Section 174, effective for tax years beginning after Jan. 1, 2022, could have additional impacts on US taxpayers that incur research costs overseas. Under previous rules, businesses had the option of deducting these expenses in the year they’re incurred, or capitalizing the costs and amortizing them over five or 10 years. Starting in 2022, businesses lose the option to deduct these costs in the year they are incurred.
Under the new rule, taxpayers must capitalize and amortize Section 174 expenses over a five-year period for research conducted in the US, or over a 15-year period for research conducted overseas. Many businesses need to review their expenditures to determine if costs they have deducted annually now qualify as “research and experimental expenditures” that must be capitalized and amortized for tax years beginning in 2022.
Taxpayers making payments for research outside the US will have some additional concerns. On its face, the new law imposes a longer amortization period on costs incurred for overseas research. So, some expenses that businesses deduct in full in 2021 will generate only one-thirtieth of that deduction in 2022, using the half-year convention to calculate the deduction in the year the cost is incurred.
The change also will have some secondary effects on calculating other items on the tax return, such as global intangible low-taxed income, foreign-derived intangible income, foreign tax credits, and base erosion and anti-abuse tax.
Capitalization of International Section 174 Expenses
Many businesses incur costs that meet the Section 174 definition of research and experimental expenditures. Until now, there has been little need to track those costs separately because they’ve been treated the same as other deductible expenses for tax purposes. Deductions for payments such as maintenance and overhead expenses on research facilities and wages for engineering and lab costs weren’t separated out from general building maintenance and wage accounts.
Businesses that have tracked costs in order to qualify for the research and experimentation tax credit may have systems in place to monitor some Section 174 expenses, but the Section 174 definition covers more types of expenditures than the limited list of costs that qualify for the R&E credit.
Businesses that make payments to service providers outside the US need to determine if the activities conducted qualify as “research” within the definition of Section 174. For example, if a business buys a raw material or a finished good from an overseas supplier, that cost probably doesn’t include a research component. But if it pays for engineering services or software development from an overseas supplier, some of the costs that have been fully deductible when incurred may now have to be amortized over 15 years.
Any business that relies on a global network of contractors and suppliers to develop products and deliver services likely will need a more detail-oriented system to track costs that qualify as Section 174 expenses and the jurisdiction in which they are incurred.
Special Concerns for Related Parties Overseas
Businesses whose global networks include related foreign subsidiaries may see additional consequences of this change. When Section 174 is applied to foreign R&D expenses incurred by controlled foreign corporations, taxpayers could see significant increases in tested income included in the GILTI calculation in the first year the rules are implemented. This will lead to additional GILTI inclusion and may result in residual GILTI tax.
In some cases, considering the new Section 174 rules, taxpayers that previously qualified for the high-tax exception under GILTI rules could become subject to the tax when foreign taxable income is recalculated for GILTI purposes. In most cases, the underlying tax paid in the foreign region will not change, as the foreign region will apply its own tax principles in computing taxable income without regard to US tax principles.
Double amortization concerns arise when a US taxpayer contracts a foreign subsidiary to perform R&D-related services. The payment to the foreign subsidiary is amortized over 15 years by the US business, and the related costs incurred by the foreign subsidiary are also amortized over 15 years for CFCs and foreign disregarded entities whose activities are includable in US income.
When this type of transaction occurs between multinational related parties, it can cause multiple layers of slower cost recovery that amplifies the impact on the taxable income of the US parent in the year the payment is made. This situation leaves the foreign subsidiary in the position of receiving the contract income for tax purposes in the year it’s earned with the benefit of only a small fraction of the deduction for related expenses.
The Section 174 change will also modify the taxable income number that provides the starting point for tax calculations such as FDII, BEAT, and the foreign tax credit. In some cases, the result could skew slightly in the taxpayer’s favor with these calculations, but the overall impact of this change will be a reduction in current-year deductions and a significant increase in current-year taxable income.
Many Questions Still Unanswered
Taxpayers applying the international aspects of the Section 174 expense amortization rules may benefit from IRS guidance. For instance, when engaging both unrelated and related foreign parties to conduct research on a taxpayer’s behalf, do both parties need to consider underlying expenses as capitalizable research? Or could a rights and risk model treat the payment as capitalizable research for one party and a deductible operating expense for the other? Additional guidance in this area could certainly help reduce the potential risk for dual amortization.
As there is no current path for this change to be deferred, taxpayers should review their expenses that could be subject to five- or 15-year amortization to project the tax impact of these new provisions on current-year tax liabilities. To learn more about how the amortization of Section 174 expenses and the related international aspects could affect your business, contact your tax adviser.
Robert Piwonski is an international tax senior manager at Plante Moran. He assists companies with global compliance and effective tax rate considerations, as well as advising on cross-border transactions, providing international tax due diligence, and offering continuous strategies to reduce worldwide cash taxes.
Caitlin Slezak is senior manager of Plante Moran’s national tax office. She advises colleagues and clients on emerging tax issues, focusing on technical tax accounting methods as they relate to tax revenue, expense recognition, and tax inventory accounting.
Jay Woods is an international tax manager at Plante Moran. As a member of the firm’s international tax services practice group, he works with internationally active clients, focusing on outbound operations and inbound services.