Companies that were anticipating large deductions for research expenses are headed for a larger-than-expected tax bill in 2022. Changes passed to the tax law in 2017 take effect in tax year 2022, and expenses previously deducted in the current tax year will now have to be amortized over five to fifteen years. The result is a smaller deduction this year, and thus higher taxes owed.
Taxpayers can use two R&D tax breaks to reduce their taxes: the R&D tax credit (Code Section 41) and the expensing of R&E expenditures (Code Section 174). The former is a narrower and targeted R&D credit that is tied to direct research expenses; the latter is where the issue lies. Together, these two provisions are expected to offset almost $87 billion in government revenue for 2020-2024, according to the Joint Committee on Taxation.
R&E Expensing No Longer Allowed
Since 1954, Section 174 and its related regulations have allowed businesses to expense qualified research spending in year one, rather than needing to capitalize and amortize in a way similar to general business expenses.
R&E expenditures include costs incurred in the “experimental or laboratory sense.” The costs must be for activities intended to eliminate uncertainty surrounding the development or improvement of a product. R&E expenditures subject to these rules include software development costs.
Prior to passage of the 2017 TCJA, R&E expenses were fully deductible in the year they were incurred. There was no distinction made between domestic expenses and those incurred internationally. Under the TCJA, as of January 1, 2022, domestic expenses must be amortized over five years, and international expenses over fifteen years. Some view this change as reducing American competitiveness in R&D because the U.S. was already falling behind other countries.
This change reduces the tax benefit of R&E expenditures and will affect a company’s cash flows and the ability to match income with deductions. The Tax Foundation says this move makes the U.S. an “outlier internationally” and will reduce the U.S.’s international competitiveness in R&D. While both the House of Representatives and the Senate have proposals to postpone the R&E amortization rule, most tax legislation is caught up in the Congressional election year standoff and is going nowhere. Furthermore, according to OECD, though the U.S. leads the world in R&D spend, China is leading in growth of R&D spending (almost 16%) with the U.S. in 5th place (less than 4%), and many predict China will catch the U.S. this year.
The AICPA has requested the IRS issue more guidance “that provides taxpayers with certainty and uniformity in the accounting for these costs, and that minimizes controversies over the categories of costs associated with R&E activities that are subject to amortization.”
America Is Falling Behind as Global Innovator
The impact of the TCJA is far broader than just taxes. The U.S. has fallen to 10th place in its R&D spend as percentage of GDP. In contrast, Israel and Korea have far less in actual dollars spent on R&D; however, as a percentage of their GDP, they lead the world, indicating their focus on science and innovation.
The R&D landscape has changed since the R&D tax credit was first established via ERTA in 1981. The R&D credit was among the first in the world, making the U.S. first in R&D. In 2018, the U.S. spent about $607 billion on research and development, with China coming in second at about $465 billion. In 2019, the gap was closed to $657 billion and $525 billion, respectively. As a share of gross domestic product, U.S. R&D expenditures is good for 10th place overall. Now, according to a 2020 Information Technology and Innovation Foundation report, the United States ranks 24th out of 30 in terms of combined federal and state research subsidies—well below both Russia and China.
Adapting To the New Rules
What should taxpayers do?
Do not wait for Congress to resolve this issue. Although it seems there is enough support to repeal or push the clock to 2026, not everyone agrees -especially those who contend any change would only help large corporations.
Taxpayers with significant research expenditures must modify their tax strategy beginning in 2022.
First, evaluate and track which expenditures come under the R&E rules. Second, project estimated taxes and adjust financial statement reporting to reflect actual numbers. Third, coordinate R&E amortization with the R&D credit. Fourth, evaluate possible state tax effects.
Consult your Frazier & Deeter tax advisor to make sure you get the tax benefits you’re entitled to for maintaining a robust research program at your company.