On Sept. 8, the IRS released Notice 2023-63 (Notice), providing additional guidance in connection with the amortization of Specified Research or Experimental (SRE) expenditures under IRC Section 174, as amended by the Tax Cuts and Jobs Act. The Notice states that the provisions contained in Sections 3 through 9 are applicable for taxable years ending after Sept. 8, 2023. Noteworthy portions of the Notice are highlighted below.
Section 4.03(1) of the Notice clarifies that labor costs – including those for contract employees and independent contractors – related to those who perform, supervise, or directly support SRE activities are considered Section 174 expenditures. All elements of compensation are to be included with the exception of severance, which is excludable and deducted by taxpayers in the period paid or incurred. SRE-related labor costs expenses included in the Notice expenses related to pension costs and stock-based compensation.
Operation and management activity costs
Section 4.03(1)(e) provides guidance pertaining to certain costs related to operation and management (i.e., rent, utilities, etc.) activities. Specifically, in addition to items such as rent, utilities, and insurance, expenditures such as taxes (i.e., property), repairs and maintenance, and security are now considered SREs subject to Section 174.
Section 5.03 of the Notice provides guidance on what constitutes software development for purposes of Section 174. Though the list is not exhaustive, it includes:
- Planning the development of the computer software (or the upgrades and enhancements to such software)
- Designing the computer software (or the upgrades or enhancements to such software)
- Building a model of the computer software (or the upgrades or enhancements to such software)
- Writing source code and converting it to machine-readable code
- Testing the computer software (or the upgrades or enhancements to such software) and making necessary modifications to address defects identified during testing, but only up until certain events occur (depending on whether the software is developed for use in the taxpayer’s trade or business or for sale or licensing to others)
- Production of the product master(s) if the computer software is developed for sale or licensing to others
Sections 5.04 and 5.05 highlight the following activities not considered to be Section 174 costs related to software developed for use in a taxpayer’s trade or business and software developed for sale or licensing to others:
- Training of employees in the use of the software
- Maintenance activities after the software is placed into service that do not constitute upgrades or enhancements (i.e., corrective maintenance to debug, diagnose, and fix programming errors)
- Data conversion activities (except activities to develop computer software that facilitates access to existing data or data conversion)
- Installation and other activities related to placing the software into service
- Marketing and promotional activities
- Distribution activities
- Customer support
Research performed under contract
Section 6 of the Notice provides guidance for taxpayers to determine whether costs paid or incurred for research performed under contract are expenditures subject to capitalization under Section 174. The Notice provides in Section 6.04 that if a research provider incurs a risk that it may suffer a financial loss related to the failure of the research to produce the desired SRE product, then costs paid or incurred by the research provider that are related to the SRE activities performed under the contract are SRE expenditures and subject to Section 174. The Notice further states, however, that even if the research provider does not have financial risk related to the research product, if it 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 the costs incurred by the research provider in connection with the SRE product are deemed to be SRE expenditures and subject to the capitalization and amortization rules under Section 174. In other words, the right to use the product or research by the research provider results in the expenditures being subject to Section 174 even if there is no financial risk to the provider. Section 6.05 of the Notice provides an example of a research provider that has neither financial risk or rights to use the SRE product.
Disposing of, retiring, or abandoning property
Section 7 reaffirms that, if a taxpayer disposes of, retires, or abandons any property with respect to which SRE expenditures are paid or incurred, no deduction is allowed with respect to the unamortized portion of the SRE expenditures. This is consistent with prior guidance related to Section 174 expenditures.
Long-term contracts under Section 460
Section 8 provides clarifying guidance related to long-term contracts under Section 460. Proposed regulations are expected to be forthcoming that would amend the existing Section 460 regulations to provide that costs allocable to a long-term contract accounted for using the PCM would include the amortization of SRE expenditures under Section 174 rather than the capitalized amount of those expenditures. The amortization of the SRE expenditures would be treated as incurred for purposes of determining the percentage of contract completion as deducted. The Notice does not contain a rule providing for how much SRE expenditures are included in the denominator of the completion factor under Section 460.
The Notice mentions two additional pieces of guidance that are anticipated to be forthcoming. First, the Treasury and IRS intend to provide procedures for taxpayers to obtain automatic consent to change its method of accounting to comply with the Notice. Second, updated procedures are anticipated to address situations in which taxpayers have, prior to the issuance of the Notice, 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.
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