With the passage of the 2017 Tax Cuts & Jobs Act, IRC Sec. 174(a) was amended requiring taxpayers to charge specified research or experimental expenditures including software development costs to a capital account and amortize them over five years (15 years for expenditures attributable to research performed outside the United States). The law was effective for tax years beginning on or after January 1, 2022. In September, the IRS issued Notice 2023-63 which provided pre-regulatory guidance in the following areas:
Capitalization and amortization of SRE Expenditures: The notice provides taxpayers with additional guidance on how to capitalize and amortize SRE expenditures. Specifically, the term “midpoint” means the first day of the seventh month of the tax year in which the SRE expenditures are paid or incurred, except for short tax years. In a short taxable year, taxpayers prorate the amortization deduction based on the number of months in that short taxable year. This guidance provides clarity into whether the five- or 15-year recovery period refers to calendar years (i.e., 60 or 180 months) or taxable years.
Definition of software development: Notice 2023-63 includes several definitions in Section 5.02(1) as it relates to software development. The guidance provides a list of certain activities that will be treated as software development including:
Planning and development of computer software
Designing the computer software or upgrades and enhancements
Building a model of the computer software
Writing source code and converting to machine-readable code
Certain testing of the computer software until it is placed in service or ready for sale or licensing
Production of the product master(s) (for computer software developed for sale or licensing to others)
Activities that do not constitute software development include employee training, maintenance after the software is placed in service, data conversion activities and installation of the computer software.
Research performed under Contract
The notice provides guidance on who, in a contract research arrangement, incurs the SRE expenditures. The two main parties to the arrangement as defined by the notice are either the research provider or the research recipient. The Notice’s guidance is very detailed and nuanced. However, the key takeaway is a research provider is only subject to sec 174 if the provider bears financial risk or the provider has a right to use any resulting SRE product in its trade or business or otherwise exploit any resulting SRE product through sale, lease or license.
Long Term Contracts
The notice provides that costs allocable to a long-term contract accounted for using the Percentage of Completion method include the amortization deduction associated with SRE expenditures, rather than the total amount of SRE expenditures incurred during the tax year.
Cost sharing under Section 482
The Notice states the IRS intends to update existing transfer pricing regulations under Section 482 to clarify the appropriate allocation of SRE costs between controlled participants in a cost sharing arrangement.
Disposition, retirement, or abandonment of property
If any property related to SRE Expenditures is disposed, retired, or abandoned during the period when the expenditures are allowed as an amortization deduction, no deduction shall be allowed with respect to such expenditures on account of the disposition, retirement, or abandonment, and the amortization deduction shall continue with respect to such expenditures. The notice provides additional guidance to specific corporate transactions, but the IRS has requested public comment concerning the appropriate application of Section 174(d) to various partnership transactions.
If you have any questions on whether Notice 2023-63 impacts your organization please contact the tax professionals at Lee & Crowley.