Tax executives, certified public accountants, CEOs, and CFOs of companies that spend a lot on research and development (R&D) have a special tax problem this year: a 2017 change to the U.S. tax code disallows immediately deducting R&D expenses and requires them to be capitalized and amortized. The change could cost U.S. companies billions of dollars.
There was hope Congress would delay the new tax treatment, but so far efforts have fallen short. With the first quarter coming to an end, companies' tax departments can't avoid the problem any longer. How did we get here? Read our FAQ to find out.
How did the change to amortization of R&D expenditures come about?
Since 1954 the U.S. tax code has allowed companies to expense R&D on their federal taxes, which gives an immediate tax deduction and, of course, reduces current tax liability, said Brent Johnson, co-founder of Clarus R+D.
In 2017, in an attempt to offset the revenue lost from cutting the U.S. corporate tax rate to 21% from 35%, Congress included in The Tax Cuts and Jobs Act a provision to require companies to capitalize and amortize R&D expenses, beginning January 1, 2022. The amortization needs to happen over 5 years for U.S. expenses and 15 years for non-U.S. or foreign expenses. The rule change is set forth in section 174(a) of the Internal Revenue Code.
Congress thought adding the new amortization rule to the original law would save the federal government $100 billion. The $100 billion would result from the slowdown of deductions over the years with the amortization and represented the lost deductions and credits to companies.
“As Congress does, it looked around for ways to pay for [the tax cuts],” said Steve Miller, former acting commissioner of the Internal Revenue Service and current national director of tax for alliantgroup. “So, it wasn’t a beacon of beautiful policy; it was merely a mechanism to raise money.”
What has been the reaction of U.S. businesses?
Businesses of many sizes and many industries have been against the tax code change, and in 2021 and early 2022 expressed their opposition. In a survey by Grant Thornton conducted in February, 17% of tax professionals indicated postponing R&D amortization was the biggest tax legislative priority for their business, second only to extending 100% bonus depreciation beyond 2022.
Eliminating the long-rooted ability to immediately expense R&D expenditures, including software development costs, creates a disincentive to engage in research and puts U.S. companies at a competitive disadvantage globally, according to a March letter to Congress from RSM and other accounting firms.
Not allowing for the immediate deductibility of R&D expenses will reduce cash flow for R&D activities and drive down the ROI on private sector R&D investments, according to the R&D Coalition.
“There's a pretty strong expectation, I would say, a remarkable likelihood that by the end of this year, when [Congress] finally passes a tax bill, they will delay the application of this rule once again for a while." — Steve Miller, national director of tax, alliantgroup
In early March, the CEOs of more than 30 big corporations urged Congress that a reversal of the rule be included in the omnibus spending package the Senate passed on March 11. But that bill contained no tax-related provisions. The CEOs said estimated taxes for the current quarter would be $8 billion higher if Congress didn’t act, citing data from the Joint Committee on Taxation. Through Sept. 30, 2022, the total tax bill could rise to $29 billion, according to the JCT.
So, the U.S. House of Representatives and the Senate oppose immediate R&D expensing?
No. Both Democrats and Republicans are very much in favor of at least delaying and possibly fully repealing R&D amortization, said Miller. The Biden administration’s Build Back Better legislation would have delayed the effective date for capitalization and amortization of R&D expenditures to tax years beginning after December 31, 2025.
Although the issue is time sensitive for companies — for first-quarter financial statements and quarterly corporate estimated tax purposes — Congress has not succeeded in attaching the provision to any bill. That doesn’t mean it won’t eventually happen in 2022.
“Every Congressperson has a company that's been impacted in their district, so I've seen no pushback,” Miller said.
Since the law is already in effect, what must CFOs do?
Without a legislative change, companies will need to factor R&D amortization into their estimated tax payments, tax returns, and financial statements beginning in 2022 quarters, according to Mark Drozdowski and Christine Kachinsky-Bye of KPMG, writing in CFO Dive.
Starting with the March 15 payment, companies will have to calculate estimated taxes without the R&D deductions. For some companies, there could be major cash tax implications from a quarterly estimated tax perspective.
Many CFOs are used to this uncertainty surrounding tax law, Miller said. They’ve had to deal with tax provisions that expire every year — called “extenders” — like the R&D tax credit [discussed below], he said. “There is always this period of unease as to whether [the extenders] are going to be passed again or not."
How could Congress take action?
Legislation that includes repeal or delay of the rule change in section 174 could still make its way through Congress.
“There's a pretty strong expectation, I would say, a remarkable likelihood that by the end of this year, when [Congress] finally passes a tax bill, that they will delay the application of this rule once again for a while,” Miller said, possibly until 2025.
Dealing with tax changes retroactively is not new for Congress. Many times companies would go an entire year, for example, without knowing whether the R&D tax credit was going to be re-upped, Miller said.
Retroactively deferring the R&D expensing provision, however, will not alleviate the short-term cash tax and reporting challenges. “Businesses will be preparing their tax provisions (and likely making their estimated tax payments) based on the requirements in the currently enacted tax law,” wrote Drozdowski and Kachinsky-Bye of KPMG.
Can the R&D tax credit help reduce tax liability?
The federal R&D tax credit, introduced in 1981, is not changed by the new tax treatment of expenses. It can be claimed by taxpaying businesses that develop, design, or improve products, processes, formulas, or software.
The credit was introduced in 1981 to increase technical jobs in America by encouraging businesses to invest in innovation. It is calculated based in part on the wages of the employees performing the qualifying work. The credit is generally between 7% and 10% of what the organization spends on qualifying research and development, explained Johnson of Clarus R+D.
The amortization rule, because it will result in some companies having a tax liability, makes it more important to go through the exercise and claim the credit, Johnson said. “The exercise of claiming the credit can be a little cumbersome, and so a lot of businesses don't do it,” he said.
And the tax credit isn’t limited to large corporations with large lab operations. Start-ups and small businesses may qualify for up to $1.25 million (or $250,000 each year for up to five years) of the R&D tax credit to offset the Federal Insurance Contributions Act (FICA) portion of their annual payroll taxes. To be eligible, a company must, among other things, have less than $5 million in gross receipts for the credit year and have no more than five years of gross receipts.
There are many different activities the credit applies to, said Johnson, but fundamentally it comes down to this: Is the organization relying on the hard sciences to develop a new product or service or improve a process?