July 27, 2023 A Fix on Impactful R&D Tax Policy Remains Elusive

New R&D capitalization requirements are affecting the manufacturing industry. The American Innovation and Jobs Act gives businesses hope.

By AJ Schiavone, Sophia Shah, and Nick Matera

Changes to tax accounting rules for research and development (R&D) costs have caught many manufacturing businesses by surprise, resulting in unexpectedly higher tax bills. The new tax rules stem from a provision in the Tax Cuts and Jobs Act of 2017 (TCJA), which eliminated immediate deductions for R&D costs under Internal Revenue Code Section 174. The new rules require capitalization of all R&D costs, including software development costs, incurred in tax years beginning after Dec. 31, 2021. Under the new rules, taxpayers are required to recover R&D costs via amortization over five years if the R&D activities are performed in the U.S. or over 15 years if the activities are performed outside of the U.S.

For many businesses, the tax liability impact has been staggering.

A corporate taxpayer that annually spends $10 million on R&D saw its 2022 federal tax bill increase by approximately $1.9 million due to the new rules. The additional tax bill is even higher for businesses that operate in states that conform to the federal tax accounting treatment of R&D costs.

The new tax accounting rules have created compliance headaches for businesses. Historically, most businesses were not overly concerned with distinguishing R&D costs from other ordinary operating expenses because the timing of the tax deduction was the same either way. Now, businesses are required to establish new accounting methods for identifying and quantifying costs that meet the tax law’s definition of research and experimental costs. Furthermore, the lack of substantive IRS guidance regarding the R&D topic leads to uncertainty for taxpayers that are trying to comply with the rules.

The TCJA was primarily aimed at reducing income tax rates. Congress incorporated certain revenue raisers, including the R&D accounting change, into the TCJA to offset some of the lost revenue from the tax rate reductions. The new R&D accounting rules are a major change in U.S. tax policy since businesses had been permitted immediate deductions for R&D costs since 1954. Thus, the new rules were surprising since they are contrary to other U.S. tax policies, such as the R&D tax credit, which incentivizes businesses to make R&D investments. 

Further, the new rules create a competitive imbalance for U.S. businesses, since many of their major economic competitors offer favorable tax accounting treatment for R&D expenditures. For example, China recently extended its policy enabling a super deduction of R&D expenses, which allows a company to deduct 200% of its R&D costs. The impact of the R&D capitalization requirement is compounded in the context of increased international competition for spending related to R&D, as the value of the U.S. R&D tax incentives are diminished due to this law change. Consequently, the requirement to capitalize and amortize expenses could affect R&D spending in the U.S., and it could also which areas manufacturers choose to locate production facilities and intellectual property.

Hope for a legislative fix

Given that new tax accounting rules could discourage businesses from making R&D investments and the fact the effective date of the new rules was set several years after the TCJA passed, many assumed the law would be reversed before it ultimately became applicable. Although there is bipartisan support for immediate expensing of R&D costs, Congress has been unable to agree on legislative terms to make it happen. Therefore, it is uncertain that a legislative fix will be in place before the 2022 tax filing deadline.

The American Innovation and Jobs Act, a bipartisan Senate bill introduced in March, would make R&D costs fully deductible; however, the bill is highly unlikely to advance since it does not include pay for provisions to offset the bill’s cost. On June 9, House Republicans introduced the Build It in America Act. The proposed legislation aims, in part, to address tax increases attributable to provisions in the TCJA, which took effect in 2022. The House bill includes a provision to permit immediate expensing of R&D costs for tax years beginning after Dec. 31, 2021, and before Jan. 1, 2026. However, the proposed Build It in America Act is facing resistance from many in the Democratic caucus, since it proposes to eliminate many of the green energy incentives passed into law in 2021 to cover the bill’s cost.

While we wait

American manufacturers invest heavily in R&D, which is the foundation for creating new and improved products, materials, and production processes. Consequently, manufacturers are significantly burdened by the R&D cost capitalization rules. Legislative relief from the TCJA’s R&D accounting rules is not a given. Therefore, manufacturing businesses must plan for increased tax bills and new accounting processes for identifying and quantifying R&D costs. With proper planning, manufacturers can optimize tax methods of accounting for R&D costs to mitigate the impact of the new rules.

About the Authors:

AJ Schiavone is a partner on the national R&D tax team at Crowe. He specializes in developing and tailoring customized work plans to strategically highlight and maximize business R&D credit benefits. He is also experienced with federal and state R&D credit examination audit defense.

He has a B.B.A. in accounting from the University of Notre Dame. His experience includes identifying industry-specific opportunities and defending federal and state research credit claims.

Sophia Shah is a senior tax manager on the federal tax consulting services team at Crowe and is located in New York City. She has more than nine years of experience in public accounting, focusing primarily on middle-to-large market R&D tax credit claims and Section 174 analyses within the manufacturing and distribution industry.

Prior to joining Crowe, Sophia focused on corporate and partnership tax compliance, income tax provisions, and business tax advisory services at EY. She has a B.S. in accounting and an M.S. in taxation from the University of North Texas.

Nick Matera is a tax manager on the federal tax consulting services team at Crowe. He has more than eight years of experience in public accounting, with a wide range from start-up to large market R&D and orphan drug tax credit claims within the technology, pharmaceutical, and manufacturing industries.

Prior to joining Crowe, Nick focused on wealth management tax services, income tax provisions, and R&D tax credit services at both PwC and CFGI. He has a B.S. in accounting and an MBA from La Salle University.

Learn more about tax services at Crowe

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