March 21, 2022
By Tim Rankins
Historically, taxpayers have been allowed to deduct “research and experimental” (R&E), or commonly referred to as R&D expenses, as an expense for tax purposes. However, the Tax Cuts and Jobs Act included a little-known provision that became effective for R&E amounts paid or incurred in tax years beginning after December 31, 2021. For tax purposes, the provision requires that taxpayers capitalize U.S.-based R&E expenses over a five-year period and foreign-based R&E expenses over a 15-year period.
What Are R&E expenses?
In general, an R&E expense is one that is directly connected to the taxpayer’s trade or business and represents costs rising from research in an experimental or laboratory setting that has an element of risk or failure. The objectives of the R&E also must be something that aims to produce a material improvement to a product or process – whether it be higher efficiency, better functionality, or something new and innovative.
To qualify as an expense for the R&D credit, that expense must be an eligible IRC Sec. 174 expense and backed up by contemporaneous documentation. Therefore, all qualified research expenses claimed for the credit are covered in this new capitalization provision.
What Does the New R&E Capitalization Rule Mean for Businesses?
Companies will be required to implement these changes for their 2022 first quarter financial reporting period, which can affect estimated tax payments, tax expense, and other tax matters. More specifically, from a financial reporting and tax provision perspective, a new temporary difference will be recorded that will increase current period taxable income, while providing for a new deferred tax asset on the balance sheet.
For tax return purposes, note that the R&E capitalization will not affect the R&D tax credit calculation. It will only impact deductions claimed as research expenses in the current tax period.
What Other Items Do Businesses Need to Consider?
- Taxpayers need to begin tracking R&E costs incurred on or after January 1, 2022 for their Q1 2022 income tax provisions and maintain proper supporting schedules for the R&D tax return position.
- For easier tracking and computation, it would be recommended to consider new G/L accounts that separate U.S.- versus foreign-based R&E costs, or alternatively workpaper improvements that bifurcate the R&E costs between U.S. and foreign since they both have differing capitalization periods for tax purposes.
- The recent “Build Back Better” legislation included a provision to delay the implementation of this R&E capitalization provision for four years, but only passed in the House (stalled in the Senate). It is unknown at this time if the delayed provision will resurface in a new bill.