Understanding IRS Notice 2023-63: Section 174 SRE Capitalization and Amortization Guidance

Notice 2023-63 Provides Clarity on Capitalization and Amortization of Research Costs

On September 8, 2023, the Internal Revenue Services (IRS) released Notice 2023-63 (the Notice), Guidance on Amortization of Specified Research or Experimental (SRE) expenditures under Internal Revenue Code Section 174. This Notice clarifies matters covered under the Section 174 enacted under the Tax Cuts and Jobs Act of 2017. Revisions to Section 174 are effective for tax years beginning after December 31, 2021, and require capitalizing and amortizing expenditures for or incident to research and experimentation activities.

IRS Notice 2023-63 provides administrative guidance to several key areas that are discussed below:

1. Identification and allocation of expenditures for SREs
2. Software development activities
3. Research performed under contracts
4. Disposition, retirement or abandonment of property
5. Interaction of Section 174 and Section 460 accounting for long-term contracts

The guidance in Notice 2023-63 is not intended to impact qualified research expenditures (QREs) used to calculate the Section 41 Credit for Increasing Research Activities (R&D Credit). The intent of the Notice is to clarify the broader definition of costs for SRE activities that must be capitalized under Section 174. The IRS also announced plans to issue regulations consistent with the general rules laid out in the Notice.

The effective date for the Notice is tax years ending after September 8, 2023. However, taxpayers may rely on the rules in the Notice for tax years starting after December 31, 2021, if the Notice rules are followed consistently and in their entirety.

The notice requests comments on the issues covered in the Notice with a deadline of November 24, 2023, and promises Proposed Regulations addressing matters covered in the Notice.

Your Guide Forward

If you have questions or want to learn more about IRC Section 174 capitalization and amortization of SRE expenditures or the Section 41 R&D tax credit, please consult your Cherry Bekaert advisor or contact Cherry Bekaert’s Tax Credits & Incentives Advisory practice today.

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Identification and Allocation of Expenditures for SRE Activities

Costs of SRE activities

The notice provides guidance on costs that must be capitalized and those that are not required to be capitalized. A key definition provided by the Notice is for SRE activities. These activities are defined as:

• Software development activities
• Activities conducted in the experimental or laboratory sense intended to discover information that would eliminate uncertainty concerning the development improvement or appropriate design of a product, component or subcomponent

The notice highlights the following examples of SRE expenditures as subject to Section 174:

a) Labor Costs – Labor costs for full-time, part-time, contract employees and independent contractors who perform, supervise or directly support SRE activities. The notice clarifies that labor costs include activities for the supervision and direct support of SRE activities, similar to rules for the R&D credit.

The following categories of expenditures must be considered in determining total labor costs:

• Basic compensation
• Stock-based compensation
• Overtime Pay
• Vacation Pay
• Holiday Pay
• Sick Leave Pay
• Payroll Taxes
• Pension Costs
• Employee Benefits
• Supplemental Unemployment Payments

b) Materials and Supplies Costs – Expenditures for materials and supplies used or consumed in the performance of SRE activities or the direct support of SRE activities, including tools and equipment that are not depreciable under Section 168

c) Cost Recovery Allowance – Depreciation, amortization, or depletion allowances for property used in the performance of or the direct support of SRE activities. This covers cost recovery allowances for property placed in service before the effective date of the new Section 174 requirements.

d) Patent Costs – Expenditures for obtaining and perfecting patents, such as attorney’s fees. Patent costs for defending or acquiring existing patents are generally not considered SRE expenditures.

e) Operations and Management – Examples of operations and management expenditures include:

• Rent
• Utilities
• Insurance
• Taxes
• Repairs and Maintenance
• Security costs
• Overhead, occupancy and related equipment costs

f) Travel Costs – Costs for travel for the performance of or the direct support of SRE activities

Costs Not Treated as SRE Expenditures

a) General and administrative service departments – Examples of costs of services and functions that only indirectly support or benefit SRE activities are not identified as SRE expenditures:

• Costs of payroll personnel preparing paychecks for research personnel
• Costs of human resource personnel who hire research personnel
• Costs of accounting personnel who account for research expenses

b) Interest on debt to finance SRE activities

c) Expenditures not considered software development activities under Section 174:

• Training employees and other stakeholder users of the software
• Maintenance after software is placed in service that does not give rise to upgrades and enhancements
• Data conversion
• Installation
• Costs to input content into websites and costs for website hosting
• Distribution, marketing and customer support

Allocation Methodology

Costs are allocated to SRE activities based on a methodology with a cause-and-effect relationship between the costs and SRE activities, or another relationship that reasonably relates the costs incurred to the benefits provided by the SRE activities. Taxpayers identify costs that meet the elements in Section 174 or develop a reasonable allocation method based on the benefits provided by the SRE activities.

A methodology used to allocate one type of expenditure does not need to be used for all other types of costs. Allocation methods are required to be used consistently across each type of cost. The Notice provides examples of appropriate allocation methodologies:

• Allocating compensation costs based on the ratio of labor hours spent on SRE activities
• Allocating deprecation for buildings used in SRE activities based on the ratio of square footage used for SRE activities over the square footage for the building covered by the depreciation
• Utilities and occupancy expenditures based on usage, square footage or labor hours allocation factors − this depends on the information and causal relationship between the costs and activities

Software Development

The Notice defines computer software as “any computer program or routine (that is, any sequence of code) designed to cause a computer to perform a desired function or set of functions and the documentation required to describe and maintain that program or routine.” This includes applications, platforms, embedded software and the like. Computer software does not include databases or procedures external to the computer’s operation.

Upgrades and enhancements are defined as modifications to existing computer software that result in additional functionality, or a material increase in speed or efficiency of the software.

Software Development Expenditures Capitalized

The Notice identifies the following activities as software development or the development of upgrades or enhancements to software. Expenses incurred for these activities are subject to capitalization and amortization:

• Planning development of the computer software, including documenting the software requirements
• Designing computer software
• Building models or prototype software programs or components
• Writing source code
• Testing the computer software and making modifications to address defects up to the point in time that for:
  • Self-developed software intended to be used by the taxpayer in its trade or business up to the placed-in-service date
  • Software developed for sale, lease or license to outside parties when technological feasibility has been established, product masters have been produced and the software is ready for release
• The production of product masters for software intended to be sold, leased or licensed to third parties

The activities noted above can be applied to upgrades and enhancements of the purchased or acquired software. Taxpayers will use the same rules to identify costs that are capitalized and amortized for upgrading and enhancing purchased software.

Activities That Are Not Software Development

The Notice identifies activities associated with acquiring or purchasing software that are not SRE activities. Costs for the following activities are not required to be capitalized:

• Selection and purchase of existing software
• Installation
• Configuration
  • Defined as manipulating pre-coded parameters to make the software compatible with the business and reengineering the business to make it compatible with the acquired software
• Planning, designing, modeling, testing or deployment activities concerning the purchase and installation of such software
• Training employees and other stakeholder users of the software
• Maintenance after software is placed in service that does not give rise to upgrades and enhancements
• Data conversion

Costs associated with developing software for sale or license to others that do not involve efforts towards upgrades or enhancements are not required to be capitalized under Section 174. These may include maintenance, support, debugging expenditures and similar activities that do not represent upgrades or enhancements.

Research Performed Under Contract

The Notice addresses activities under a contract to develop an SRE product or an SRE product that a recipient acquires from the research provider. Contracts that cover best efforts towards an identified SRE product and stipulate that a product or specifications are delivered are covered by this requirement.

An SRE product is any of the following:

• Pilot model
• Process
• Formula
• Invention
• Technique
• Patent
• Computer software
• Similar Property

A provider or recipient is not required to pursue or obtain a formal patent, trademark, or copyright for an SRE product. SRE activity must relate to the goal of producing an SRE product and not general research.

A research provider capitalizes costs when it takes financial risk or has the right to use, sell, lease or license the resulting SRE product in its trade or business. Financial risk occurs when the research provider might incur a loss due to unsuccessful research for the desired SRE product. The provider has a right to the SRE product if approval from another party is unnecessary. The Notice’s stance on funded research contrasts with the R&D tax credit concept, which requires both financial risk and rights to SRE products. The Notice recognizes situations where both the research provider and recipient may capitalize and amortize SRE activity expenditures.

Disposition, Retirement or Abandonment of Property

Section 174 provides that costs capitalized must continue to be amortized under the appropriate recovery period even when any underlying property is disposed of, retired or abandoned.  Amortization continues to the end of the amortization period.

The Notice addresses general stock transactions where a corporation continues operations under materially similar corporate structures. The acquiring company must continue to amortize the unamortized SRE expenditures as if the transaction did not occur.

Additionally, the Notice discusses asset transactions not described in Section 381(a), such as when the corporation transfers assets to the acquiror and then ceases to exist. The company is allowed a deduction equal to the unamortized SRE expenditures when this happens.

Interaction of Section 174 Requirements and Section 460 Long-Term Contracts

Capitalizing research and development costs per Section 174 clashes with tax calculations under Section 460 for long-term contracts. Section 460 mandates the percentage-of-completion method (PCM), where contract costs are deducted as incurred, creating a mismatch when SRE expenditures are capitalized. PCM aims to align contract income with spending progress, but the new Section 174 and Section 460 interaction goes against this.

The Notice provides that the IRS intends to issue proposed regulations for Section 460, calling for the use of amortization deductions under Section 174 as allocable contract costs, rather than SRE capitalized costs for determining income recognized under PCM. With the future guidance, Section 174’s capitalized costs will not be treated as allocable contract costs, but rather the amortization expense will be reported as the allocable contract cost.