Contributor: Andrew Hoh | Senior Manager, Tax Credits & Incentives Advisory
On December 22, 2023, the Department of the Treasury and the Internal Revenue Service (IRS) released Notice 2024-12 and Rev. Proc. 2024-9 providing taxpayers with timely information concerning accounting method changes and the treatment of specified research and experimental (SRE) expenditures under Section 174 and Section 460.
Notice 2024-12 clarifies the scope of contract research costs subject to Section 174 and some of the language initially included in Notice 2023-63. While Rev. Proc. 2024-9 relieves the need for certain taxpayers to file non-automatic accounting method changes by year-end specifically, Rev. Proc. 2024-9 allows taxpayers to comply with the guidance in Notice 2023-63 by filing an automatic accounting method change for taxable years beginning after December 31, 2021.
Recent Updates
Notice 2024-12
Notice 2024-12 modifies the treatment of costs paid or incurred by a research provider for research performed under contract. This clarifies that a research provider would not have SRE expenses if it is not at risk, and any rights it acquires are either:
- Separately bargained for; or
- Limited for the sole purpose of performing SRE activities under the contract with the research recipient (collectively referred to as an excluded SRE product right).
Notice 2024-12 waives the previous requirement for taxpayers who chose to rely on any of the rules in Sections 3 through 9 of Notice 2023-63 to have relied on all the rules in Sections 3 through 9. This was to address instances where taxpayers may have been required to amend a tax return that was filed before or shortly after Notice 2023-63 was issued. Taxpayers may not be able to change certain positions on the return that were inconsistent with various sections.
Notice 2024-12 also clarifies that Rev. Proc. 2000-50 is now obsolete for expenditures paid or incurred for taxable years beginning after before December 31, 2021.
Finally, Notice 2024-12 clarifies the interim guidance in Notice 2023-63 regarding the treatment of Section 174 SRE expenditures under Section 460 for those taxpayers on the PCM.
Rev. Proc. 2024-9
Rev. Proc. 2024-9 modifies the Rev. Proc. 2023-24 annual list of automatic accounting method changes. This is to provide procedures for obtaining automatic consent from the IRS to change methods of accounting for expenditures paid or incurred in tax years beginning after December 31, 2021, relying on the interim guidance provided in Notice 2023-63. Specifically, Rev. Proc. 2024-9 allows an automatic accounting method change to be filed for taxpayers seeking to change their method of accounting from:
- Capitalizing SRE expenditures to inventoriable property or depreciable property and recovering such expenditures through cost of goods sold or depreciation, respectively, to capitalizing and amortizing such expenditures under Section 174;
- Treating an expenditure that does not meet the definition of an SRE expenditure as an SRE expenditure subject to capitalization and amortization under Section 174 to otherwise treating that expenditure under the appropriate provision of the code; and
- Permits Section 460 changes for the numerator and denominator and not require the cutoff method based only on new contracts, and permits a Section 481(a) adjustment for post-2021 costs.
Automatic accounting method changes filed for the 2022 tax year under Rev. Proc. 2024-9 continue to be filed on an expedited basis. Including a change to rely on the interim guidance from Notice 2023-63. Such accounting method changes are made with a Section 481(a) adjustment determined on a cut-off basis and without the requirement to file a Form 3115 (e.g., statement included with the 2022 tax return).
Rev. Proc. 2024-9 specifies that for tax years filed after December 31, 2021, an accounting method change is made by filing a Form 3115 with a modified Section 481(a) adjustment. This adjustment takes into account only SRE expenditures incurred in 2022 and beyond, unless such change results in a negative Section 481(a) adjustment. In which the taxpayer may make the method change on a cut-off basis. Taxpayers may not take into account this adjustment for amounts paid or incurred prior to the effective date of the TCJA under the automatic change provisions. An adjustment is available for amounts paid or incurred in tax years beginning after December 31, 2021.
In addition to the implications of Section 481(a), Rev. Proc. 2024-9 further provides that the five-year limitation of Rev. Proc. 2015-13 is waived for the taxpayer’s first or second taxable year beginning after December 31, 2021. There is no restriction that prevents a subsequent accounting method change from being filed when a previous accounting method change has been filed for the same item within the past five years. Therefore, taxpayers are permitted to file an accounting method change to comply with the interim guidance provided in Notice 2023-63. This is for the second tax year beginning after December 31, 2021, even if a previous accounting method change was filed for the first tax year beginning after December 31, 2021.
Rev. Proc. 2024-9 limits audit protection for accounting method changes to conform with the interim guidance offered in Notice 2023-63 regarding the treatment of SRE expenditures. This limitation leaves open to challenge the treatment of such amounts in future IRS examinations if the taxpayer didn’t make an accounting method change with the 2022 tax return.
Rev. Proc. 2024-9 further clarifies Rev. Proc. 2000-50 is obsoleted for costs of developing computer software paid or incurred in any tax year beginning after December 31, 2021. This continues to apply to costs of developing computer software paid or incurred in any tax year beginning on or before December 31, 2021.
Section 174 Background
Notice 2023-63 was originally released on September 8, 2023, to provide clarification on the treatment of Section 174 expenses as amended by the Tax Cuts and Jobs Act (TCJA). There were several areas of clarification including software development definitions, treatment of abandoned or disposed research, and the treatment of research conducted under long-term contracts.
Treatment of Expenses Incurred for Research Performed Under a Contract
One of the key clarifications is related to the treatment of expenses incurred for research performed under contract. Notice 2023-63 provided that if a research provider bears financial risk under the terms of the contract with the research recipient, then costs paid or incurred by the research provider that are incident to the SRE activities are also SRE expenditures, and therefore subject to capitalization under IRC Section 174. If the research provider does not bear financial risk, but still maintains the right to otherwise use any resulting SRE product in its trade or business (or otherwise exploit any resulting SRE product through sale, lease or license), then costs incurred by the research provider are still SRE expenditures, and therefore subject to capitalization under Section 174.
Treatment of SRE Expenditures Under Section 460
Section 460(a) generally requires use of the percentage-of-completion method (PCM) to account for taxable income from a long-term contract. Treasury Regulation Section 1.460-4(b)(2)(i) provides that under the PCM, the portion of the contract price a taxpayer must report in a taxable year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs. This ratio represents the portion of a contract considered completed for purposes of the PCM. Under the PCM, a taxpayer generally deducts allocable contract costs as they are incurred. An increase in the percentage of the contract price to be reported is generally matched by deduction of the incurred costs that cause the increase.
Currently, allocable contract costs include research or experimental expenses, other than independent research and development expenses. Consequently, when these expenses are incurred, they increase the portion of a contract considered completed and the percentage of the contract price required to be reported. The current Section 460 regulations were drafted with respect to taxable years in which a taxpayer could currently deduct research or experimental expenses under former Section 174. Section 174(a) now requires that SRE expenditures be charged to a capital account and deducted over the applicable Section 174 amortization period. As a result, under the current Section 460 regulations, incurred SRE expenditures increase the percentage of the contract price required to be reported, although Section 174(a) prevents a corresponding current deduction of those incurred SRE expenditures.
Section 8 of Notice 2023-63 provides interim guidance regarding the application of the PCM under Section 460 if allocable contract costs include SRE expenditures and allows taxpayers to treat only the amortization of incurred SRE expenditures as increasing the percentage of the contract price required to be reported.
Note, a taxpayer adopting this methodology is required to report any portion of the contract price not previously reported by the taxable year following the taxable year in which the contract is completed, notwithstanding that some portion of the SRE expenditures remain unamortized.
Under current Treasury Regulation Section 1.460-5(g), a change in a taxpayer’s method of allocating costs to its long-term contracts must be made on a cut-off basis, with the change applying only to contracts entered into on or after the year of change.
Final Thoughts
In Notice 2024-12, the IRS announced that it will issue proposed regulations further clarifying the items addressed in Notice 2024-12 and Rev. Proc. 2024-9 in the future. The clarification around a research provider’s responsibility to classify its expenses as SRE activities is welcome and may help taxpayers from unnecessarily capitalizing SRE expenses that would otherwise be deductible as a normal and ordinary business expense. Contracts that do not explicitly provide that the research provider has an SRE product right, and is otherwise not at risk, may be able to exclude such expenses incurred under the contract from Section 174 capitalization.
It will be critical to review the language written in research provider contracts to distinguish between a research provider having an SRE product right and a research provider having an excluded SRE product right. Furthermore, taxpayers should evaluate their current tax accounting methods for SRE expenditures considering the guidance provided in Notice 2024-12, Rev. Proc. 2024-9 and Notice 2023-63. This will allow taxpayers to determine whether an automatic accounting method change should be filed with the 2023 tax return.
Guide You Forward
If you have questions or want to learn more about Section 174 capitalization and amortization of SRE expenditures, please consult your Cherry Bekaert advisor or contact Cherry Bekaert’s Tax Credits & Incentives Advisory practice today.
As of the date of this publication, Congress announced a bipartisan deal that would provide a number of tax breaks for businesses, including the expensing of Section 174 SRE expenditures incurred in the U.S. The proposed change would allow taxpayers to expense these costs retroactively back to tax years beginning after December 31, 2021, and before December 31, 2025. Foreign SRE expenditures will continue to be capitalized under the proposed deal. Further updates will be forthcoming if the proposed legislation is enacted into law.
Related Guidance
Planning for Capitalization of Research and Experimentation (R&E) Costs
R&D Update: What’s Going On With Section 174?
Section 174 New Requirements and Its Impact on Technology Companies
Section 174 Research & Software Development Costs – A Guide to Compliance
