Easing The Pain of Research & Experimental (R&E) Expenditure Capitalization
Easing The Pain of Research & Experimental (R&E) Expenditure Capitalization
The new Section 174 rules require taxpayers to capitalize and amortize R&E costs incurred in taxable years beginning on or after Jan. 1, 2022. Amortization is calculated using a straight‐line recovery period of either five years for costs incurred in the U.S. or 15 years for costs incurred outside the U.S. As taxpayers adapt to the new rules and attempt to comply, they may experience:
- A substantial increase in taxable income;
- An expedited use of net operating losses (NOLs), necessitating a valuation allowance analysis for ASC 740 purposes; and/or
- A strain on cash flow as a result of an increase in current tax liabilities.
Tax planning will depend on a taxpayer’s specific fact pattern and will be influenced by future IRS guidance, but under current rules, the foreign-derived intangible income (FDII) deduction could become an important tax planning opportunity to help mitigate the adverse impact of the new rules.
Section 174 and FDII Interplay
The new Section 174 rules were introduced under the Tax Cuts and Jobs Act of 2017 (TCJA) along with many other tax changes, including the creation of a new permanent tax benefit: the FDII deduction under Section 250. The impact on taxable income wrought by the capitalization and amortization of Section 174 costs brings certain tax provisions, such as FDII, back to the forefront.
Effective for tax years beginning after December 31, 2017, the FDII deduction creates a preferential tax rate for income derived by U.S. C corporations, or partnerships with C corporation partners, serving foreign markets. FDII is a new category of income and is broadly defined to include other sources of income beyond amounts directly derived from the exploitation of intangible assets. Revenues from the sale, lease, license, exchange or other disposition of general property and intangible property to foreign persons, including foreign related parties, as well as revenues from services provided to foreign persons, including foreign related parties, may qualify as FDII.
If applicable, the FDII deduction is a permanent tax benefit equal to 37.5%1 times the net income from these qualified revenue streams,2 resulting in an effective tax rate of 13.125%3 on qualified income, compared to the federal statutory corporate rate of 21%. The computation of the FDII deduction is complex and requires the identification and analysis of potentially qualifying revenue streams and other relevant data, an understanding of the taxpayer’s organizational structure and any intercompany transactions, and the allocation and apportionment of expenses and other tax adjustments.
There is a taxable income limitation that applies when computing the FDII deduction. If a taxpayer’s combined FDII and GILTI amount exceeds taxable income after the application of any NOL deductions, the amount of the FDII and GILTI deduction needs to be reduced pro rata by the amount of the excess. Furthermore, taxpayers previously in an NOL position or able to fully offset taxable income with pre-TCJA NOL carryforwards were unable to claim the FDII deduction.
Fast forward to the 2022 tax year, and some taxpayers with historical losses are now becoming taxable as a result of the new Section 174 rules and looking for ways to offset the increase in taxable income. To the extent these taxpayers enter into foreign transactions, they should carefully evaluate their activities to determine whether they may avail themselves of the FDII deduction for all years in which they are taxable. Additionally, taxpayers that claimed the FDII deduction in the past should still be interested in reviewing their FDII approach with a fresh pair of eyes due to its interaction with Section 174 and the way in which expenses were historically allocated and apportioned, as well as other tax provisions.
Ultimately, taxpayers may see not only a reduction in their current federal income taxes payable, but also a substantial reduction in their effective tax rate due to an increase in the FDII benefit, specifically as a result of the change in Section 174 tax treatment. Careful consideration and a multidisciplinary approach to assessing the benefit are warranted. A few key considerations are noted below.
Proper evaluation and classification as U.S. or foreign Section 174 expenses: R&E expenditures incurred outside the U.S. by CFCs must be amortized over 15 years, increasing the GILTI inclusion and therefore tested income. An increase in GILTI would increase taxable income for the U.S. shareholder, but not deduction-eligible income for FDII purposes. As such, the increase in taxable income solely as a result of an increase in the GILTI inclusion would not result in a larger FDII benefit. Furthermore, if a U.S. taxpayer pays its CFC to conduct research and development (R&D) activities, assuming such costs are Section 174 costs to the U.S. taxpayer, such expenses will need to be amortized over 15 years. While this specific fact pattern would be unfavorable for such taxpayers from a Section 174 perspective, there would be a corresponding benefit, potentially in greater measure, from the FDII deduction.
Potential implementation or refresh of transfer pricing studies due to R&D arrangements: If a U.S. taxpayer performs R&D on behalf of its foreign affiliates, have they received payment for those services? If so, how much compensation is appropriate? Payments received from the foreign affiliate could yield foreign-derived deduction-eligible income and a FDII benefit. Taxpayers may also have the inverse arrangement, whereby a U.S. taxpayer hires a foreign affiliate to perform R&D activities on its behalf. In that scenario, the arrangement would need to be further reviewed to ensure such costs are appropriately deemed to be Section 174 costs of the U.S. taxpayer or its foreign subsidiary. There could be other nuanced funding or cost sharing arrangement considerations that should be analyzed for Section 174 purposes and ultimately may impact the FDII benefit.
Allocation and apportionment of Section 174 expenses: Specific rules govern the allocation and apportionment of Section 174 expenses under Treas. Reg. §1.861-17 for FDII, GILTI and foreign tax credit (FTC) purposes. Taxpayers that have historically forgone tracking Section 174 costs may have allocated and apportioned such expenses as an ordinary trade or business expense (e.g., salaries and wages). Because the methodology of allocating Section 174 costs could result, in certain instances, in significantly different outcomes from the allocation of other Section 162 expenses, the identification of Section 174 costs going forward will likely impact the FDII computation, as well as other provisions involving the allocation and apportionment of expenses under Section 861.
How can BDO help?
Computing the FDII deduction is nuanced and involves a multistep process requiring data analysis and documentation considerations. When coupled with the intricacies of implementing the new Section 174 rules, companies seeking to understand the potential ramifications of the rules on their FDII deduction (among other affected areas of the tax return) may find themselves overwhelmed with the myriad complexities arising from the interactions of these provisions.
BDO can assist companies by assessing the impact of Section 174 capitalization on their FDII calculation and performing detailed modeling analyses to identify potential planning opportunities to maximize the benefits of the FDII deduction. Our total tax mindset involves a multidisciplinary approach, with specialists from various service lines ready to help companies navigate the challenges of today’s ever-changing tax landscape.
1 For years beginning after December 31, 2025, the deduction rate is reduced from 37.5% to 21.875%.
2 Subject to taxable income limitations.
3 For years beginning after December 31, 2025, the FDII deduction results in an effective rate of 16.406% on qualified income.