IRS Revises LB&I Directive for R&D Credits
IRS Revises LB&I Directive for R&D Credits
The IRS Large Business & International Division (LB&I) released on September 10, 2020 a revised version of a 2017 Directive (related BDO Alert) for large taxpayers that are claiming the research and development (R&D) credit under Section 41 of the Internal Revenue Code and that expense R&D costs on their financial statements pursuant to ASC 730. The revised directive is supplemented by a separately published press release and FAQs. The updated guidance is effective for tax years ending on or after July 31, 2020, and the 2017 Directive will continue to apply to original returns timely filed (including any extensions) on or after September 11, 2017 for tax periods ending before July 31, 2020.
The 2017 Directive—intended to make the process of resolving exams involving Section 41 research credits more efficient—allows LB&I examiners to accept certain R&D costs currently expensed on a taxpayer's Certified Audited Financial Statements pursuant to ASC 730 as qualified research expenses (QREs).
The revised directive makes the following changes and clarifications:
- Updates the taxpayers to whom the directive applies;
- Clarifies the exam and review process;
- Expands the IRS's discretion for determining taxpayer eligibility;
- Identifies additional documentation requirements;
- Makes certain software development costs ineligible; and
- Makes certain other costs ineligible.
Overview of the Revised Directive
1. Taxpayers to Whom the Directive Applies
Like the 2017 Directive, the Revised Directive applies to taxpayers that meet the following requirements:
- Have assets of $10 million or more;
- Follow U.S. GAAP to prepare their Certified Audited Financial Statements; and
- Show the amount of currently expensed financial statement R&D either (1) as a separate line item on the income statement included in, or (2) separately stated in a note to, their Certified Audited Financial Statements.
As a part of the eligibility requirements, the Revised Directive now explicitly states that taxpayers to whom the Directive applies must use these same U.S. GAAP financial statements to reconcile book income to federal tax income on Schedule M-3.
The Revised Directive adds that taxpayers must be able to provide certain underlying books and records and substantiate their U.S. ASC 730 Financial Statement R&D amount (Part V Requirements). If a taxpayer does not or cannot provide such documentation to the exam team’s satisfaction, the Territory Manager or his/her delegate may determine that the Directive does not apply.
2. Exam and Review Process
If the exam team is not satisfied that a taxpayer has met the Part V requirements, it may request additional information not listed in Part V, provided approval has been obtained from the Territory Manager or his/her delegate.
Taxpayers must submit the requested information “within a time period subject to the LB&I IDR enforcement process.” Per the Internal Revenue Manual, this process generally requires a “discussion with the taxpayer and/or their representative…to confirm an understanding of the items requested and to set a reasonable response date for the request.”
3. Expanded IRS Discretion for Determining Taxpayer Eligibility
The 2017 Directive specifically stated that “LB&I examiners will not challenge QREs which are the Adjusted ASC 730 Financial Statement R&D costs for the Credit Year” (emphasis added). The Revised Directive states that if the IRS determines that a taxpayer has satisfied its requirements, “this Directive provides an administrative solution for LB&I examiners to accept, as sufficient evidence of QREs, the Adjusted ASC 730 Financial Statement R&D for the Credit Year” (emphasis added). The change allows examiners more flexibility to challenge taxpayer QREs than provided by the 2017 Directive.
4. Additional Documentation Requirements
The Revised Directive requires taxpayers to retain and make available upon request two additional documents:
- A written narrative of the methodology and calculations for determining the amounts listed on Appendix C Lines 3a and 3b of the Directive. If no amounts are listed on Appendix C Lines 3a and/or 3b, the taxpayer must provide an explanation of the methodology used to verify that none of these expenses are present in the U.S. Financial Statement R&D amount. The explanation should include sufficient information to demonstrate that the taxpayer made a reasonable effort to quantify non-ASC 730 Financial Statement R&D; and
- A written statement or presentation “designed to mitigate material misstatement of the taxpayer’s expenses reported per financial statements,” what the Revised Directive calls “Substantiation of Internal Control Over Financial Reporting (ICFR).”
5. Ineligible Software Development Costs
The FAQs clarify that the Revised Directive does not apply to costs to develop certain software, namely:
- Internal-use software, i.e., software that is not for sale, lease or otherwise marketed by the taxpayer. Software sold to related parties or as part of a cost sharing arrangement for internal use is not software for sale, lease or otherwise marketed;
- Website software;
- Hosted software, with some exceptions; and
- Software to provide services.
6. Other Ineligible Expenditures
Expenditures identified under the following ASC provisions are also ineligible under the Revised Directive:
- ASC 730-10-55-2; and
- All non-ASC-730 provisions.