The change in the tax regime for research and experimentation expenses under the tax code Section 174, effective for tax years beginning after January 1, 2022, may have additional impacts on U.S. taxpayers who incur foreign search costs. Under the previous rules, businesses had the option of deducting these expenses in the year they are incurred or capitalizing the costs and amortizing them over five or ten years. From 2022, businesses lose the ability to deduct these costs in the year they are incurred.
Under the new rule, taxpayers must capitalize and amortize Section 174 expenses over a period of five years for research conducted in the United States, or over a period of 15 years for research conducted abroad . Many companies need to review their expenses to determine if the costs they deducted annually now qualify as “research and experimentation expenses” that must be capitalized and amortized for tax years beginning in 2022.
Taxpayers making payments for research outside the United States will have additional concerns. At first glance, the new law imposes a longer amortization period on the costs incurred for research abroad. So some expenses that businesses deduct in full in 2021 will generate only one-thirtieth of that deduction in 2022, using the half-year convention to calculate the deduction in the year the cost is incurred.
The change will also have secondary effects on the calculation of other elements of the tax return, such as low tax intangible worldwide income, intangible income of foreign origin, foreign tax creditand base erosion and anti-abuse tax.
Capitalization of Section 174 International Expenses
Many companies incur costs that meet the Section 174 definition of research and experimental expenditure. Until now, there was little need to track these costs separately, as they were treated the same as other tax-deductible expenses. Deductions for payments such as research facility maintenance and overhead costs and salaries for engineering and laboratory costs were not separated from general building maintenance and payroll accounts .
Companies that have tracked costs in order to qualify for the Research and Experimentation Tax Credit may have systems in place to monitor certain Section 174 expenses, but the Section 174 definition covers more of expense types than the limited list of costs that are eligible for R&E credit.
Businesses that make payments to service providers outside the United States must determine whether the activities being conducted qualify as “research” under Section 174. For example, if a business purchases a raw material or finished product to a foreign supplier, this cost probably does not include a research component. But if it pays for engineering or software development services from a foreign vendor, some of the costs that were fully deductible when incurred may now have to be amortized over 15 years.
Any company that relies on a global network of contractors and suppliers to develop products and provide services will likely need a more detailed system to track costs that qualify as Section 174 expenses and jurisdiction. in which they are engaged.
Special concerns for foreign related parties
Companies whose global networks include related foreign subsidiaries may see additional consequences of this change. When Section 174 is applied to foreign R&D expenditures incurred by controlled foreign corporations, taxpayers could see significant increases in tested revenue included in the GILTI calculation in the first year the rules are implemented. This will result in additional inclusion of GILTI and may result in residual tax on GILTI.
In some cases, given the new rules in Section 174, taxpayers who were previously eligible for the high tax exception under the GILTI rules may become subject to tax when foreign taxable income is recomputed for the purposes of GILTI. In most cases, the underlying tax paid in the foreign region will not change because the foreign region will apply its own tax principles in calculating taxable income without regard to US tax principles.
Double amortization issues arise when a US taxpayer engages a foreign subsidiary to provide R&D-related services. The payment to the foreign subsidiary is amortized over 15 years by the U.S. business, and related costs incurred by the foreign subsidiary are also amortized over 15 years for CFCs and non-considered foreign entities whose activities may be included in income American.
When this type of transaction occurs between multinational related parties, it can result in several levels of slower cost recovery which amplifies the impact on the US parent’s taxable income in the year the payment is made. This situation leaves the foreign affiliate in the position of receiving the contract income for tax purposes in the year it is earned with the benefit of only a small fraction of the related expense deduction.
The change to Section 174 will also change the Taxable Income Number which provides the starting point for tax calculations such as FDII, BEAT and Foreign Tax Credit. In some cases, the result might skew slightly in favor of the taxpayer with these calculations, but the overall impact of this change will be a reduction in current year deductions and a significant increase in current year taxable income.
Many questions still unanswered
Taxpayers applying the international aspects of the Section 174 expense write-off rules may benefit from guidance from the IRS. For example, when engaging unrelated and related foreign parties to conduct research on behalf of a taxpayer, should both parties consider the underlying expenses to be capitalizable research? Or could a rights-and-risks model treat the payment as capitalizable research on the one hand and a deductible operating expense on the other? Additional guidance in this area could certainly help reduce the potential risk of double amortization.
Since there is currently no avenue to defer this change, taxpayers should review their expenses that may be subject to amortization over five or 15 years to project the tax impact of these new provisions on tax liabilities. tax for the current year. To learn more about how Section 174 expense depreciation and related international aspects might affect your business, contact your tax advisor.
Robert Piwonsky is a senior international tax manager at Plante Moran. He assists companies with global compliance and effective tax rates, as well as advice on cross-border transactions, providing international tax due diligence and proposing ongoing strategies to reduce cash taxes in the world.
Caitlin Slezak is a senior executive at the Plante Moran National Tax Office. She advises colleagues and clients on emerging tax issues, focusing on technical tax accounting methods as they relate to tax revenue, expense accounting and tax inventory accounting.
Jay Woods is international tax manager at Plante Moran. As a member of the firm’s International Tax Services practice group, he works with internationally active clients, focusing on outbound transactions and inbound services.
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