When the Tax Cuts and Jobs Act (TCJA) became law in 2017, the majority of changes were good for U.S. businesses. There were, however, some changes that did not come into effect immediately, as well as some that were not so great. One example of both is an upcoming change to the tax treatment of research and development (R&D) costs. This change may be an unpleasant surprise for businesses that are not prepared.
Currently, IRC Section 174 allows companies to choose how to treat eligible R&D expenses: either deduct in the current year, or elect to amortize. TCJA, however, removed the option to deduct, and will require capitalizing R&D and amortizing over either five years for domestic R&D, or 15 years for international R&D. This change, unless Congress amends the law, will be effective starting in 2022.
So, why was this change made and what does this really mean for businesses?
Although less favorable overall, an argument can be made that the change was made to encourage R&D spending in the U.S. The ability to treat domestic and international R&D the same way removes the incentive to perform the R&D in the U.S. (Research and Experimentation Tax Credit notwithstanding). In addition, the TCJA had to be paid for, and savings had to be found somewhere. The anticipated additional government revenue as a result of not allowing a current deduction was one way to find those savings.
The implications are significant. Let’s look at the following example:
ABC Company currently spends $10M in R&D. Under current law, ABC Company can deduct the full $10M in the year the costs were incurred. With a 21% corporate tax rate, the present value of the deduction is $2.1M.
In 2023, for example, after the new law takes effect, ABC company will have to amortize the $10M over five years. Therefore, only 21% of $2M, or $420k, can be taken as a tax benefit each year. The immediate cash tax benefit of the R&D will be reduced by $1.68M.
Now consider a situation where some of the $10M in spending is outside the U.S. and the benefit is reduced even more because the amortization period is 15 years for the international R&D instead of 5 years.
If companies consistently spend the same in R&D year over year, they will never catch up; they will always be years behind in getting full benefit of their R&D expenditure. For start-ups, those years can be critical to survival. For established, large companies, the difference in those years can be millions of dollars, the funding of projects, and/or real jobs.
Where do we go from here?
Since 2017, there have been several congressional attempts to reverse this change. In addition, the Biden Administration’s Green Book refers to innovation and R&D as major goals of the proposed changes. Although no details are provided as to specific changes to R&D incentives, it is possible that reversing this policy as well as enhancing the R&D credit will be included in the changes. We can only wait to see what emerges in the details.
Assuming the law does not change, companies have the next few months to plan for its enactment. What that means will be different for each company, but it could significantly impact R&D forecasting, planning, and project implementation. Reach out to GTM for assistance with models and “what-if” scenarios to help plan for the change.