February 20, 2018 Implications of certain tax reform provisions on research incentives The Tax Cuts and Jobs Act (the Act), while making no substantive changes to Section 41, made a number of changes to other areas of corporate tax law that will affect taxpayers taking advantage of the research credit. The following are high-level summaries of provisions that may significantly affect the research credit, Section 174 and the orphan drug credit (Section 45C). For more detailed summaries of these research incentive provisions, see Tax Alert 2017-2131. Section 174: Amortization of research or experimental expenditures Currently, under Section 174, taxpayers may elect to either deduct research or experimental expenditures paid in connection with a present or future trade or business or amortize those costs over no less than 60 months. Alternatively, taxpayers may elect to amortize their research expenditures over 10 years under Section 59(e). Similarly, software development costs may be expensed currently, amortized over 60 months from the date development is completed in accordance with Revenue Procedure 2000-50, or amortized over 36 months from the date the software is placed in service in accordance with Section 167(f)(1). For amounts paid or incurred in tax years beginning after December 31, 2021, however, the Act modifies Section 174 and requires taxpayers to treat research or experimental expenditures as chargeable to a capital account and to amortize these expenses over five years (15 years for foreign research). Additionally, the Act specifically requires any software development costs to be treated as research or experimental expenditures under Section 174. Under the Act, capitalized research or experimental expenditures that relate to property that is disposed of, retired or abandoned during the amortization period will continue to be amortized for the duration of the amortization period. The modifications to Section 174 under the Act remove Section 174(e), which currently makes Section 174 applicable to research or experimental expenditures "only to the extent that the amount thereof is reasonable under the circumstances." The Act does not remove the current exclusions from Section 174 for: (1) expenditures for the acquisition or improvement of land or depreciable property used in connection with the research or experimentation or (2) exploration expenditures. Although the Act did not make substantive amendments to Section 41, the Act modified Section 41(d)(1)(A) to remove the reference to "expenses under [S]ection 174" to conform Section 41 to the amendments made to Section 174. The amendment to Section 41 applies for amounts paid or incurred in tax years beginning after December 31, 2021. Implications For expenditures paid or incurred in tax years beginning after 2021, taxpayers will be required to capitalize and recover Section 174 expenditures over five (or 15) years and will no longer be able to recover Section 174 expenditures in the year they are incurred (or upon disposal, retirement or abandonment). This is a significantly unfavorable change for taxpayers currently deducting their research and experimental expenditures under Section 174. Additionally, the effect of the Section 174 amortization provision for state tax purposes may be substantial if the deduction of such expenditures typically reduces the taxpayer's state tax burden. For all research expenditures, taxpayers should consider more carefully identifying which research and development related costs may be properly characterized as ordinary and necessary business expenses deductible under Section 162. For foreign research costs that cannot be included in determining the research credit, taxpayers could continue to immediately expense those costs in the year incurred without losing any research credit benefit, rather than amortize over 15 years. Further, although the corporate alternative minimum tax has been repealed (discussed later), Section 59(e) was not. Section 59(e), however, only applies to an amount "allowable as a deduction … under [S]ection 174(a) … ," so when the new provisions related to Section 174 take effect, the costs under Section 174 will no longer be "allowable as a deduction." Section 174 also will refer to "specified research or experimental expenditures," while Section 59(e) continues to refer to "research or experimental expenditures." When the new Section 174 provisions take effect, the reference to Section 59(e) in the current Section 174(f)(2) will be removed. Thus, it seems clear that taxpayers will no longer be able to elect to amortize research or experimental expenditures ratably over 10 years for tax years beginning after 2021. The modifications made to Section 174 include a new subsection that specifically includes any amount paid or incurred in connection with software development as a research or experimental expenditure (and, therefore, within the scope of the provision). Presently, these costs may be deducted or amortized under Revenue Procedure 2000-50. Once the new Section 174 provisions take effect after 2021, Revenue Procedure 2000-50 will no longer apply to any software development costs, and they will be subject to the required amortization under Section 174. As a general rule, purchased software may be amortized over 36 months under Section 167(f)(1). This means that, under the Act, taxpayers developing software will be in a less favorable tax position than those acquiring it. Regarding the removal of the requirement for expenditures to be reasonable for Section 174 to apply, the Act should provide taxpayers with the opportunity to include in their research or experimental expenditures amounts paid or incurred in tax years beginning after 2021 that have been challenged by the IRS as "unreasonable" under current law. Section 45C: Orphan drug credit Under prior law, Section 45C allowed a taxpayer to claim a credit equal to 50% of qualified clinical testing expenses incurred in connection with the testing of a drug for a rare disease or condition (the orphan drug credit). Under the Act, the orphan drug credit is limited to 25% of qualified clinical testing expenses for tax years beginning after December 31, 2017. Additionally, under a new Section 280C(b)(3), for tax years beginning after December 31, 2017, taxpayers may elect a reduced orphan drug credit in lieu of reducing allowable deductions in a manner similar to the Section 280C(c)(3) election for the research credit. Implications Although the provision cuts the orphan drug credit in half, this credit remains beneficial for eligible taxpayers. The new Section 280C provision may be welcome for the administrative ease it provides; however, as discussed next, Section 280C elections may not be advantageous for all taxpayers when considering other provisions in the Act. Section 280C: Reduced credit election Under Section 280C(c)(3) and (b)(3), taxpayers must choose between reducing the Section 174 expense deduction (or reducing the basis created by costs that a taxpayer has elected to treat as deferred expenses under Section 174(b)) or electing to reduce their credits available under Section 41 and, for tax years beginning after December 31, 2017, under Section 45C. If a taxpayer does not make the election under Section 280C, it may claim 100% of the credit it has computed, but cannot deduct all of the qualified research expenses (QREs) or qualified clinical testing expenses (QCTEs) for which it is claiming the respective credit. Alternatively, under the Section 280C election, the taxpayer will reduce the amount of the credit claimed rather than adjusting the Section 174 deduction. Before the enactment of the Act, the amount of this reduction was the amount of the credit multiplied by the maximum rate of tax under Section 11(b)(1), i.e., 35%. The Act replaced Section 11(b)(1) with Section 11(b) and a 21% corporate rate. A conforming amendment was made to Section 280C(c)(3) and (b)(3) to replace the reference to Section 11(b)(1) with a reference to Section 11(b). Note that fiscal-year taxpayers should apply Section 15(e) to determine a blended rate for their tax year that includes January 1, 2018. The Section 280C election must be made on a timely filed (including extensions) original return and cannot be made on an amended return filed after the extended due date of the return. The reduced credit election is a year-by-year election which, once made, is irrevocable for that year. Implications Electing the reduced credit under Section 280C is common due to its administrative convenience, and because it preserves deductions that may reduce state taxes. Taxpayers commonly made a "protective" Section 280C election — electing the reduced credit on a timely-filed, but blank, Form 6765 when the taxpayer had not yet computed its research credit for that year but planned to file an amended return to claim the research credit. As discussed in the sections that follow, however, Section 280C elections may not be the most advantageous choice under the new provisions of the Act. Especially for the 2017 tax year, given the substantial reduction in the corporate rate in 2018, taxpayers should consider the impact of making, or not making, a Section 280C(c)(3) election for purposes of evaluating the highest value of tax attributes that could be carried forward (net operating loss carryforward versus research credit carryforward) and the immediate impact of a higher or lower research credit for purposes of Section 965 (the transition tax on deferred foreign income). See further discussion later. Fiscal-year taxpayers claiming the reduced research credit should be aware that the Section 280C(c)(3) election for the fiscal year including January 1, 2018, will result in a reduced credit using the Section 15 blended rate for the tax year ending in 2018, rather than the rate under prior law (35%). Electing the reduced credit under Section 280C(c)(3) for this tax year will not result in a mismatch of tax rates. Section 172: Net operating losses For losses arising in tax years beginning after December 31, 2017, the net operating loss (NOL) deduction is limited to 80% of taxable income. The carryback provisions are repealed for losses arising in tax years ending after December 31, 2017, except for losses incurred in a farming trade or business (which is allowed a two-year carryback) or in a property and casualty company (which is allowed a two-year carryback and 20-year carryforward). For losses arising in tax years ending after December 31, 2017, companies are allowed an indefinite carryforward. Implications The modification of Section 172 related to carryforward and carryback changes applies to NOLs arising in tax years ending after December 31, 2017. Therefore, a fiscal-year taxpayer with a tax year ending after December 31, 2017, cannot carry back NOLs arising in its tax year that includes December 31, 2017. Taxpayers with tax years ending on or before December 31, 2017, with current-year NOLs that exceed taxable income will want to consider whether it is better to make the Section 280C(c)(3) election and increase their Section 174 deduction to get a larger carryback, or to forgo the Section 280C election to increase their research credit carryforward. It will likely be more advantageous for a taxpayer to increase its research credit carryforward because the research credit does not depend on tax rate and a higher research credit may offset a taxpayer's tax liability for a longer period. For taxpayers operating in states that do not have a research credit, however, it may make sense to maximize their Section 174 deductions to reduce state tax liability. Further, taxpayers looking to maximize their cash on hand now and taxpayers with expiring credits may also prefer to increase their NOL carryback. Taxpayers should model both options to determine what works best for their particular situation. Section 965: Tax on deferred foreign income Under the Act, Section 965 requires certain US shareholders of certain foreign corporations to include in income an amount of previously untaxed deferred foreign income (mandatory income inclusion). Existing attributes can be used to offset the tax resulting from the mandatory income inclusion, including the research credit. The mandatory income inclusion is an inclusion in the US shareholder's gross income under Section 951(a) (i.e., a Subpart F inclusion) and occurs in the foreign corporation's last tax year beginning before January 1, 2018. For a calendar year-end US shareholder that owns a calendar year-end foreign corporation, the income inclusion will be reported for the US shareholder's tax year ended December 31, 2017. If the foreign corporation has a fiscal year ended November 30, 2017, the income inclusion will be reported for the US shareholder's tax year ending December 31, 2018. Implications For the tax year that the tax is imposed on the mandatory income inclusion, a taxpayer may want to forgo the election of the reduced credit under Section 280C to maximize the research credit available to offset the tax imposed for the transition year. Additionally, taxpayers that have qualifying research activities but have not taken a research credit should evaluate the benefit of the research credit with respect to the additional tax burden imposed under Section 965. Alternative minimum tax repeal The corporate alternative minimum tax (AMT) is repealed for tax years beginning after 2017. Taxpayers with an AMT credit may use the credit to offset regular tax liability. Taxpayers may claim a refund of 50% (100% for years beginning in 2021) of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning before 2022. Implications Due to the repeal of the AMT, taxpayers that formerly did not claim the research credit because they were perpetually subject to AMT should reconsider claiming the credit. Note that the limitation on the general business credit in Section 38(c) no longer contains an AMT component for corporate taxpayers, as they are no longer subject to AMT. However, the general business credit (which includes the research credit) continues to be limited to 25% of so much of the taxpayer's net regular tax liability as exceeds $25,000. In December 2015, the Protecting Americans from Tax Hikes Act (PATH Act) amended the research credit to allow certain small businesses to apply the research credit against AMT and payroll tax liabilities. Since the corporate AMT is repealed, this benefit to small corporate taxpayers no longer exists. Qualified small businesses may, however, continue to claim the research credit against payroll tax liability. As noted, the repeal of the corporate AMT does not affect taxpayers' ability to elect to amortize research or development expenditures over 10 years under Section 59(e). Section 59A: Base erosion and anti-abuse tax The Act created a new minimum tax, the base erosion and anti-abuse tax (BEAT). The BEAT applies to a corporation (other than RICs, REITs or S corporations) with average annual gross receipts of at least $500 million for the three-year period ending with the preceding tax year that has a "base erosion percentage" for the current tax year of at least 3% (2% for certain banks and security dealers) (an applicable taxpayer). The "base erosion percentage" is generally the aggregate amount of "base erosion tax benefits" divided by the aggregate amount of all allowable deductions. A "base erosion tax benefit" is generally any deduction allowed for the tax year with respect to any "base erosion payment." A "base erosion payment", in turn, is generally any deductible amount paid or accrued to a related foreign person, and any amount paid or accrued in connection with the acquisition of depreciable or amortizable property from a related foreign person. Base erosion payments do not include cost of goods sold (unless paid or accrued to a surrogate foreign corporation (when status as such is obtained after November 9, 2017)), certain amounts paid with respect to services that qualify for the services cost method under Section 482, and certain qualified derivative payments. The base erosion minimum tax amount owed by an applicable taxpayer under the BEAT for tax years beginning before January 1, 2026, is the excess of 10% (5% for tax years beginning in calendar year 2018, 11% and 6%, respectively, for certain banks and security dealers) of the taxpayer's "modified taxable income" over its regular tax liability for the year, reduced by all Chapter 1 income tax credits (except the research credit and applicable Section 38 credits (i.e., the low-income housing credit, renewable electricity production credit, and investment credit allocable to the energy credit)). "Modified taxable income" for these purposes is the taxable income for the year of the taxpayer, determined without regard to any base erosion tax benefit or the base erosion percentage of any NOL for the year. For tax years beginning after December 31, 2025, the base erosion minimum tax amount is computed as 12.5% (13.5% for certain banks and security dealers) of an applicable taxpayer's modified taxable income in excess of its regular tax liability for the year reduced by all Chapter 1 income tax credits, including the research credit and applicable Section 38 credits. Implications An applicable taxpayer subject to the BEAT may consider forgoing the election of the reduced credit under Section 280C. Because a higher regular tax liability favorably affects the computation of the BEAT amount for tax years beginning before January 1, 2026, forgoing a Section 280C election is an indirect means to reducing the taxpayer's liability under the BEAT for those tax years. Looking forward: Section 174 amortization Taxpayers should start considering how best to classify their research and development related costs once the Section 174 amortization provision applies (amounts paid or incurred in tax years beginning after December 31, 2021). One option may be to evaluate costs to see if they may be classified as ordinary and necessary business expenses under Section 162, rather than Section 174 costs, possibly because there is no technical uncertainty associated with the activities to which the costs relate. This would allow taxpayers to immediately expense these costs under Section 162, rather than amortize under Section 174. In evaluating which costs may be treated as Section 162 expenses, taxpayers will have to segregate software development costs because those costs will be deemed Section 174 expenditures. Furthermore, such software development costs would have to be further segregated between development costs incurred in the US and those incurred outside of the US for purposes of determining the applicable amortization period. Reclassifying expenses as deductible under Section 162, rather than research or experimental expenditures under Section 174, is not a change in method of accounting. Rather, it is a factual determination based on whether there is uncertainty about the research activity such that the expenses would or would not qualify under Section 174. Companies with a large amount of foreign research expenditures should pay particular attention to how such costs are characterized. Furthermore, taxpayers should consider how characterizing costs as Section 162 costs could affect their BEAT liability from two perspectives: the benefit of a higher research credit and the benefit of a greater amount capitalized as cost of goods sold. Taxpayers should keep in mind that engineering or design costs related to the production of tangible personal property that are not allowable Section 174 costs must be capitalized under Section 263A. Capitalizing such amounts paid or accrued to a foreign related person to inventory under Section 263A may favorably affect a taxpayer's BEAT liability to the extent such capitalized amounts are recovered as cost of goods sold. However, not all amounts paid or accrued to a foreign related person with respect to self-constructed assets that are capitalized under Section 263A may permanently avoid the BEAT. For example, such capitalized amounts paid or accrued to a foreign related person may give rise to a deduction or amortization allowance with respect to the self-constructed asset in a subsequent tax year that is subject to the BEAT. Accordingly, taxpayersshould take into account the manner in which amounts capitalized under Section 263A are recovered (e.g., as cost of goods sold or as a deduction for depreciation (or amortization)) in determining the timing and extent to which such capitalized amounts are subject to the BEAT. IRS directive One interesting consideration is the future use of the recent IRS Large Business & International Directive pertaining to the research credit (the Directive). Under the Directive, amounts expensed under ASC 730 (with some modifications) may be used in determining a taxpayer's research credit. Although the intent of the Directive was to provide research credit claim examination efficiency by accepting as sufficient evidence of qualified research expenses an amount determined under a taxpayer's financial statements, the research credit amount computed under the Directive may be significantly larger than the research credit amount computed under Section 41. The combination of the ideas discussed previously and use of the Directive could make a meaningful difference for certain taxpayers. For the reasons stated earlier regarding the potential benefits of having a larger research credit (value of credit carryforwards, Section 965 tax offset), computing the research credit under the Directive may be an attractive option. For more information on the Directive, please see Tax Alert 2017-1549. Key takeaways Taxpayers will want to consider whether, under the changes imposed by the Act, it makes more sense to maximize their Section 174 deduction and elect the reduced credit under Section 280C, or maximize their research credit and take advantage of credit carryforwards. Since the research credit is a permanent benefit, does not depend on the tax rate, and, in combination with a proper Section 280C election, may help to minimize a taxpayer's total tax liability considering the BEAT and regular tax, it may be better to maximize a taxpayer's research credit amount. Also, with the Section 11 rate reduction, the reduced research credit is larger than in the past, as a taxpayer will keep 79% of its credit with a reduced credit election, as opposed to only 65% under prior law. For taxpayers operating in states that do not allow a research credit but do allow a Section 174 deduction, however, it may make sense to increase Section 174 deductions. These same considerations apply to taxpayers claiming an orphan drug credit due to the new Section 280C provision. Taxpayers should model how these options provide the best results under their specific facts. The following are few very streamlined and simplified considerations. Taxpayers with NOL carryforwards that will not be in NOLs in the future: Taxpayers will likely be better off with an increased research credit (rather than an NOL carryback on an amended return) unless they have expiring credits that need to be used first. Taxpayers that had been in AMT: Taxpayers should review their research expenses to estimate the research credit that will be available to them now that they are no longer AMT-limited. Taxpayers with significant Section 174 expenses but small research credits: For future tax years, consider reviewing the costs to see if any of them can be characterized as expenses under Section 162. Taxpayers with significant Section 174 foreign expenses: For future tax years, consider how the location of the research activity impacts tax liabilities (15-year amortization of foreign research). Taxpayers with significant state research expenses: In states that do not have a research credit, increasing Section 174 expenses and electing Section 280C may be the better answer. Partnerships: Partnerships may want to continue maximizing their Section 174 deductions and electing the reduced credit under Section 280C because they will not be subject to the BEAT and AMT considerations do not apply. These are fact-specific considerations, and any given taxpayer's unique facts may make one option preferable over others. Therefore, it is imperative to model the various options to ensure taxpayers take advantage of the best planning opportunities available to them. ———————————————
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