September 25, 2020
LB&I Division revises directive on the credit for increasing research activities
On September 10, 2020, the Commissioner for the Large Business and International (LB&I) Division of the IRS issued a revised directive on the credit for increasing research activities under IRC Section 41 for taxpayers that expense research and development (R&D) costs on their financial statements under ASC 730 (LB&I-04-0820–0016; 2020 ASC 730 Directive). Revised FAQs were also released to further explain the new directive and to clarify changes to the IRS's prior directive on the same topic, which was issued on September 11, 2017 (LB&I-04-0917-005; 2017 ASC 730 Directive). For more information on the 2017 ASC 730 Directive, please see Tax Alert 2017-1549.
This 2020 ASC 730 Directive, like the 2017 ASC 730 Directive, is intended to provide an efficient methodology for determining qualified research expenses (QREs) for taxpayers meeting the directive's requirements and, thus, will save resources and effort for both taxpayers and the IRS examiners when R&D costs are a potential audit issue.
The 2020 ASC 730 Directive makes the following key revisions to the 2017 ASC 730 Directive:
The 2020 ASC 730 Directive applies to eligible LB&I taxpayers that calculate their QREs under the 2020 ASC 730 Directive on timely-filed original returns for tax periods ending on or after July 31, 2020. Taxpayers may continue to apply the 2017 ASC 730 Directive to original returns timely filed on or after September 11, 2017, for tax periods ending before July 31, 2020.
The 2017 ASC 730 Directive established a safe-harbor methodology for determining a category of QREs that would not be challenged by the IRS. The 2017 ASC 730 Directive established how the safe-harbor amount should be calculated and the documentation taxpayers must maintain to qualify for the safe harbor.
2020 ASC 730 Directive
Definition of eligible taxpayer
The 2020 ASC 730 Directive modifies the 2017 ASC 730 Directive definition of "eligible taxpayer" by specifying that it only applies to LB&I taxpayers that use US GAAP Certified Audited Financial Statements showing the amount of currently expensed Financial Statement R&D to reconcile book income to federal tax income on Schedule M-3.
New examination procedures, expanded documentation requirements
The 2017 ASC 730 Directive directed IRS examiners not to challenge qualifying QREs if the taxpayer complied with the certification requirements set out in the directive. It did not, however, allow the exam team to request additional information outside of the list of documentation that taxpayers were required to retain and make available upon request.
In contrast, the 2020 ASC 730 Directive expands the procedures examiners must follow in determining whether a taxpayer has satisfied the requirements of the revised directive. Specifically, the 2020 ASC 730 Directive allows the exam team to request information in addition to the documentation listed in the directive if the exam team determines that the taxpayer did not satisfy the directive's requirements. Before requesting additional information, however, the 2020 ASC 730 Directive requires the exam team to receive approval from the territory manager or the territory manager's delegate.
The 2020 ASC 730 Directive also expands the list of documentation that taxpayers must retain and make available upon request to include the following:
Internal-use software and website development costs
The 2017 ASC 730 Directive did not specify whether taxpayers may include development costs for software that is not sold, leased or otherwise marketed (internal-use software) or website development costs when calculating Adjusted ASC 730 Financial Statement R&D. The 2020 ASC 730 Directive does not allow taxpayers to take those costs into account. The Appendix C instructions for computing the Adjusted ASC 730 Financial Statement R&D require taxpayers to remove all internal-use software costs from their US Financial Statement R&D. The Appendix C instructions further specify that 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." Further, Appendix E now defines US ASC 730 Financial Statement R&D as "US Financial Statement R&D adjusted by removal of all expenses for software development activities paid or incurred in the development of software not for sale, lease, or otherwise marketed and for expenses incurred in activities listed in ASC 730-10-55-2 and other non-ASC 730 expenses."
The revised FAQs have been updated to advise that, for purposes of the 2020 ASC 730 Directive, website development costs will be treated the same as internal-use software. The FAQs also advise that software present in a hosting arrangement is typically considered internal-use software, unless both of the following criteria are met:
The 2020 ASC 730 Directive and the revised FAQs reflect some of the concerns raised by the IRS in examinations of QREs determined under the 2017 ASC 730 Directive and ideas expressed in the LB&I Concept Unit titled ASC 730 Research and Development — How it Relates to IRC 41 and 174 (April 2018). The revisions give the IRS more discretion to exclude taxpayers from the scope of the directive and seems to respond to certain unexpected results of taxpayers' application of the 2017 ASC 730 Directive.
The explicit exclusion of development costs of software that is not sold, leased, or otherwise marketed (including hosted software, with limited exceptions) will reduce the applicability of the directive for some taxpayers, and increase compliance cost and the use of IRS examination resources if taxpayers choose to include such costs in QREs for their R&D credit. The revised FAQs are important to understanding what kinds of software-development activities are excluded and included in ASC 730 expenses (for example, software used in research and development and software that is a pilot project are included). The additional documentation requirements and need for additional diligence with respect to excluding specific types of costs could also be more burdensome to taxpayers that compute their QREs under the 2020 ASC 730 Directive.
For eligible taxpayers computing their R&D credit for tax years ended before July 31, 2020 (e.g., tax years ended December 31, 2019), the 2017 ASC 730 Directive still applies for computing QREs covered by that directive, and the 2020 ASC 730 Directive does not apply. Both directives require taxpayers to include the QREs calculated under the applicable directive on their timely-filed original return and, therefore, refund claims and carryforward adjustments based on QREs determined under either of the directives are not allowed.
Although the revised directive is more restrictive than the previous version, the 2020 ASC 730 Directive may be useful to taxpayers to reduce controversy with respect to their R&D credit claims if they have the detailed information required to fulfill the directive's documentation requirements.