The Treasury Department and the IRS have issued corrections to proposed regulations (REG-105495-19) and final regulations (TD 9882) on the allocation and apportionment of research and experimental (R&E) expenditures. (For prior coverage of the regulations, see Tax Alert 2019-2155.)

Background

Treas. Reg. Section 1.861-17 provides guidance for allocating and apportioning R&E expenditures. Under Treas. Reg. Section 1.861-17(e)(1), taxpayers may elect to apply either a sales method or an optional gross income method of apportionment, subject to a requirement to apply either method for five consecutive years.

Final regulations. Treas. Reg. Section 1.861-17(e)(3) includes a one-time exception to the five-year binding election period. Under that exception, taxpayers may change between the sales method and gross income method for "each" tax year beginning after December 31, 2017 and before January 1, 2020, without IRS consent.

Proposed regulations. The proposed regulations, which would be effective for tax years beginning after December 31, 2019, include guidance for apportioning R&E expenditures under either the sales method or a new gross-receipts-based method. The proposed regulations would also eliminate the existing gross income method of apportioning R&E expenditures.

The Preamble to the proposed regulations permitted taxpayers applying the sales method to rely on Prop. Reg. Section 1.861-17 for tax years beginning after December 31, 2017 and before January 1, 2020.

Corrections

Final regulations. The final regulations were published on December 17, 2019, after many taxpayers already filed tax returns for tax years beginning in 2018. Accordingly, it was unclear whether, and how, taxpayers could change methods for the 2018 tax year. The correcting amendment to the final regulations clarifies that this change between the gross income method and the sales method could be made by filing either an amended or a final return.

It was also unclear whether the final regulations' reference to "each" tax year required the change be made for all tax years beginning after December 31, 2017 and before January 1, 2020. The correcting amendment clarifies that the change may be made for all such years, or only for the last tax year beginning before January 1, 2020.

Proposed regulations. The technical correction to the proposed regulations similarly clarifies that a taxpayer may rely on the proposed regulations for all years beginning after December 31, 2017, or only for the last tax year beginning before January 1, 2020, if the taxpayer is on the sales method only in that year. Thus, the correcting amendments clarify that a taxpayer may rely on Prop. Reg. Section 1.861-17 when adopting the sales method in a tax year beginning in either 2018 or in 2019, provided that the taxpayer applies it consistently to that tax year and any subsequent year. This reliance provision also applies to taxpayers that were previously on the sales method.

Implications

The allocation and apportionment of R&E expenses has a very large tax impact. This is particularly true after the enactment of the Tax Cuts and Jobs Act in 2017, including for purposes of the foreign tax credit limitation under IRC Section 904 and the deduction under IRC Section 250. Because of this, Treasury and the IRS provided taxpayers a one-time opportunity to change their method for allocating and apportioning R&E expenses; they have also issued new regulations updating those rules and allowed taxpayers to early adopt parts of those regulations. These corrections provide greater clarity regarding how those rules operate.