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In Revenue Procedure 2023-8, released December 12, 2022, under IRC Section 446 and Treas. Reg. Section 1.446-1(e), the IRS allows taxpayers to obtain automatic consent to change the accounting method for "specified research or experimental expenditures" (specified R&E expenditures) to comply with IRC Section 174, as amended by the Tax Cuts and Jobs Act (TCJA). As amended, IRC Section 174(a)(2) requires taxpayers to charge specified R&E expenditures to a capital account. Taxpayers must amortize the expenditures over five years (15 years if the specified R&E expenditures relate to foreign research), beginning with the midpoint of the tax year in which taxpayers pay or incur the expenditures. IRC Section 174, as amended, applies to specified R&E expenditures paid or incurred in tax years beginning after December 31, 2021.

Revenue Procedure 2023-8 adds Section 7.02 to the List of Automatic Changes in Revenue Procedure 2022-14 to allow taxpayers to make this automatic change in accounting method.

Background

The TCJA primarily modified IRC Section 174 by requiring capitalization and amortization of specified R&E expenditures, classifying all software development costs as specified R&E expenditures, and restricting recovery of specified R&E expenditures until the end of the amortization period, even if the research is abandoned or disposed. Before the TCJA, IRC Section 174 allowed taxpayers to deduct research and experimental expenditures (pre-2022 R&E expenditures) in the tax year incurred. Taxpayers could also elect to capitalize and amortize these expenditures over not less than 60 months, beginning in the month the taxpayer first benefitted from the research. A taxpayer that did not expense or capitalize and amortize IRC Section 174 pre-2022 R&E expenditures had to treat the costs as chargeable to a capital account, as IRS Section 174 did not provide any cost recovery provisions for such amounts.

Section 13206(b) of the TCJA deems the amendments to IRC Section 174 to be "a change in method of accounting" that is initiated by the taxpayer, made with IRS consent and applied on a cut-off basis (with no adjustment under IRC Section 481(a) allowed).

Applicability rules

Revenue Procedure 2023-8 applies to taxpayers that are changing their accounting method to comply with amended IRC Section 174 for specified R&E expenditures paid or incurred in tax years beginning after December 31, 2021. The procedure does not apply to a change in the treatment of pre-2022 R&E expenditures, or software development expenditures, paid or incurred in tax years beginning before January 1, 2022. Sections 7.01 and 9.01 of Revenue Procedure 2022-14 address those changes.

To effectuate the change in accounting method for the first tax year beginning after December 31, 2021, Section 3.01 of Revenue Procedure 2023-8 waives Treas. Reg. Section 1.446-1(e)(3)(i)'s requirement to file Form 3115. Instead, taxpayers may file a statement with their timely filed (including extensions) original federal income tax return implementing the requested change for the requested year of change. See Revenue Procedure 2015-13, Section 6.03(1)(a)(i)(A). For each taxpayer, the statement must include the following information:

1. The name and employer identification number or social security number, as applicable, of the applicant that has paid or incurred specified R&E expenditures after December 31, 2021
2. The beginning and ending dates of the first tax year in which the change to the required IRC Section 174 method takes effect for the applicant
3. The designated automatic accounting method change number (number 265)
4. A description of the type of expenditures included as specified R&E expenditures
5. The specified R&E expenditures paid or incurred by the applicant during the year of change
6. A declaration that the applicant is changing its accounting method for specified R&E expenditures to capitalize them to a specified research or experimental capital account, and amortize them over either five years for domestic research or 15 years for foreign research (as applicable), beginning with the midpoint of the tax year in which they are paid or incurred in accordance with the method permitted under IRC Section 174 for the year of change

Additionally, the declaration must state that the applicant is making the change on a cut-off basis.

Revenue Procedure 2023-8 requires a change for the first tax year beginning after December 31, 2021, to be implemented on a cut-off basis (i.e., no IRC Section 481(a) adjustment is allowed).

For a change in accounting method under Section 7.02 of Revenue Procedure 2022-14 for a year of change later than the first tax year beginning after December 31, 2021, a taxpayer must file a Form 3115 and include an attachment with:

1. A description of the type of expenditures included as specified R&E expenditures
2. The tax year(s) in which the specified R&E expenditures subject to the change were paid or incurred by the applicant
3. A declaration that the applicant is changing its accounting method for specified R&E expenditures to capitalize them to a specified research or experimental capital account, and amortize them over either five years for domestic research or 15 years for foreign research (as applicable), beginning with the midpoint of the tax year in which they are paid or incurred in accordance with the method permitted under IRC Section 174 for the year of change

Additionally, the declaration must state that the applicant is making the change with a modified IRC Section 481(a) adjustment that takes into account only specified R&E expenditures paid or incurred in tax years beginning after December 31, 2021.

For a year of change later than the first tax year beginning after December 31, 2021, taxpayers must implement the change in accounting method using a modified IRC Section 481(a) adjustment that takes into account only specified R&E expenditures paid or incurred in tax years beginning after December 31, 2021.

Audit protection

Taxpayers are not eligible for audit protection under Section 8.01 of Revenue Procedure 2015-13 for pre-2022 R&E expenditures incurred in tax years beginning before January 1, 2022, for changes described in Revenue Procedure 2023-8. Audit protection applies to the treatment of specified R&E expenditures paid or incurred in a tax year beginning after December 31, 2021. See section 7.02(7) of Revenue Procedure 2022-14, as modified by Section 3 of Revenue Procedure 2023-8.

In addition, Section 2.03(7) of Revenue Procedure 2023-8 states that " … the IRS may change the characterization or classification of expenditures as specified research or experimental expenditures as defined in [IRC Section] 174(b) in order to apply [IRC Section]174 as well as the change under section 7.02 of Revenue Procedure 2022-14, as modified by section 3 of this revenue procedure, to the proper amount of expenditures paid or incurred in each taxable year beginning after December 31, 2021."

EY insight: Taxpayers' treatment of pre-2022 R&E expenditures for tax years beginning before January 1, 2022, may change if examined by the IRS.

Transition rule

Revenue Procedure 2023-8's amendment to Section 7 of Revenue Procedure 2022-14 includes a transition rule for taxpayers that filed a return on or before January 9, 2023, for a tax year beginning after December 31, 2021 (e.g., a taxpayer with a short tax year that began and ended in 2022). In this case, taxpayers are deemed to have complied with the procedures for making a method change to comply with amended IRC Section 174, if they:

1. Reported the specified R&E expenditures paid or incurred for their tax year beginning after December 31, 2021 on Part VI of Form 4562, Depreciation and Amortization, filed with the tax return
2. Properly capitalized and amortized the specified R&E expenditures in accordance with amended IRC Section 174 for that year

EY insight: The transition rule is narrow and does not provide any relief for a taxpayer that filed a return for a short period but did not report the amortization of R&E expenditures on Part VI of Form 4562. The relief does not apply even if the taxpayer treated those expenditures in accordance with IRC Section 174, as amended by the TCJA, and reported the amortized amount properly on the applicable "Other Deductions" or "Other Expenses" line of its return.

It is unclear why the transition rule does not apply to all taxpayers that complied with amended IRC Section 174 for returns filed on or before January 9, 2023, but either (1) changed their accounting method by relying on the statutory language of Section 13206(b) of the TCJA or (2) were unable to file a timely change in accounting method under the non-automatic procedures of Revenue Procedure 2015-13 (as could be the case for an acquired entity).

Scope restriction relief

Revenue Procedure 2023-8's amendment to Section 7 of Revenue Procedure 2022-14 removes the limitation on automatic change eligibility under Section 5.01(1)(f) of Revenue Procedure 2015-13, which otherwise would apply if the taxpayer previously changed the same item within the five years ending with the year of change. Relief from this eligibility limitation, however, only applies for the taxpayer's first tax year beginning after December 31, 2021.

EY insight: A taxpayer that changed its accounting method for software development costs to adopt a method described in Revenue Procedure 2000-50 may make a change under Section 7.02 of Revenue Procedure 2022-14, even if it made the prior change recently.

No inference for prior years

Revenue Procedure 2023-8's amendment to Section 7 of Revenue Procedure 2022-14 instructs taxpayers not to infer that the procedures under Revenue Procedure 2023-8 apply to pre-2022 R&E expenditures or method changes made for earlier years, under the pre-TCJA versions of IRC Section 174 and its related regulations.

EY insight: The list of regulations for which "no inference may be drawn" excludes Treas. Reg. Section 1.174-2, which defines research and experimental expenditures. Excluding this provision may indicate that the Treasury Department and the IRS intend to continue applying that regulation to R&E expenditures paid or incurred after December 31, 2021.

Effective date

Revenue Procedure 2023-8 is effective for specified R&E expenditures paid or incurred in tax years beginning after December 31, 2021, in which IRC Section 174 is effective.

EY insight: The effective date in Section 5 of Revenue Procedure 2023-8 refers to "specified research or experimental expenditures," which did not appear in IRC Section 174 before the TCJA amendment; this suggests Revenue Procedure 2023-8 will not apply if the effective date of amended IRC Section 174 is deferred or if the TCJA amendment to IRC Section 174 is repealed. If the TCJA amendment to IRC Section 174 is deferred or repealed, taxpayers may still consult Sections 7.01 and 9.01 of Revenue Procedure 2022-14 for method change guidance on IRC Section 174 research and experimental expenditures and software development expenditures under Revenue Procedure 2000-50.

Implications

The revenue procedure is welcome relief for taxpayers preparing to file non-automatic method changes by the end of 2022 to comply with amended IRC Section 174.

As a result of this revenue procedure's publication, taxpayers may be able to delay filing the method change until the extended due date of their 2022 tax return, in case Congress enacts legislation in 2022 or early 2023 retroactively repealing the TCJA changes to IRC Section 174 or deferring their effective date.

Revenue Procedure 2023-8, however, does not provide specific relief for taxpayers with short tax years that began and ended in 2022 and have already filed returns. Likewise, it does not offer transition guidance for taxpayers that may have filed non-automatic method changes in 2022 to effect a change in accounting method to comply with amended IRC Section 174. Finally, the revenue procedure does not indicate how a taxpayer that makes a method change on its 2022 return under Section 7.02 of Revenue Procedure 2022-14 may potentially revert to its pre-2022 method of accounting if Congress retroactively repeals the TCJA changes to IRC Section 174 or defers their effective date.

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Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor