On December 22, 2023, the IRS and Treasury Department released Notice 2024-12 (Notice), which modifies previously issued Notice 2023-63 that describes proposed guidance that the Treasury Department and IRS intend to include in proposed regulations under IRC Section 174. For more information on Notice 2023-63, see Tax Alert 2023-1526.

Background

Prior law IRC Section 174 allowed taxpayers to deduct research or experimental expenditures (pre-2022 R&E expenditures) in the tax year paid or incurred. Taxpayers could also elect to capitalize and amortize these pre-2022 R&E 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 IRC Section 174 did not provide any cost recovery provisions for such amounts.

In contrast, current law IRC Section 174 (1) requires SRE expenditures to be capitalized and amortized over five years (or 15 years if the SRE expenditures relate to foreign research within the meaning of IRC Section 41(d)(4)(f)), (2) classifies all software development costs as SRE expenditures, and (3) restricts recovery of SRE expenditures until the end of the amortization period, even if the research is abandoned, retired or disposed. Current law IRC Section 174 applies to SRE expenditures paid or incurred in tax years beginning after December 31, 2021.

Modification of Section 6 of Notice 2023-63 — Research performed under contract

Section 6 of Notice 2023-63 provides guidance for determining whether costs paid or incurred for research performed under contract are SRE expenditures under IRC Section 174. This section of Notice 2023-63 includes several new terms for applying these interim rules.

A "research provider" (defined in Section 6.02(1) of Notice 2023-63) is a party that contracts with a research recipient (defined in Section 6.02(2)) to (a) perform research services for the research recipient with respect to an SRE product, or (b) develop an SRE product that the research recipient acquires from the research provider. An SRE product is defined as "any pilot model, process, formula, invention, technique, patent, computer software, or similar property (or a component thereof) that is subject to protection under applicable domestic or foreign law." Know-how that is not subject to legal protection does not constitute an SRE product of the research provider under these rules. Section 6.02(3) of Notice 2023-63 defines "financial risk" as the research provider's risk of suffering a financial loss from the research's failure to produce the desired SRE product.

Section 6.04 of Notice 2023-63 requires a research provider to treat its research costs as SRE expenditures if it bears financial risk under the terms of the contract with the research recipient. Additionally, a research provider must treat its research costs as SRE expenditures if it has a right to use any resulting SRE product in its trade or business or otherwise exploit any resulting SRE product through sale, lease or license (regardless of whether the research provider bears financial risk and regardless of how the research recipient treats the costs). A research provider will not be treated as having rights to use or exploit the SRE product if that right is conditioned on obtaining approval from an unrelated party to the agreement.

In Section 2.04 of Notice 2024-12, the Treasury Department and the IRS acknowledge that, contrary to their intent, the guidance in Section 6.04 of Notice 2023-63 regarding a "right to use" or the exploitation of an SRE product could be interpreted to:

 … require a research provider that does not bear financial risk under the terms of the contract with the research recipient to improperly treat as SRE expenditures the costs paid or incurred by the research provider to perform SRE activities on behalf of the research recipient under such contract if the research provider obtains an SRE product right that (1) is separately bargained for (that is, an SRE product right that arose from consideration other than the cost paid or incurred by the research provider to perform SRE activities under that contract) or (2) was acquired for the limited purpose of performing SRE activities under that contract or another contract with the research recipient.

To avoid this unintended interpretation, Section 3 of Notice 2024-12 provides the following modified guidance for determining whether a research provider has rights to use or exploit the SRE product:

For purposes of applying [S]ection 6.04 of Notice 2023-63, if a research provider that does not bear financial risk under the terms of the contract with the research recipient obtains an excluded SRE product right (that is, an SRE product right described in [S]ection 2.04(3) of this [N]otice) and does not obtain any other SRE product right under the terms of such contract, then the costs paid or incurred by the research provider to perform SRE activities on behalf of the research recipient under such contract are not SRE expenditures.

Section 2.04(3) of Notice 2024-12 defines an "excluded SRE product right" as an SRE product right that "(1) is separately bargained for (that is, an SRE product right that arose from consideration other than the cost paid or incurred by the research provider to perform SRE activities under that contract) or (2) was acquired for the limited purpose of performing SRE activities under that contract or another contract with the research recipient."

Modification of reliance on Notice 2023-63

Section 10.01 of Notice 2023-63 provides that taxpayers may choose to rely on the rules in Sections 3 through 9 of Notice 2023-63 for tax years beginning after December 31, 2021, "provided the taxpayer relies on all the rules in [S]ection 3 through 9 of this [N]otice and applies them in a consistent manner."

Notice 2024-12 modifies Section 10 of Notice 2023-63 to allow taxpayers to rely on some, but not all, of the provisions in Notice 2023-63 by removing the requirement that taxpayers must rely on all the rules in Sections 3 through 9. With regard to this modification, Notice 2024-12 states "[t]o facilitate reliance on the rules described in Notice 2023-63 in a more administrable manner, [S]ection 4 of this [N]otice modifies [S]ection 10.01 of Notice 2023-63 to remove the requirement that a taxpayer must rely on all the rules described in [S]ections 3 through 9 of the [N]otice if it chooses to rely on any of the rules described in [S]ections 3 through 9 of the [N]otice."

Section 4 of Notice 2024-12 modifies Section 10.01 of Notice 2023-63 to read as follows:

.01 In general. It is anticipated that the forthcoming proposed regulations will provide that rules consistent with the rules described in [S]ections 3 through 9 of this [N]otice would apply for [tax] years ending after September 8, 2023. Except as otherwise provided in this [S]ection 10.01, prior to the publication date of the forthcoming proposed regulations in the Federal Register, a taxpayer may choose to rely on the rules described in [S]ections 3 through 9 of Notice 2023-63 for expenditures paid or incurred in [tax] years beginning after December 31, 2021, provided the taxpayer relies on them in a consistent manner. Taxpayers are not required, however, to rely on all the rules described in [S]ections 3 through 9 of Notice 2023-63. Taxpayers may not rely on the rules described in [S]ection 7 of Notice 2023-63 for SRE expenditures paid or incurred with respect to property that is contributed to, distributed from, or transferred from a partnership.

Clarification of Section 12 of Notice 2023-63 regarding Section 5 of Revenue Procedure 2000-50

Section 5 of Notice 2024-12 clarifies that, for amounts paid or incurred in tax years beginning after December 31, 2021, Section 5 of Revenue Procedure 2000-50 is removed as obsolete. However, for amounts paid or incurred in tax years beginning on or before December 31, 2021, Section 5 of Revenue Procedure 2000-50 continues to apply.

Applicability dates

Notice 2024-12's modification to Section 6 of Notice 2023-63 is effective as of September 8, 2023 (the publication date of Notice 2023-63). Taxpayers can rely on Sections 3 and 4 of Notice 2024-12 for expenditures paid or incurred in tax years beginning after December 31, 2021.

Implications

Notice 2024-12 modifies prior guidance for determining whether a research service provider has rights to use or exploit research performed under contract. The "excluded SRE product rights" defined in Notice 2014-12 are commonly reflected in "background IP" clauses of research services contracts, subsequent royalty agreements, or in limited risk distributor arrangements.

Taxpayers that have filed a tax return in which they capitalized certain costs incurred by a research provider that are not otherwise SRE expenditures (pursuant to the modifications provided in Notice 2024-12) may have a remedy to change that treatment through the newly released procedural guidance in Revenue Procedure 2024-9 (also released by the IRS and the Treasury Department on December 22, 2023). Specifically, Revenue Procedure 2024-9 modifies Section 7.02 of Revenue Procedure 2023-24 to allow automatic accounting method changes related to IRC Section 174(a) and to conform with the modifications made to Notice 2023-63 by Notice 2024-12.

Taxpayers who provide research services will want to consider how existing research services contracts and other agreements align with the guidance provided in Notice 2024-12. Taxpayers may want to make changes to research services contracts and subsequent agreements in light of this new guidance. Additionally, taxpayers should evaluate the modifications to the IRC Section 174 method change procedures in Section 7.02 of Revenue Procedure 2023-24 (following the modifications provided in Revenue Procedure 2024-9) to determine whether any accounting method change opportunities are available. Notice 2024-12 also allows taxpayers flexibility in applying some, but not all, of the interim guidance provided in Sections 3-9 of Notice 2023-63. Because the guidance described in Notice 2023-63 and Notice 2024-12 is not required to be applied retroactively, taxpayers can continue relying on prior law for tax years ending on or before September 8, 2023.

Notice 2024-12 also allows taxpayers flexibility in applying some, but not all, of the interim guidance provided in Sections 3-9 of Notice 2023-63. Because the guidance described in Notice 2023-63 and Notice 2024-12 is not required to be applied retroactively, taxpayers can continue relying on prior law for tax years ending on or before September 8, 2023.