Until recently, Section 174 of the US Internal Revenue Code allowed taxpayers who incurred research expenses to deduct them in the current year.
The Tax Cuts and Jobs Act 2017 amended this provision to require specified research and experimentation (SR&E) expenditure to be capitalized and amortized, but delayed the effective date of this provision. amendment, which applies to taxation years beginning on or after January 1, 2022.
Although the U.S. House of Representatives proposed extending current-year spending on research fees under the Build Back Better Act, it fell through and the new Section 174 is now in effect. vigor. The amortization period is five years for domestic SR&E expenditures and 15 years for foreign SR&E expenditures.
The application of the new Section 174 raises many questions, but a key question is how it applies to suppliers of contracted research and development (R&D) services, particularly when providing such services to an affiliated entity. .
Not all R&D expenditures are SR&E expenditures subject to new section 174 – SR&E expenditures are defined as “research or experimental expenditures that are paid or incurred . . . in connection with the taxpayer’s trade or business.
Applying this definition to an entity that owns intangible property (IP) and pays a related party for R&D services is quite straightforward: the cost of obtaining those services is an expense that the IP owner incurs in the part of its business, and therefore it is necessary to capitalize and amortize this cost under the new section 174. Economically, this makes sense. The IP owner will typically experience the benefits of R&D services (i.e. increased IP value) over an extended period of time, which justifies capitalization.
How this definition applies to the affiliate service provider is less clear. Assume that the service provider does not own the intellectual property and does not perform any business other than providing contracted R&D services. In a sense, the expenditures that the service provider incurs in performing these activities could be understood as expenditures incurred in the course of its business of providing R&D services, which would appear to make them SR&E expenditures subject to the new section 174. Yet this defies economic common sense.
When revenue from R&D services is recognized in the year the services are rendered, the contracted R&D service provider derives no continuing benefit from the services it has provided that would justify capitalization. In addition, the recipient of affiliated services who owns the intellectual property is already required to capitalize the cost of those services (including any element of profit paid to the service provider).
On the other hand, Treas. Reg. Section 1.174-2(a)(3) defines research and experimental expenditures subject to section 174 by reference to “products” which are in turn defined as IP “for use by the taxpayer in its business or its business and the products held for sale, rental or license”.
Although a contracted R&D service provider provides services related to the development of an IP product, that IP product is not used by the service provider in its business or held by the service provider for sale, rental or license. Rather, it is the recipient of the service who owns the IP product and uses it in his business. This regulation therefore makes it possible to conclude that the expenditures of a service provider are not SR&E expenditures subject to section 174.
Why is this important? Let’s assume for a moment that the new section 174 applies to the costs of R&D service providers. If the service provider is a US entity, it would be required to amortize its R&D costs rather than deduct them. Over time, the effects of changing Section 174 may lessen, but in the early years of the new Section 174, it could significantly increase the service provider’s taxable income.
If, on the other hand, the service provider is a foreign corporation controlled by a U.S. parent, the U.S. parent could have significant Global Low-Tax Intangible Income (GILTI) inclusions because, for the purposes of To determine the service provider’s tested revenue, the depreciation deductions allowed under the new section 174 would be taken into account rather than the total amount of the provider’s R&D costs.
The new Section 174 does not directly affect transfer pricing (TP), but it does have significant implications for a number of TP structures, including cost-sharing agreements as well as R&D service provider agreements. discussed in this article.
The application of the new law to service agreements remains unclear. In any given case, the taxpayer will need to consider the facts and circumstances, weigh the authorities, and consider all issues associated with determining whether the expense is subject to Section 174.
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