The proposed regulations [PDF 232 KB] will be published in the Federal Register on Friday, September 6, 2013. A public hearing has been scheduled for January 8, 2014 at 10am. Comments and requests to speak at the hearing must be received no later than 90 days after September 6, 2013, the official date of publication in the Federal Register.
Section 174 was enacted as a part of the Internal Revenue Code of 1954 to eliminate uncertainty in the tax accounting treatment of R&D expenditures and to encourage taxpayers to carry on R&D activities. Under the guidance provided in section 174, taxpayers are allowed to either currently deduct R&D expenditures as they are paid or incurred, or treat them as deferred expenses amortizable over a period not less than 60 months.
Existing regulations provide that a determination of whether costs qualify as R&D expenditures under section 174 depends upon whether the costs are incident to activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Applying this general rule, costs relating to the production of a product—after the uncertainty relating to the development or improvement of the product is eliminated—typically do not qualify under section 174.
Existing regulations define “product” to include a “pilot model,” as well as processes, formulas, techniques, and similar property, without explaining what a pilot model is.
Further, the current regulations provide that expenditures for the acquisition or improvement of property that is subject to an allowance for depreciation or depletion are not deductible under section 174. However, expenditures for R&D that result, as an end-product of the R&D, in depreciable property to be used in the taxpayer’s trade business may be allowable as a current R&D expenditure as long as the costs meet the general requirements of section 174.
To further clarify this position, the regulations provide that amounts expended for R&D do not include the costs of the component materials of depreciable property, the costs of labor, or other elements involved in its construction and installation, or costs attributable to the acquisition or improvement of the property. This rule is referred to as the “Depreciable Property Rule.”
Over the years, many questions have been raised concerning the application of the current regulations and the Depreciable Property Rule to costs incurred by taxpayers in the development of tangible property. There have been numerous IRS examinations in which the qualification of material costs used in developing such property has been an issue.
In an attempt to provide taxpayers with further guidance and clarity on these issues, today’s proposed regulations would make the following changes to the current section 174 regulations:
- First, the proposed regulations clarify that the ultimate success, failure, sale, or other use of the research or property resulting from the R&D activity is not relevant to a determination of eligibility under section 174. Thus, the fact that the taxpayer sells a piece of property that includes materials that were characterized as R&D expenses when they were used, or the taxpayer begins to use the completed property in its trade or business, will not per se disqualify those R&D expenses.
- Second, the proposed regulations would amend the existing regulations to clarify that the Depreciable Property Rule is an application of the general definition of R&D expenditures under the current regulations and is not to be applied to exclude otherwise eligible expenditures.
- Third, the proposed regulations provide a definition of the term “pilot model”—i.e., any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term “pilot model” includes: (1) a fully functional representation or model of the product; or (2) a component of a product (to the extent the “shrinking-back” provision, described below, applies).
- Fourth, the proposed regulations state that the costs of producing a product—after uncertainty concerning the development or improvement of a product is eliminated—are not eligible under section 174 because these costs are not for R&D.
- Fifth, the proposed regulations provide a “shrinking-back” provision—similar to a rule in the research credit regulations—to recognize situations in which the costs of a component part of a larger product can qualify as R&D expense, even though the development of the overall product has passed the point at which uncertainties have been resolved.
Examples in the proposed regulations illustrate, among other things, that material and labor costs of a component can be R&D expense even though the rest of the property is functional.
Examples also conclude that all material and labor costs of a product being developed and eventually sold can qualify as R&D expense, if the uncertainties about development apply throughout the product; the pilot model itself can be sold without disqualifying any of the R&D expense.
These proposed regulations specifically deal with qualification of costs under section 174, and do not directly address whether these costs could also be qualified research expenses under the section 41 research credit.
The standards for the cost of a supply used in qualified research to be a qualified research expense are nearly identical to those that need to be satisfied under section 174 for material costs to be an R&D expense, and the guidance in these proposed regulations would appear to apply equally under section 41.
Proposed effective date
These regulations are proposed to apply to any tax year ending on or after the publication date of a Treasury decision adopting these rules as final regulations.
The IRS, however, will not challenge return positions consistent with these proposed regulations. Thus, taxpayers may rely on these proposed regulations until the date that the final regulations are published in the Federal Register.