Balancing Intellectual Property and Research Investments Across Borders

HOST: MAGGIE: Welcome, everyone, and thanks for tuning in to Cherry Bekaert's latest technology podcast, where we are continuing a brief series on global tax matters for tech companies.

HOST: MAGGIE: Today our discussion will focus on research and development activities and the impact of Section 174 when conducting business either overseas or in multiple countries.

HOST: MAGGIE: You'll hear from members of Cherry Bekaert's Tax Credits and Incentives Advisory Practice: Martin Karamon, Vivian Kohrs, and Bryan Weems. I'll now hand it over to them.


MARTIN KARAMON: Thank you, Maggie, and everyone for joining the podcast today and listening. I'm proud to be the leader of our Tax Credits and Incentives Advisory Group.

MARTIN KARAMON: We have added many members to the team over the last few years, including people from the Big Four and other firms. We focus on everything from research and development analyses to cost segregation and energy provisions under the Inflation Reduction Act, in addition to state credits and incentives and new markets tax credits work.

MARTIN KARAMON: If anyone has questions after listening to this podcast on R&D and Section 174 or anything else, please reach out to Cherry Bekaert. I'm proud to introduce two members of my team today: Vivian Kohrs, a director in our group primarily focused on R&D, and Bryan Weems, a senior manager focused on R&D.

MARTIN KARAMON: At the end of this episode, I'll give a brief update on pending legislation, but I want to focus on the law as it exists today. With that, we'll kick it over to Bryan Weems. Bryan, how are you doing?


BRYAN WEEMS: Doing well. Thanks for having me, Martin. This is a broad topic, so to start it may help to provide background on the capitalization requirements surrounding Section 174 and define what Section 174 costs are.

BRYAN WEEMS: Stepping back to 2017, one of the budget items from the TCJA was the mandatory capitalization of Section 174 costs beginning after December 31, 2021. For work occurring domestically, those costs are capitalized and amortized over five years with a half-year convention, so year one provides only 10% of the deduction instead of a full first-year deduction.

BRYAN WEEMS: For activities occurring overseas, boots on the ground, whether employees or contractors, the costs are amortized over a 15-year period with a half-year convention, resulting in significant spread rather than immediate deductibility.

BRYAN WEEMS: When we say Section 174 costs, we mean specified research or experimental expenditures, abbreviated SRE. SRE is a broad definition that includes costs incident to development.

BRYAN WEEMS: A non-exhaustive list includes labor costs for contractors and employees who perform, supervise, or directly support SRE activities; materials and supplies used or expended in the development process; legal costs for filing or obtaining patents; and cost recovery allowances associated with property or equipment used in performing SRE.

BRYAN WEEMS: A practical example is a software engineer working in an office: a portion of rent and facility costs is allocated to that engineer, a portion of electricity powering the laptop is allocated, and the fully burdened cost of employment, including fringe benefits, should be considered when identifying costs incident to development.

BRYAN WEEMS: With the regulations and Notice 2023-63, which was released in September 2023, there remains some lack of clarity. Vivian, could you speak to that topic?


VIVIAN KOHRS: When Notice 2023-63 came out, we were pleased because it provided guidance the IRS had delayed until the 2022 tax filing year, released in September 2023. That created a mad dash for many taxpayers, but even with the notice there is still a lack of clarity in the regulations and notices that can result in potential double capitalization.

VIVIAN KOHRS: Double capitalization is a significant issue for the tech industry, particularly for companies with multi-entity structures or foreign entities. It occurs when the same set of research and experimentation costs must be capitalized by both the payee and the payer of the R&D activities.

VIVIAN KOHRS: For example, a U.S. entity may pay a foreign entity in India or Ukraine to develop software. If both the U.S. entity and the foreign entity share the IP, both parties potentially may need to capitalize under Section 174. The foreign entity's Section 174 treatment can affect the flow-through income back to the U.S., so companies must analyze Section 174 when structuring intercompany IP agreements.

VIVIAN KOHRS: Review intercompany agreements, cost-sharing agreements (CSAs), transfer pricing documentation, and possibly project charters for significant multinational initiatives, because documentation and the facts and circumstances will drive how costs are quantified and allocated.


BRYAN WEEMS: In practice, we see several outcomes. Double capitalization can occur as Vivian described. In one case, an intercompany agreement showed the U.S. entity solely performed services on behalf of the foreign parent and had no right to exploit the research; it was a pure reimbursement. Based on the facts, the costs incurred in the U.S. were treated as Section 162 ordinary business expenses rather than Section 174 costs.

BRYAN WEEMS: In another case, a multinational headquartered in EMEA had R&D and manufacturing in the U.S. Transfer pricing documentation showed the U.S. R&D had no right to exploit the results on behalf of the global parent, but the local manufacturing and production activities were impacted by the R&D. The R&D did not affect the U.S. entity's rights, but local manufacturing production, QC, and trial runs did produce Section 174 costs that needed to be quantified for the return.

BRYAN WEEMS: Documentation and the reimbursement mechanics between parties are critical to determine whether costs are Section 174 or Section 162 and whether double capitalization applies.


VIVIAN KOHRS: There is also the scenario where a tech company performs R&D on behalf of a customer under contract. Notice 2023-63, Section 6, addresses that situation. The notice indicates that if the research provider performs specified research and retains either development rights or financial risks, the costs to perform the research are Section 174 costs that the provider must capitalize.

VIVIAN KOHRS: The distinction from R&D tax credit rules is important. For the R&D tax credit, taxpayers generally need both rights and risks to claim the credit for a contract research activity. Under Section 174, however, retaining either rights or risks can create capitalization obligations, broadening the scope of costs that may be Section 174 costs compared to those that qualify for the R&D tax credit.

VIVIAN KOHRS: If a company does not plan to exploit IP developed under contract, it may be appropriate to consider exclusive rights assignments to customers, but that should be a business decision and not driven solely by Section 174 considerations.


BRYAN WEEMS: The tax tail shouldn't wag the business dog. Section 174 has substantial cash and financial statement impacts because capitalization is mandatory. My recommendation is to get tax involved early in business decisions, whether for a significant ERP implementation affecting multiple entities or when formulating transfer pricing documentation. Aligning tax, CTO, finance, and legal stakeholders is essential.


VIVIAN KOHRS: I agree. When structuring contracts for performing R&D for others or paying others to perform R&D, involve tax to evaluate the business and cash flow implications. The Section 174 add-back to taxable income can be very substantial.

VIVIAN KOHRS: Martin, are there other items taxpayers should consider?


MARTIN KARAMON: Yes. First, while claiming the R&D credit is elective, the Section 174 capitalization regime is mandatory. Some companies assumed that if they did not claim an R&D credit, they could avoid Section 174 capitalization, but that is incorrect. Taxpayers must identify and capitalize SRE amounts, and then they may consider calculating credits to offset any additional taxable income resulting from capitalization.

MARTIN KARAMON: Second, some companies with large net operating losses have questioned the need to focus on Section 174 capitalization. However, the IRS has issued IDRs related to Section 174 to clients deep in NOL positions, so Section 174 is on the IRS's radar and requires analysis and documentation.

MARTIN KARAMON: Finally, in late January the House passed the Tax Relief for American Families and Workers Act of 2024, which, if passed by the Senate and signed by the president, would temporarily eliminate the capitalization requirement for domestic R&D back to 2022 and reinstate it in 2026, while leaving the foreign capitalization requirement intact. That bill has been with the Senate since late January and my expectation is it will not pass before the presidential election, so we are following the law as written today.

MARTIN KARAMON: If there are new developments, we will release another podcast and other writings from Cherry Bekaert. Thank you to Bryan, Vivian, Maggie, and everyone who joined. As you heard today, careful planning can help minimize the amount that must be capitalized and potentially yield credits to offset tax liability.