For tax years beginning in 2022 and later, R&E expenses are required to be capitalized and amortized over a five-year period (or a 15-year period in the case of expenditures attributable to foreign research) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. R&E expenses are no longer allowed as deductible expenses as incurred.
Determine If Annual Deducted Costs Qualify as R&E Expenditures
Beginning in 2022, businesses that have foreign subsidiaries need to review their related party expenditures to determine if the costs they have deducted annually will qualify as R&E expenditures that are now required to be capitalized and/or amortized. Contract research performed by a CFC for a U.S. parent would require the U.S. parent, who incurred the R&E expense, to capitalize the expense over 15 years. When performing contract research, the U.S. parent would be the party to use the product or research in connection with its trade or business or deemed to have paid or incurred the R&E expenditures.
In general, a CFC would not have to capitalize R&E expenditures unless the R&E activity was self-directed and the CFC itself bears the risk rather than the U.S. parent. Note that research or experimental expenditures under Treas. Reg. 1.174-2 are research and development costs in the experimental or laboratory sense that are incurred in connection with the taxpayer’s trade or business if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. The costs paid or incurred by the R&D service provider in performance of cost reimbursement contract, including grant, are not specified research or experimental expenditures. The costs paid or incurred under such contracts are Section 162 expenses rather than specified research or experimental expenditures. The work under the R&D service contract was not performed under its own orders and the R&D service provider did not bear any risk. The end of research does not result in a product or subset of the product (as defined under Treas. Reg. 1.174-2) which the service provider can use in connection with its trade or business.
Where a CFC is required to capitalize its R&E expenses, this would impact the E&P of the CFC as well as the U.S. shareholder, who could see significant increases in tested income for the GILTI calculation in the first year that the rules are implemented. This may also give rise to additional GILTI inclusions and as well as residual tax on GILTI inclusions.
Claiming the High-Tax Exception Under GILTI?
Under the new Section 174 rules, U.S. shareholders that claimed the high-tax exception under the GILTI rules on their CFC income may be subject to tax when foreign taxable income is recalculated for GILTI purposes. Keep in mind that the underlying tax paid by the CFC will not change as the local country tax principles will be applied in computing taxable income. Section 174 will impact the U.S. taxable income, which is the starting point for tax calculations for FDII, BEAT, and FTCs. In some cases, it may be favorable to the U.S. taxpayer. But the overall impact of section 174 R&E will be a reduction in current-year deductions and a significant increase in current-year taxable income.