New regulations offer stronger incentives for R&E investments

Recently, the IRS finalized taxpayer-friendly regulations under section 174 of the Internal Revenue Code pertaining to the treatment of research and experimentation (R&E) expenses incurred in connection with the development and production of tangible property, including pilot models and prototypes. These regulations, which affect all taxpayers developing or improving products, finalize temporary regulations issued in September of 2013.

Background

Section 174 provides taxpayers with the option of currently deducting R&E expenses as they are paid or incurred or deferring and amortizing them over a period of at least five years. To qualify for section 174 treatment, expenses must relate to activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product or process.

In accordance with section 174(c), any expense for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the R&E that is subject to an allowance for depreciation is not eligible for section 174 treatment. Furthermore, under Treasury Regulations section 1.174-2(b)(4), known as the “Depreciable Property Rule,” amounts expended for R&E 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.

Historically, the IRS used the Depreciable Property Rule to contend that tangible property resulting from R&E precludes section 174 treatment in instances where such property is sold to a customer and becomes depreciable property in the hands of the customer or where such property is used in a taxpayer’s trade or business and becomes depreciable property in the hands of the taxpayer. Taxpayers and practitioners maintain that the IRS has adopted an unreasonably inclusive interpretation of property subject to depreciation that results in unpredictability in determining whether an expense qualifies under section 174. If taxpayers are required to consider whether a subsequent event—such as the sale of a pilot model or prototype to a customer—results in depreciable property, then section 174 is not achieving its objective of encouraging companies to invest in R&E activities.

New final regulations

The final regulations provide much welcome clarity and guidance on the deductibility of section 174 expenses for tangible property resulting from R&E activities. The final regulations include the following changes:

  • Provide that if expenses qualify as R&E, the ultimate success, failure, sale, or other use of the research or property resulting from the R&E is not relevant to the determination of eligibility under section 174.
  • Amend Treas. Reg. section 1.174-2(b)(4) to provide that the Depreciable Property Rule is an application of the general definition of R&E expenditures to depreciable property and should not be applied to exclude otherwise eligible expenditures.
  • Define the term “pilot model” as 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. A pilot model includes a fully functional representation or model of the product or component of a product.
  • Clarify the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible expenses under section 174.
  • Provide a “shrinking-back” provision to address situations in which the requirements for R&E expenditure qualification are met with respect to only a component part of a larger product and are not met with respect to the overall product itself.

Takeaway

The changes adopted in the final regulations create a stronger incentive for companies to invest in R&E activities given the broader definition of R&E and the increased predictability concerning the treatment of R&E costs. Taxpayers need no longer be concerned with the possibility of otherwise eligible section 174 expenses being reversed by the IRS due to a subsequent event such as the sale of a pilot model or prototype. Furthermore, since meeting the section 174 requirements is a prerequisite to qualifying for the section 41 Credit for Increasing Research Activities, these regulations will also impact qualified research expense (QRE) determinations under section 41.

The final regulations apply to taxable years ending on or after July 21, 2014. Taxpayers may apply the final regulations to open taxable years.

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