KPMG report: Updated accounting method change procedures and clarification of rules under section 174

A KPMG report concerning two forms of guidance addressing section 174.

The IRS on December 22, 2023, released the following two forms of guidance addressing section 174:

• Notice 2024-12 clarifies and modifies Notice 2023-63 addressing the capitalization and amortization of specified research or experimental (SRE) expenditures under section 174. Of note, the notice specifically clarifies the previously issued guidance relating to contract research providers.
• Revenue Procedure 2024-9 updates the procedures for changing methods of accounting under section 174.

Background

Public Law 115-97 (December 22, 2017), commonly referred to as the “Tax Cuts and Jobs Act” (TCJA), amended section 174 in several ways with the intent of raising revenues to offset tax cuts in other areas. Among the key amendments was the removal of the ability to currently deduct section 174 expenditures, requiring taxpayers to capitalize such costs and recover them through amortization over five years for expenditures incurred in the U.S. and over 15 years for expenditures incurred outside of the U.S.

The IRS on December 12, 2022, released an advance copy of Rev. Proc. 2023-8, providing accounting method change procedures applicable to companies required to capitalize and amortize SRE expenditures. Subsequently, the IRS on December 29, 2022, released Rev. Proc. 2023-11 to amend the procedures set forth in Rev. Proc. 2023-8 for making post-2022 accounting method changes with respect to obtaining audit protection. The IRS on June 15, 2023, released Rev. Proc. 2023-24, providing an updated annual list of automatic accounting method changes, which incorporates the automatic method change procedures issued in Rev. Proc. 2023-11 under section 174.

The IRS on September 8, 2023, issued Notice 2023-63 addressing issues related to section 174 as amended by the TCJA. Given the lack of a legislative deferral or repeal of the requirement to capitalize SRE expenditures, this notice was welcome guidance for taxpayers working to prepare their current year tax returns because it covered several areas that have been unclear in previous guidance. For a more detailed analysis of Notice 2023-63.

Key points from Notice 2024-12

Notice 2024-12 clarifies and modifies Notice 2023-63, which announced that the Department of Treasury and IRS intend to issue proposed regulations addressing the capitalization and amortization of SRE expenditures under section 174. Specifically, Notice 2024-12 clarifies and modifies three areas of Notice 2023-63 as highlighted below.

Research performed under contract: excluded SRE product right. Notice 2023-63 provides that a research provider’s costs paid or incurred in performing SRE activities under a contract with the research recipient are SRE expenditures if the research provider bears financial risk or has an SRE product right (i.e., a right to use any resulting SRE product in a trade or business or otherwise exploit any resulting SRE product through sale, lease, or license). However, research providers that have an SRE product right only upon obtaining approval from an unrelated party (within the meaning of section 267 or 707) are not treated as having an SRE product right.

While Notice 2023-63 eliminated significant uncertainty that contract research providers faced in evaluating the proper treatment of costs, it did not explicitly address a situation in which a research provider separately acquires rights for consideration thus compensating the research owner for those rights. These arrangements are common for multi-national corporations with complex intercompany research services arrangements. For example, in many cases, in addition to a research services agreement, the parties enter a separate agreement granting the research provider rights to distribute the product developed under the research services agreement and requiring the research provider to pay the research recipient an arms-length royalty for those rights. While not explicitly addressing this situation, KPMG interpreted the notice to exclude expenditures from the definition of SREs in this situation,[1] and Notice 2024-12 confirms that interpretation. Removing the ambiguity, Notice 2024-12 explicitly explains that costs paid or incurred by the research provider to perform SRE activities when the research provider separately bargains for the SRE product right, whether in the same contract or a separate contract, are not SRE expenditures of the research provider (referred to as an “excluded SRE product right”) and thus not subject to capitalization under section 174.

Notice 2024-12 is effective as of September 8, 2023, and may be relied on for expenditures paid or incurred in tax years beginning after December 31, 2021, until forthcoming proposed regulations are published.

Key points from Rev. Proc. 2024-9

Rev. Proc. 2024-9 modifies Section 7.02 of Rev. Proc. 2023-24, which provides automatic procedures for changing methods of accounting for SREs under section 174 paid or incurred in tax years beginning after December 31, 2021. In addition, Rev. Proc. 2024-9 adds Section 19.02 to Rev. Proc. 2023-24 to provide an automatic change for taking SREs into account under the percentage of completion method (PCM) under section 460. These changes are effective for Forms 3115 filed on or after December 22, 2023.

The following highlights the key points from the guidance:

General Scope: Option to change a method to rely on the statute or Notice 2023-63. Section 7.02 of Rev. Proc. 2023-24 provides two options for a taxpayer to change its method of accounting relating to the substantive rules for defining SREs: (1) A change in method of accounting to interpret the statute (i.e., section 174, as amended by the TCJA) without regard to the notice (DCN 265), or (2) a change in method of accounting to rely on Notice 2023-63, as modified by Notice 2024-12 (DCN 270). Given that that the notices may be relied on by taxpayers, in whole or in part, but taxpayers also have the continued opportunity to rely on a reasonable interpretation of the statute without relying on the notices, in most instances a taxpayer following the approach of reasonably interpreting the statute would likely be able to contend that any positions taken that are consistent with the notices are also reasonable interpretations of the statute, but not vice versa. As such, we recommend that any taxpayer making a change under the new procedure designate the change to be under DCN 265, or both DCN 265 and DCN 270, but not DCN 270 by itself.