Merry Christmas!
There is an arctic outbreak in the Eastern United States and the Midwest. The cool air invades Northern Canada. The temperatures dropped by about 20 degrees below average. Bad road conditions, power outages due to storms, and below-freezing temperatures throughout.
We need something merry and we shall have it. The tax foliants had it on their parchment ever yellow since 2018. The breather, the evident relief for the high-tech US companies. The law had sought to encourage selling IP to foreign countries and paying royalties to foreign jurisdictions. It is much easier from the tax administration point of view, all you do is tax license payments at source at a flat rate, with no messing with deductions, credits, etc.
The talk persisted that the rest of the world had complained about a gargantuan dominance of the US in the high-tech sector, and the decision was made to relieve the country from this burdensome unfair advantage that evoked so much acrimony in the hearts and minds of the ruling elites of other countries.
Starting in 2022, under the modernized code section 174, the US taxpayers may not deduct their research and experimental (R&E) expenses in the year they were incurred but rather capitalize and amortize them over five or fifteen years depending on where the research was done, in the US or outside, respectively.
There are no IRS regulations issued to date for this new law.
What is considered R&E has been well established, and so far there is no additional guidance, except for the twist described in the “Twist” section below. R&E expenses are research and development costs in the experimental or laboratory sense, which include all costs that are incident to the development or improvement of a product. Expenditures qualify as research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that eliminates uncertainty as to the development or improvement of a product.
For example, say a US company earned $1mil, spent $200K on administration and marketing, and the rest $800K on R&E because it wanted to invest into and improve its product or service. Very good. It is normally expected that we can all go home for Christmas.
But a meticulous accountant calls out to everyone.
Accountant: “Wait a second or a minute..! We are looking at $71,200 (800K less allowable amortization of 800K divided by the 5 years, and assuming that work was done evenly throughout the year divided by 2 or 80K, thus: (800K less 80K)x 21% less Federal tax credit for R&D, usually 10% of the qualifying expense or $80K, roughly) Federal tax bill but only a few thousand dollars in the bank account to pay it.
The staff, knowing all too well not to get in front of their boss while she is not in a good mood, bows out with uneasy smiles.
She dismisses the perspective at first, stating that congress voted many times to either delay or do away with this provision. But the pedantic accountant observes that the saving grace has not made it to the $1.7 trillion omnibus reconciliation bill passed on Thursday, the 22nd. The president said he would sign it. Time is running out…
Accountant: “It is certainly good for competitiveness and communities overall but in our particular case, we need to do something. If you recall, we were approved for a $100,000 line of credit when the times were good. We can use that to pay the tax, but you are guaranteeing it personally…”
Boss, to her husband: “Darling, you too, go ahead, pick up the kids, get the dinner going, I’ll be home soon.” After he leaves, she continues to the accountant: “There is icing on the cake here. We cannot amortize it over 5 years or take a tax credit because even though we have been paying for R&E to the US entity Work Anywhere Anyhow Inc., all the research that is done for us was from outside the country. Thus, it is $162,400 of tax due…”
Accountant: “…Plus the underpayment penalties of roughly $5,000…”
The blizzard is insistently pounding with an icy rain at the steamed-up windows. The gale is tearing at the frames in a devilish playful mockery, teasing out attention. It is dark, quiet, and lonely before Christmas.
She does not have the money to pay the tax, and the investors would not invest in an entity that has to pay tax on the 80% of its income for the year while spending above its earnings. Making the matter worse, if a buyer for the technology arrives, these capitalized costs may not be deducted but will need to continue to be amortized, and such amortization will be useless, and will not refund any tax payable on such a sale. It would be a triple tax: the initial deduction is (practically) disallowed, amortized costs cannot be deducted against the sales proceeds from the sale of the IP, and the shareholders will pay personal tax on what is left when the entity dissolves.
If the business is bankrupt, she will have to close the doors and sell the remaining assets to their foreign competitors who can deduct the R&E expenses freely in their foreign jurisdictions.
She is very happy and content for the community at large and thinks that it is an amazing opportunity to fight inflation and rebuild the US economy. This is all good. Unfortunately, it is not working out for her personally, for the investment of time and money, and effort that she has made over the years. What she is doing, somehow, is no longer needed.
Twist
From the example above, we can see that many business owners of high-tech companies may get into a significant pickle. If this was not enough, there is an additional amazing twist. It is not what one can take out of the picture to make it perfect, it is what one can add…
The new law we are discussing here, with the effective date of January 1st, 2022, specifies that it is not to be applied to:
- Any expenditures for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation and of a character that is subject to the allowance for depreciation (Sec. 167) or depletion (611). Those sections cover tangible property, copyrights, books, patents, and extraction industries. It also covers off-the-shelf software, which can be amortized over three years or expensed under other provisions.
- Any expenditure paid or incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other minerals (including oil and gas). Yes, we got it, the extraction industry is not affected by this rule.
Thus, it may not be too terrible. There might be industries where innovative businesses can move in search of reasonable deductions.
Towards the bottom of that law, there is a modest addition:
For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.
This means that ANY development of a software product is automatically treated as R&E and deductions are limited. In the case when foreign developers are used, the deduction is practically non-existent. For every dollar paid to a foreign developer, US taxpayers need to add anywhere from 21 to 50 cents. This means that any software company operating now in the US shall be concerned with its tax bill even if it has generated a net profit.
The law says “any.” Does it mean no deduction even if it is a support service, customization or development on behalf of another entity that is funding the research? This provision can be read very broadly.
There is an apparent unhappiness with the software industry at how they handled the Y2K issue twenty years ago. The realization has finally come to bear, and the lawmakers have decided to act. At this point, the Y2K has long gone and there is no strategic threat to the country’s economy. Even if most of the industry stops coding and starts on the extraction of natural resources, we can definitely live with as much coding as has been done to date for decades to come.
As pointed out at the beginning of this article, there is no IRS guidance on how to apply these rules. A lot needs to be clarified.
There is a sliver of hope in the alarming weather report. The West coast and Florida are warm for the most part. Thus, the mind-numbing frost has not spread everywhere; yet.
