Accounting firms and their clients are growing worried about upcoming changes in the ability to deduct research and development costs and are asking Congress to do something about it.
On Wednesday, a group of officials from RSM US LLP sent a letter to leaders in Congress explaining their concerns, co-signed by a list of leaders from other companies and accounting firms like Mauldin & Jenkins, PBMares, Sax and HMA CPA. KPMG has also been warning recently about the impact on life sciences companies in particular.
The concerns involve a provision of the Tax Cuts and Jobs Act of 2017 that takes effect this year. It will require companies to capitalize and amortize research and experimentation expenditures, instead of continuing to expense them fully in the year in which they were incurred. RSM and the other firms contend creates a disincentive to engage in research and, as such, significantly reduces U.S. competitiveness.
“Despite the many challenges currently facing our nation, with the beginning of a new year comes fresh optimism about prospects for a brighter future,” said RSM. “However, for research-oriented U.S. companies, concerns remain about a new law that took effect on Jan. 1, 2022, eliminating the long-rooted ability to immediately expense research and experimental expenditures, including software development costs. Instead, such costs must be capitalized and amortized over a period of five years or 15 years, depending on where the expense is incurred. It is our belief that this new requirement, as set forth in section 174(a) of the Internal Revenue Code, as amended by the 2017 Tax Cuts and Jobs Act, creates a disincentive to engage in research and, as such, would significantly reduce U.S. competitiveness.”
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The provisions may have an outsize impact on life sciences companies.
“In 2022, the TCJA will require capitalization of R&D costs including software development costs, allowing a deduction over five years if these activities take place in the U.S. and its possessions, or over 15 years for outside-U.S. activities,” said Christine Kachinsky, U.S. life sciences tax industry leader at KPMG. “The impact of these changes to the current expensing of R&D and software development costs to tax planning will be significant and may not be limited to cash tax considerations.”
She noted that many tax calculations are affected by R&D deductions, including foreign tax credit computations as well as international reform under the TCJA targeting the foreign earnings of a multinational, with implications for their effective tax rate, or ETR.
“Finally and perhaps the most troubling for the life sciences industry with many co-development, collaboration and intercompany funding agreements, the limitation on current deductions for R&D costs may often create a mismatch between the timing of revenue recognition for R&D funding from related or unrelated parties and the corresponding deduction for relevant expenses,” said Kachinsky. “Until it becomes clearer that Congress will repeal or delay the TCJA changes to R&D deductions, companies should begin to assess and model the potential impact of these changes from both a cash tax and ETR perspective. Unfortunately, if recent history tells us anything, many tax bills come out the very end of the calendar year as a ‘holiday surprise.’ Further, companies may want to consider the possibility of an increase in the corporate tax rate, which would have a more costly impact on delayed R&D deductions than anticipated.”
The issue goes beyond the life sciences industry. “This issue of the need to capitalize R&D expenses that has come into effect beginning in January of 2022 applies across all industries,” said Kachinsky. “It’s got very broad application. The fact of the matter is, because software development is now included in what would otherwise be termed R&D for purposes of mandatory capitalization, this provision really does extend to basically all industries that you can think of.”
The life sciences industry, including biopharmaceuticals companies, are especially focused on the issue, however. “R&D is one of the single largest expense items on a life science company’s income statement,” said Kachinsky. “If you think about it, for the emerging biopharma and those pre-revenue companies that are just starting out in the discovery stage of research, their only expense may be R&D. Even at the other end of the spectrum, which is very large biopharma that have been well established and have many marketed products, they still continue to develop new therapies and drugs and continue to innovate. Therefore their R&D expenses continue to be very large. If you look at the top 20 biopharma, for example, on average, they spend well in excess of $5 billion a year on R&D, so it’s a huge impact.”
The TCJA of 2017 included a provision that said for calendar years beginning Jan. 1, 2022, taxpayers would need to capitalize and amortize R&D expenses over five years for U.S. expenses and over 15 years for non-U.S. or foreign R&D expenses. The TCJA included the provision as a revenue raiser, but it was expected to be repealed before it actually took effect. The Build Back Better Act, which is currently stalled in the Senate, would have delayed the effective date as the Biden administration tries to secure support from moderate Democrats like Sen. Joe Manchin of Virginia and Kyrsten Sinema of Arizona amid unanimous opposition from Republicans.
“It was everyone’s expectation that provision wouldn’t go into effect because either it would be repealed through another bill, and we actually saw some bills proposed earlier to repeal it or at worst, it would be deferred and they would kind of kick the TCJA can down the road a few years,” said Kachinsky. “Build Back Better included a provision to defer the effective date of R&D mandatory capitalization that was instituted as a result of the TCJA.”
With the Build Back Better Act currently in limbo, the TCJA requirements are now set to take effect, prompting angst in the life sciences and other industries.
“Build Back Better did not pass by December 1, and therefore, the mandatory capitalization provision did come into effect,” said Kachinsky. “The Biden administration’s last commentary around Build Back Better was it might have to be broken up in order to pass. So the prospect of trying to navigate the process to get Build Back Better passed is certainly a challenge. In the meantime, what this means is that the TCJA provision is effective, and until something passes, either through Build Back Better or through some other avenue, companies are going to need to capitalize R&D. This has a billion-plus-dollar cash tax impact to life science companies. If you think about it, they have to start paying quarterly estimated taxes beginning in the first quarter using this provision. So starting with that March 15 payment, companies will have to calculate estimated taxes without these deductions. Therefore, the need to pay this additional cash tax is very significant. Even if this provision is undone later in the year, how many quarters will go by where these companies have to pay in before this gets reversed? There’s some uncertainty there. So there are major cash tax implications from a quarterly estimated tax perspective for the life science industry as well as many other industries.”
Firms are calling on Congress to do something about the new requirements. “Congress may not be able to fully influence macroeconomic concerns around issues such as high inflation and the tightness of the labor market, but it can immediately act to reinstate full expensing of research and experimental expenditures,” said the RSM letter sent to congressional leaders. “Recognizing the well-grounded basis tax policy and intent underlying the treatment accorded these costs under prior law, Congress should make research costs deductible again as soon as possible. As you are no doubt aware through formal commentary and other previous efforts to address this issue, full expensing of research and experimental cost enjoys broad bipartisan support. Those of us now confronting the implications of the current law certainly share this view and strongly support the inclusion of section 174 legislation in any upcoming legislative vehicle to which it can be attached. While there is a cost to reinstating full deductibility, the cost of not doing so would surely be greater.”