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Notice 2023-63: Technical guidance for research expenditure capitalization

2023 year-end tax letter

The IRS recently announced in Notice 2023-63 (the Notice) that it intends to issue proposed regulations containing much anticipated technical guidance for capitalizing and amortizing specified research or experimental (SRE) expenditures under §174, as amended under the Tax Cuts and Jobs Act (TCJA). Amended §174 applies to SRE expenditures paid or incurred in tax years beginning after Dec. 31, 2021. Affected taxpayers should review the Notice and begin assessing the implications to their tax planning and reporting positions for SRE expenditures going forward, particularly given the uncertain prospects for near term legislative relief.

The Notice serves as interim guidance until the IRS issues the proposed regulations, and therefore no action is required at this time. Alternatively, taxpayers may rely on the interim guidance provided in the Notice until the proposed regulations are issued, provided the provisions are applied consistently and in their entirety. The Notice states that until updated procedural guidance is issued, taxpayers should follow existing accounting method change procedures to make method changes to comply with amended §174, and generally may not retroactively make changes via an amended return. However, taxpayers should be aware that the Notice proposals are subject to change and should therefore carefully consider whether early adoption is cost beneficial prior to undertaking implementation efforts.

This discussion summarizes and analyzes several of the key proposals under the Notice.


As noted, the TCJA amended §174 for R&E expenditures paid or incurred in taxable years beginning after Dec. 31, 2021. Under amended §174, SRE expenditures are required to be capitalized and amortized over five years or 15 years, for U.S.- and foreign-performed research, respectively, beginning with the midpoint of the year in which the expenditures are paid or incurred. Additionally, SRE expenditures now include software development costs.

Under prior law, R&E expenditures could be currently deducted or capitalized and amortized over not less than 60 months at the taxpayer’s election.

The TCJA specifies that implementing amended §174 is treated as a change in method of accounting initiated by the taxpayer and made on a cutoff basis without a catch-up adjustment.

In December 2022, the Treasury issued automatic accounting method change procedures to implement amended §174 consistent with the TCJA provisions. These procedures have since been incorporated into the automatic method change list.


Notice 2023-63 provides valuable interim guidance, offering clarification and favorable interpretations on various aspects of TCJA's §174 changes. Some notable highlights include the exclusion of certain indirect G&A expenses, guidance on capitalizable software development costs and clarification on the "risks and rights" test for contract research. However, taxpayers should be aware that the Notice's proposals are subject to change in forthcoming proposed regulations. This may necessitate careful consideration of early adoption and potential impacts on other tax attributes and calculations.


Key provisions and implications of the Notice are summarized below:

Section 3 - Capitalization and Amortization

Foreign research is defined and the method for determining amortization under the “midpoint” convention, referenced above, including for a short taxable year, is clarified. The term foreign research means any research conducted outside the U.S., the Commonwealth of Puerto Rico, or any U.S. territory or possession. Taxpayers must look to where the SRE activities are performed for purposes of determining whether the expenditures are attributable to foreign research. The term midpoint generally refers to the first day of the 7th month of the taxable year in which the SRE expenditures are paid or incurred. The Notice provides helpful explanations to determine the amortization deduction for a short tax year under various scenarios and includes illustrative examples.

Section 4 - SRE Expenditures

Guidance is provided to determine SRE expenditures subject to capitalization under amended §174. In particular, taxpayers will likely appreciate that the new guidance draws primarily from existing definitions and allocation methods under the rules in Sections 174 and 263A, and therefore their current calculations may require minimal modification to comply with this provision. The Notice also provides helpful non-inclusive lists of capitalizable and excludable expenses; see chart below.

The exclusion of indirect G&A service department costs (e.g., payroll, human resources, accounting) is particularly welcome, given the considerable time and effort often required to allocate these costs. The Notice requires that SRE expenditures be allocated on the basis of reasonable “cause and effect” factors and relationships, consistent with the “facts and circumstances” methodology described in the UNICAP regulations, and also contains a comprehensive example to illustrate the allocation methods and principles. However, the Notice unfortunately provides no simplified methods or safe harbors for allocating SRE costs.

Capitalizable expenses  Excludable expenses 
Labor costs. Full-time, part-time, contract employees. Includes basic compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits.  General and administrative costs that indirectly support or benefit SRE activities. Ex. certain payroll, human resources, and accounting departments. 
Materials and supplies. Includes certain nondepreciable tools and equipment.  Interest on debt financing SRE activities. 
Cost recovery allowances. Depreciation, amortization, or depletion on property used in SRE activities.  Costs to input content into a website. 
Patent costs. Including attorney’s fees incurred in making and perfecting a patent application.  Website hosting costs. Ex. Internet hosting fees.
Operation and management costs.  Certain rent, utilities, insurance, taxes, repairs, security and similar overhead costs directly or indirectly used in SRE activities.   Amortization of SRE expenditures and R&E paid or incurred prior to Jan. 1, 2022. 
Travel costs. Used in performance of or in support of SRE activities.  Costs to register an internet domain name. 
Section 5 - Software Development

TCJA requires software development costs to be capitalized as SRE expenditures, raising concerns amongst taxpayers. The Notice addresses this by providing guidance determining which software development costs are capitalizable. Fortunately, the Notice maintains consistency with pre-TCJA definitions and exclusions, clarifying that upgrades and enhancements must be capitalized.

Upgrades and enhancements are defined as modifications to existing computer software, including purchased software, which result in additional functionality or materially increase the speed or efficiency of the software. However, as under prior law, activities related to purchasing, configuring and installing purchased software are not subject to capitalization under §174.

Additionally, the Notice also lists capitalizable and noncapitalizable software development activities, which are largely drawn from existing guidance (see chart below). While the guidance helpfully clarifies the treatment of software development costs, the IRS recognizes that the technologically dynamic and subjective nature of software development initiatives will necessitate the need for supplemental guidance to address issues and situations not covered in the Notice.

Capitalizable activities  Noncapitalizable activities
Planning the development, including identification and documentation of requirements  Software developed for use in the trade or business 
Designing Software developed for sale or licensing to others 
Building a model  
Writing source code and converting it to machine-readable code   
Testing and making necessary modifications   
Production of product master(s)   
Section 6 - Contract Research

The party (research provider or the recipient) that should be treated as conducting the research is another area of uncertainty and controversy. Under the Notice, the treatment of the research recipient is consistent with existing rules under §174.

With respect to the research provider, the Notice proposes that the provider is generally not required to treat its expenditures under the contract as capitalizable research unless it bears the economic risk that it will suffer a financial loss (e.g., under a fixed price arrangement) in the event the research fails to produce the specified results. However, the provider must capitalize its costs as SRE expenditures (rather than deduct them, for instance, as §162 expenses) if it has the right to use or exploit the SRE product without having to obtain approval from an unrelated party, even if it does not bear the financial risk under the terms of the contract, and regardless of the fact that the recipient may also be required to capitalize the same SRE costs.

The Notice also provides an example illustrating the application of the proposed contract research rules. Given the evolving and fact-specific nature of contract research arrangements, additional guidance is expected in the forthcoming regulations, including for related foreign research providers and recipients, special rules for certain contracts (manufacturing, government, PCM), and consideration of additional factors or safe harbors.

Section 7 - Disposition, Retirement or Abandonment of Property

This section outlines rules related to new §174(d), which was added by the TCJA to provide that capitalized SRE expenditures may not be recovered (deducted) upon abandonment, disposition or retirement of the related property. The Notice provisions allow for an amortization deduction even if SRE expenditures relate to property disposed of before the midpoint of the taxable year and provide special rules and examples for certain corporate transactions. While the Notice provides welcome clarification in certain retirement, disposition and abandonment situations, unfortunately many common scenarios are left unaddressed and very limited relief from §174(d) is provided. Hopefully, further modifications will be provided in the forthcoming proposed regulations.

Section 8 - §460 PCM Contracts

The Notice proposes amendments to the §460 long-term contract rules, specifically regarding including SRE expenses in percentage of completion method (PCM) calculations. These changes aim to prevent potential distortion of income and expenses related to long-term contracts. Under the PCM, contract revenue is determined by multiplying the total contract sales price by the ratio of total allocable contract costs incurred to date (including research costs) divided by the estimated total allocable contract costs for the contract. Allocable contract costs (including research costs) are generally deducted against the PCM revenue to determine net income from the long-term contract. The proposed rules clarify that research expenses for purposes of these calculations consist of SRE amortization expense and not the total SRE expenditures paid or incurred (i.e., capitalized) for the year.

Section 9 - §1.482-7 Cost Sharing Arrangement Payments

This section discusses proposed changes to the rules for determining the treatment of cost-sharing transaction (CST) payments between controlled participants in a cost-sharing arrangement. CST payments are made to ensure that each participant’s share of intangible development costs (IDCs) is in proportion to its share of reasonably anticipated benefits (RAB) to be received from exploitation of the developed intangibles. Under current (pre-TCJA) rules, CST payments received reduce the recipient’s deductible IDCs. Any payment in excess of the deductible IDCs is treated as consideration for the use of land or tangible property furnished by the recipient under the cost sharing arrangement. The payor treats CST payments as the cost of developing intangibles at the location where the development is conducted. Pursuant to modifications proposed by the Notice to incorporate the TCJA §174 amendment, the CST payment proportionally reduces the amount of the recipient’s capitalizable and deductible IDC’s; with any payment in excess of the payor’s ratable share of total IDCs treated as income by the recipient. The Notice provides examples to illustrate the application of the modified rule.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Kathleen Meade

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