Prior to passage of the TCJA, Section 174 of the Internal Revenue Code gave businesses two options for deducting research and development (R&D) expenses:
- Expensing all qualified R&D expenditures in the same taxable year in which they were incurred; or
- Amortizing, or spreading out, the deduction for such expenditures for up to five years.
Under the TCJA
The TCJA removed the option of expensing R&D costs in the same taxable year and will require companies to amortize their Section 174 deductions over five years or fifteen years for costs incurred outside of the United States. This change to Section 174 will apply to expenses incurred in all years beginning after 2021.
Looking to the Future
In today’s globalized economy, technology is advancing at unprecedented pace. For most businesses, this means dealing with continuous updates to industry standards and customer demands. For manufacturers in particular, this means increased complexity, cost, and risk as features and functionality requirements are in a constant state of change. As a result, R&D investments are more important than ever as companies strive to keep pace with the continuing evolution of markets and competition. In the United States, the ability to deduct R&D expenses in the same year they are incurred is critical to maintaining our nation’s competitive edge.
Suppose a hypothetical U.S. company – Company A – invests about 30 percent of its annual revenues on R&D, with 60 percent of those expenditures taking place in the United States and the remaining 40 percent going in R&D in other countries. In addition, let’s assume Company A funds a substantial portion of the R&D costs of its international R&D centers worldwide.
Under the previous law, Company A could expense all those expenditures in the same taxable year they were incurred. With passage of the TCJA, beginning in 2022, Company A will be required to amortize R&D costs for federal income tax purposes and to write-off these costs over five years in the case of domestic R&D costs, or 15 years in the case of non-U.S. expenditures.
Assuming Company A maintains its 60-40 division of R&D investments, their tax deduction for single year’s R&D costs will be deferred for a period of nine years. Taking a conservative estimate, the deferral of the U.S. tax deduction would increase Company A’s after-tax cost of its R&D by four to five percent and double the company’s current average annual cash payments for taxes. This substantial negative impact on the Company A’s cash flow would significantly impair its ability to invest in R&D at the same levels as today, diminishing their competitiveness over time.