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IRS clarifies Section 174 regulations

3 Oct 2013

In September 2013, the IRS issued proposed regulations that were intended to clarify what most US taxpayers already understood to be correct for the past 60 years - that the ultimate use of a product does not alter the nature of the expenditures incurred by the taxpayer to eliminate uncertainty. Taxand USA discovers why the IRS needed to delve deeper into this issue. 

In 1954 Section 174 was enacted to encourage corporations to conduct research activities by providing certainty about the deductibility of their research expenses. In general, unless a taxpayer elects to defer and amortise its research expenses, Section 174 provides that a taxpayer is entitled to deduct, in the year paid or incurred, any research or experimental expenses that are reasonable under the circumstances. Surprisingly, Section 174 did not define what constitutes research or experimental expenditures, and therefore in 1994 the IRS defined this term as including:

  • Research and development cost in the experimental or laboratory sense
  • All costs incident to the development or the improvement of a product, including costs of obtaining a patent
  • Experimental or laboratory sense means activities undertaken to eliminate development or improvement uncertainty
  • Uncertainty can relate to capability, method or design of the product
  • The nature of the product, the improvement or the technological advancement it represents is not important - only the nature of the activities being conducted is important

The new proposed regulations add 2 additional points that most taxpayers and practitioners already understood to be the case: 

  • The ultimate success, failure, use or sale of the product is not relevant to the determination as to whether the expenditures are Section 174 expenses
  • Costs may be eligible under Section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated

Most taxpayers already believe that circumstances encountered after the conduct of research should not retroactively alter the nature of the original deduction itself. However, many IRS Exam teams have routinely proposed various adjustments to alter the nature of the deduction, usually denying that the expenditures under examination were Section 174 expenditures. The reason that Exam teams asserted these proposed adjustments is that a cost must qualify as a deductible Section 174 research expense in order for it to be considered as qualifying for the Section 41 tax credit. The preamble to the proposed regulations frankly states that this clarification was needed in order "to counter an interpretation that section 174 eligibility can be reversed by a subsequent event."

Discover more: IRS clarifies Section 174 regulations

Your Taxand contact for further queries is:
Kathleen King
T. +1 703 852 5013

Also published in Thomson Reuters' Taxnet Pro, 3 October 2013

Taxand's Take

It is refreshing to see that this IRS management team recognises that much of the current taxpayer-IRS research expense controversy often stems from "left-field" interpretations by its rank-and-file Exam teams. Perhaps these proposed regulations are the first of much needed steps necessary to eliminate such confusion and controversy, as opposed to past ineffective actions that usually fueled disagreement and resulted in wasted resources for both the IRS and taxpayers. 

Taxand's Take Author