ARTICLE | April 24, 2023
Authored by RSM US LLP
An unfavorable change in the required tax treatment of research and development expenditures is affecting mergers and acquisitions by introducing buyers to new potential costs and tax liabilities via their targets.
The issues are particularly relevant in industries and sectors characterized by R&D initiatives and software development—including life sciences, technology and manufacturing.
Regardless of how a transaction is structured, due diligence and tax modeling can help buyers understand the ramifications of this tax law change and avoid costly surprises.
Section 174: New requirements for tax treatment of R&D expenses
New rules under section 174 require taxpayers to capitalize and amortize specified research expenditures instead of immediately deducting them from taxable income. This change was enacted as part of the Tax Cuts and Jobs Act of 2017 and became effective for tax years beginning after Dec. 31, 2021.
The costs attributable to domestic research now must be amortized over five years, while costs attributable to non-U.S. research must be amortized over 15. Significantly, capitalizable costs include software and development expenditures.
At the time TCJA was enacted, many expected—and hoped—that Congress would act to reinstate the immediate expensing of R&D expenditures under prior law before the effective date of the change. However, despite strong bipartisan support, proposed bills to revert to prior law, and multiple attempts to include a measure in broader legislative vehicles enacted into law during the 117th Congress, the capitalization requirement indeed became effective at the beginning of 2022. As a result, taxpayers are having to come to terms with the new rules as they calculate ASC 740 tax provisions, make tax payments and plan for their cash expenditures.
In the context of an M&A transaction, investors and their tax advisors should consider the impact of required capitalization of R&D and software development expenditures. Regardless of whether a deal is structured as the acquisition of stock or taxable assets, buyers should be mindful of key considerations for tax diligence, purchase agreement negotiation and cash tax projections in operating models.
In a transaction structured as the acquisition of stock in a C corporation, a buyer will typically inherit the federal and state income tax liabilities of the target through its ownership of the corporation. In addition, the accounting methods utilized in the calculation of taxable income generally remain in place and do not change without an affirmative election of new accounting methods.
When performing tax due diligence, a buyer and their advisor should seek to understand the following with respect to the tax treatment of R&D expenditures under section 174:
- What activities of the target may give rise to costs requiring capitalization?
- What has the target done to identify, quantify and document capitalizable costs?
- Has the target followed proper procedures around accounting method changes, if applicable?
- How does the capitalization of costs affect the target’s overall tax posture?
- Has the target made the appropriate tax payments after taking into account the new rules?
In many instances, a target corporation may have incurred net operating losses in tax years before 2022, and therefore may not be expecting to pay tax even if the new section 174 requirements cause them to have positive taxable income before applying an NOL. Even when a target has significant NOLs, this position should be scrutinized for reasons including:
- Utilization of NOLs and other tax attributes can be limited by section 382
- Utilization of NOLs incurred in tax years beginning after Dec. 31, 2017, is limited to 80% of taxable income
- State NOLs may differ from federal and may have different rules around utilization
A section 382 analysis is generally necessary to determine whether a corporation has undergone one or more changes in ownership that could limit their utilization of NOLs and other attributes. Such an analysis can be complex from factual and technical perspectives, and calculations are not always intuitive.
Corporations that have consistently incurred losses prior to the new section 174 rules being effective may have not performed the necessary analysis to determine whether NOLs are limited and to substantiate that determination. This creates risk in the event NOLs are needed to offset taxable income in a pre-closing period, or if the buyer is factoring the tax attributes into their valuation.
A buyer and their advisor should consider whether NOLs and other attributes are available to use against the taxable income created by section 174. To the extent pre-closing tax liabilities are anticipated but unpaid, proper provisions should be included in the purchase agreement. Additionally, to the extent the corporation has failed to adopt proper methods for the 2022 tax year, the buyer should consider the effects of correcting the method, including possible recognition of a section 481(a) adjustment in post-closing tax periods.
Finally, there may be opportunities and risks with respect to the section 41 R&D tax credit. If the target has been claiming an R&D tax credit, consider whether the credit was appropriately calculated and whether proper documentation has been maintained. For targets that have not been claiming a credit, or have not been capturing all available credits, opportunities may exist. It is important to note that not all costs required to be capitalized under section 174 are eligible costs for purposes of the R&D tax credit.
In a transaction structured as a taxable asset acquisition, accounting methods generally do not carry over to the buyer. Buyers will be able to elect their own methods, including with respect to section 174.
Intangible assets acquired in an asset acquisition are generally capitalized under section 197 and amortized over 15 years. This is true of internally developed software, irrespective of how the target treats section 174 costs.
In a transaction structured as a taxable asset acquisition for both tax and legal purposes, in most cases a buyer is not expected to inherit historical federal income tax liabilities of the target. However, a buyer may inherit historical income tax liabilities in transactions that are equity acquisitions for legal purposes but deemed asset acquisitions for tax purposes, such as stock purchases with section 338 elections, or acquisitions of disregarded entities.
Many variations on tax structure can exist, and buyers and their advisors should consider how structure informs risks and affects treatment of section 174 costs.
Modeling and projecting under the new section 174 rules
Buyers can avoid surprises and preserve cash flows by being mindful of the tax law changes when preparing operating models and projecting cash taxes. The impact on timing of cash taxes can be significant, and deferral of deductions may cause cash outflows for taxes to be unexpectedly high as a percentage of EBITDA or book net income metrics.
In addition to the change to R&D expensing, recent changes to the section 163(j) rules on interest deductibility and section 168(k) bonus depreciation rules may also increase projected cash taxes.
For tax years beginning after Dec. 31, 2021, allowable interest expense under section 163(j) is equal to 30% of tax basis EBIT. Previously, the calculation was based on 30% of tax basis EBITDA.
And while the TCJA initially permitted 100% expensing for qualified depreciable property placed in service, this bonus percentage will be reduced by 20% each year beginning in 2023, with bonus depreciation fully phased out in 2027.
These unfavorable changes, combined with more expensive borrowing in the current interest rate environment, place an increased emphasis on cash tax modeling for companies and their investors.
It is critical that buyers and their advisors evaluate the impact of new section 174 capitalization rules when purchasing a business that engages in R&D or software development. The new rules could significantly and negatively affect the target’s tax posture, which could subject the buyer to unwelcome tax costs and consequences. Consider historical exposures, purchase agreement negotiations and tax projections as part of updated tax diligence processes.
This article was written by Bill Jachym and originally appeared on Apr 24, 2023.
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