Notice 2024-12

Background

Section 174, as amended by the Tax Cuts and Jobs Act of 2017 (TCJA), disallows the immediate deduction of a specialized research and experimentation (SRE) expenditure in the current tax year. Instead, for taxable years beginning after 31 December 2021, taxpayers must capitalize SRE expenditures and amortize the cost over a 5-year period for SRE expenditure attributable to domestic research or a 15-year period for an SRE expenditure attributable to foreign research. Generally, SRE expenditures are costs that represent research or experimental activities in the experimental or laboratory sense and costs paid in connection with the development of computer software. 

H.R. 7024, which passed the House of Representatives but has not been taken up for consideration by the Senate yet, if enacted, would postpone the TCJA's changes to section 174 to taxable years beginning after 31 December 2025 for domestic research. Nevertheless, the content of Notice 2014-12 and Notice 2023-63 will still be important for foreign research and for changes to what the Treasury and the IRS view as research and experimental expenditures. 

Notice 2023-63

On 8 September 2023, the Treasury and the IRS issued Notice 2023-63, which describes forthcoming proposed regulations implementing the changes to section 174 and the treatment of SRE expenditures. To review our in-depth analysis of Notice 2023-63 and more on the history of section 174, see Notice 2023-63 Provides Preview of Eagerly Anticipated Rules on the Treatment of Research & Development Costs. 

Among other topics, Notice 2023-63 addressed the proposed treatment of costs paid or incurred by research services providers that will be included in the forthcoming proposed regulations (a "research provider rule"). 

Research provider rule

Notice 2024-12 purports to "clarify" the "research provider" rule announced in Notice 2023-63.

The research provider rule in Notice 2023-63 can be summarized as stating that expenditures are section 174 expenditures (and, thus, subject to capitalization and amortization) if either of the following conditions is satisfied: 

• The research provider bears financial risk with respect to the failure of the research (the "financial risk prong").
• The research provider has the right to use any resulting SRE product (i.e., legally protected IP) in the trade or business of the research provider or otherwise exploit any resulting SRE product through sale, lease, or license (the "right to use prong"). A research provider does not have the right to use any resulting SRE product if an unrelated party to the research arrangement has the right to approve the research provider's use or exploitation of the resulting SRE product.

Notice 2024-12 refers to the second condition as obtaining an "SRE product right,"¹ and states that Treasury and the IRS are aware that Notice 2023-63 may have been interpreted in a manner that caused taxpayers to "improperly treat" certain research provider expenditures as section 174 expenditures.²

Notice 2024-12 then "clarifies" that certain "excluded SRE product rights" obtained by the research provider do not satisfy the "right to use prong" and will not independently cause the research provider's expenditures to be section 174 expenditures.³ Excluded SRE product rights are: 

• Rights separately bargained for
• Rights acquired for the limited purpose of performing SRE activities under that contract or another contract with the research recipient. 

An SRE product right that is "separately bargained for" is "an SRE product right that arose from consideration other than the cost paid or incurred by the research provider to perform SRE activities under [the contract with the research recipient]."⁴

Observation: This is a welcome development for taxpayers. The clarification provided in Notice 2024-12 is consistent with our original analysis of Notice 2023-63, which noted that many contract research arrangements provide that the research provider will perform additional services for the research recipient (such as manufacturing the products developed for the research recipient) and that expenses attributable to such additional services should not be within the scope of the rules requiring capitalization and amortization.

Additional modifications to Notice 2023-63

Consistency Rule: To "facilitate reliance on the rules described in Notice 2023-63 in a more administrable manner," Treasury and the IRS also do away with its "consistency rule," providing that taxpayers are permitted to rely on one section of Notice 2023-63 without relying on all the others. It remains necessary under Notice 2014-12, however, to consistently apply a single rule (e.g., the research provider rule).⁵

Observation: This is a similarly welcome development, particularly for taxpayers that want to rely on Notice 2023-63 but are unable to rely on all the provisions in the original notice without amending a previously filed return and requesting an accounting method change.

Pre-2022 Software Development Expenditures: Finally, Notice 2014-12 clarifies that certain guidance, which was obsoleted by Notice 2023-63 (regarding the treatment of software development costs), was only obsoleted for expenditures paid or incurred in taxable years beginning after 31 December 2021, and not for expenditures paid or incurred for taxable years beginning on or before 31 December 2021.⁶

Effective date for proposed regulations

There have been some questions about whether the Notice signals an intent to alter the effective date of the forthcoming proposed regulations. While this could end up being the case, Notice 2024-12 confirms the effective date for the proposed regulations as tax years ending after 8 September 2023.⁷

Importantly, taxpayers may rely on the new guidance for expenses paid or incurred in tax years beginning after 21 December 2021.

Rev. Proc. 2024-9

The Treasury and the IRS released Rev. Proc. 2024-9, modifying Rev. Proc. 2023-24 (the annual automatic method change list), to provide taxpayers with procedures to automatically change methods of accounting for expenditures paid or incurred after 31 December 2021, relying on the guidance provided in Notice 2023-63, as modified by Notice 2024-12.

Specific automatic changes authorized under Rev. Proc. 2024-9 include:

• A change from capitalizing SRE expenditures⁸ to inventoriable property or depreciable property and recovering such expenditures through cost of goods sold or depreciation, respectively, to the required section 174 method.
• A change "from treating an expenditure that does not meet the definition of an SRE expenditure as an SRE expenditure subject to capitalization and amortization under section 174(a) or section 3.02 of Notice 2023-63, as applicable, to treating that expenditure under the appropriate provision of the Code."⁹

Notably, there is no audit protection for:

• Expenditures paid or incurred in taxable years beginning on or before 31 December 2021.
• A change in the second taxable year beginning after 31 December 2021, with respect to expenditures paid or incurred in the first taxable year beginning after 31 December 2021, if the taxpayer did not make, or attempt to make, a change for the first taxable year beginning after 31 December 2021.

Pre-2022 Software Development Expenditures: Additionally, Rev. Proc. 2024-9 clarifies that section 5 of Rev. Proc. 2000-50 is obsolete for costs of developing computer software paid or incurred in a tax year beginning after 31 December 2021, but continues to apply to such costs for tax years beginning on or before 31 December 2021.¹⁰

Finally, Rev. Proc. 2024-9 waives the general 5-year restriction against automatic changes for changes pursuant to the notice in recognition that many taxpayers attempted, without guidance, to change methods in the year following the TCJA.

1 Notice 2024-12, § 2.04(2).

2 Notice 2024-12, § 2.04(3).

3 Notice 2024-12, § 2.04(3), (4).

4 Notice 2024-12, § 2.04(3).

5 Notice 2024-12, § 5.

6 Notice 2024-12, § 6.

7 Notice 2024-12, § 4.

8 For these purposes, SRE expenditures are defined in section 174(b) and Notice 2023-63, § 4.02(2), as applicable.

9 Rev. Proc. 2024-9, § 7.02(1)(c)(ii).

10 Rev. Proc. 2024-9, § 3.02, modifying Rev. Proc. 2023-24, § 9.