Doing R&D outside the USA?  It may be time to evaluate your geographical footprint…

• May 31, 2023
• Jennifer Clement

By Kyle Dawley

The requirement to capitalize research and experimental (R&E or R&D, used interchangeably) expenses under Internal Revenue Code (IRS) Section 174 was not deferred in a 2022 year-end tax bill, adding confusion and uncertainty to an already ambiguous situation. Despite strong bipartisan support to fix the Section 174 law change, Congress has not addressed this pressing issue so far.

The Tax Cuts and Jobs Act (TCJA) eliminated full expensing of R&E expansion under Internal Revenue Code Section 174 effective January 1, 2022. That means R&E costs must now be capitalized and amortized – 5 years for domestic and 15 years for foreign R&E. 

The purpose of this article is to focus on the implications of international R&D from a US tax perspective. The example below illustrates these effects along with the historic position that foreign activities have never qualified for the R&D tax credit.

Consider the following three scenarios for the same company:

1. 100% of R&E is done offshore.
2. 100% of R&E is USA domestic, with no application of an R&D credit.
3. 100% of R&E is USA domestic, with application of an R&D credit.

This difference from 5 years for domestic to 15 years for foreign R&E was a provision in the TCJA where Congress disincentivized companies who are spending on and profiting from offshore R&E.

Does it make sense to continue offshoring R&E?

This change to Section 174 along with a few other U.S. international tax changes from TCJA have some companies taking a serious look and performing an analysis of the operational savings they may have from offshore R&E with the negative tax effects.

Foreign subsidiaries of U.S. taxpayers

In situations where companies operate in a foreign jurisdiction through a branch or foreign disregarded entity, additional care should be taken to distinguish between foreign and domestic R&E booked to the trial balance.  U.S. companies have never been allowed to take an R&D tax credit for “foreign activities” and so the foreign activities have historically been ignored but that ignorance with the amortization of these foreign expenses is no longer allowed.  Analysis must be done as to why similar trial balances accounts between the U.S. company and its foreign sub(s) are or are not considered Section 174 expenses.  This analysis must focus on the underlying activities and how they differ substantively.    

Devilish details – what is “foreign activity?”

For example, U.S. companies owning at least a ten percent interest in a controlled foreign corporation (“CFC”) as defined under Section 957, a separate analysis under sec. 174 must be conducted with respect to the activities of the foreign corporation. In a nutshell, activities must be treated differently from R&E. 

In cases where the controlled foreign corporation has R&E expenditures, the 15 year amortization requirement may have significant implications in the calculation of the CFC’s tested income, and more specifically, in the determination of whether the effective tax rate of that tested income qualifies for the high-taxed tested income exception election for purposes of calculating the U.S. owner’s global intangible low taxed income (“GILTI”).

Important to note:  Companies who are not accustomed to paying tax on the earnings of a foreign subsidiary may find themselves with taxable income from those operations on their U.S. tax return.  Furthermore, in the common situation where a cost-plus foreign subsidiary is performing research and development for a US parent, special attention must be given to accuracy of transfer pricing, intercompany agreements, and invoicing to confirm the proper entity or entities are capitalizing any R&E. 

FDII and IC-DISC

To lighten the impact of this immediate increased taxable income from the changes to Section 174 there are some export incentives that can be a function of taxable income and resulting in higher current permanent benefit.  The first of which is the Interest Charge Domestic International Sales Corporation (IC-DISC).  This export incentive has been around since the 1970s and is generally seen in closely held S Corporation and Partnership operating companies. The second export incentive is the Foreign Derived Intangible Deduction (FDII) under Section 250 which was enacted to encourage multinational corporations to locate intangible assets in the United States rather than in offshore jurisdictions. Under Section 250, companies can deduct 37.5 percent of qualifying deemed intangible income (DII).  The simple example below illustrates this interplay and assumes all the income is qualifying export income:  

While the tax due now is much higher it important to realize that the deduction is delayed and this can create a permanent deduction that is higher as a result of this new amortization requirement under Section 174.  

Key Takeaways

Under Section 174, millions of dollars of additional topline may result in a higher tax bill. Companies conducting a significant portion of their R&E offshore may be taking a hard look at their geographical footprint going forward, to determine where and when it might make sense to conduct R&E closer to home. 

Time for a cost/benefit study for your company?  Let’s talk.   

Tags: International Tax, Lean automation, R&D Deductions, R&E Expensing, Section 174, Section 174 Delay, M&D General | Comments Off on Doing R&D outside the USA?  It may be time to evaluate your geographical footprint…