Tax alert

Notice 2023-63, Notice 2024-12 and Revenue Procedure 2024-9

Main takeaways

Notice 2023-63 provides additional context and examples related to the applicability of Section 174 treatment to certain cost categories and potential fact patterns.

Notice 2024-12 provides a clarification on Section 174 costs paid by a “research provider” (contractor) to perform research activities on behalf of a “research recipient” (taxpayer) where the research provider does not bear “financial risk” (is being funded by the taxpayer). In such cases, the research provider may not be mandated to capitalize their R&D expenditures.

Notice 2024-12 clarifies that for amounts paid or incurred in tax years beginning after December 31, 2021, Section 5 of Rev. Proc. 2000-50, which addresses the treatment of costs of developing computer software, is removed as obsolete. Section 5 of Rev. Proc. 2000-50 continues to apply to amounts paid or incurred in tax years beginning on or before December 31, 2021.

Revenue Procedure 2024-9 provides an option for taxpayers to treat their percentage-of-completion method costs under Section 460 for long-term contracts as being allocable under Section 174 versus Section 162.

Rev. Proc. 2024-9 creates a new automatic change to allow taxpayers to conform to Section 8 of Notice 2023-63, which concerns the treatment of specified research or experimental (SRE) expenditures under the percentage of completion method. For changes made in Year Two or after, the guidance also allows for a Section 481(a) adjustment, which is somewhat surprising as nearly all other Section 460 accounting method changes are made on a cut-off basis.

In addition to allowing for the automatic change and the Section 481(a) adjustment, the guidance specifies that taxpayers may choose whether the denominator of their completion ratio contains all amortization allocable to the contract (in many cases, the full amount of the SRE expenditure) or only that portion of the allocable amortization that is expected to be deductible during the term of the contract.

Explained in detail

As most companies performing R&D activities are now aware, the Tax Cuts and Jobs Act (TCJA) of 2017 included a tax revenue-generating measure set to take place for tax years beginning on or after January 1, 2022, which requires taxpayers to capitalize their R&D spend over a five-year period for domestic activities, or a fifteen-year period for foreign activities, under Internal Revenue Code Section 174. Prior to the passage of the TCJA, and since 1954, these same costs were otherwise expensed immediately.

This unpopular change to the tax code was never meant to take effect. Lawmakers were given nearly five years to change the rule prior to the effective date but failed to do so. Taxpayers and practitioners are currently anticipating that policymakers will eventually reach an agreement that would prevent the current Section 174 requirements from continuing to be effective for 2023 tax filings and beyond.

One of the primary issues with Section 174 and the required capitalization and amortization treatment is that R&D activities and costs were originally poorly defined, particularly with reference to costs that are considered “incident” to R&D activities. Section 174 was also updated to comprise SRE expenditures, which now includes “the development of any software,” as outlined in Section 174(c)(3). However, the amendment did not provide any specifics regarding the exact types of activities that would constitute software development for the purposes of Section 174.

This lack of clarity caused taxpayers and practitioners to continue reiterating the need for additional guidance to the IRS to better clarify the activities and costs that must be categorized as R&D under Section 174.

The Internal Revenue Service published Notice 2023-63 on September 8, 2023, which provides prospective guidance as to how to navigate the ill-defined rules to properly comply with Section 174 capitalization.


The forthcoming proposed regulations are anticipated to provide rules consistent with those described in Sections Three through Nine of the notice and apply for taxable years ending after September 8, 2023.

While taxpayers are not required to apply the rules in Notice 2023-63, they may apply them for tax years beginning after December 31, 2021, provided they rely on all the rules and apply them consistently. Notice 2024-12 provides more flexibility than the original Notice 2023-63, allowing taxpayers to be selective in applying the rules originally set forth in Notice 2023-63.

Allocation method

According to Notice 2023-63, taxpayers must allocate costs to SRE activities, based on a cause-and-effect relationship between the costs and the SRE activities or another relationship that reasonably relates the costs to the benefits provided to the SRE activities.

For example, if a taxpayer consistently allocates labor costs outlined in Section 4.03(1)(a) of this notice to SRE activities, they would do so by multiplying these labor costs by the ratio of the total time spent by the individual or individuals engaged in performing, supervising or directly supporting SRE activities during the taxable year to the total time spent by the same individual or individuals providing all services for the taxpayer during the taxable year.

The allocation method used for one type of cost may differ from the one used for another type of cost. However, the allocation method used for each type of cost must be applied consistently.

SRE activities defined under Section 174

Notice 2023-6 provided additional clarification on costs and activities that would fall under the definition of SRE for Section 174 purposes, which include the below categories:

  1. Labor costs of full-time, part-time and contract employees and independent contractors who perform, supervise or directly support SRE activities. Labor costs include all elements of compensation, such as basic compensation, stock-based compensation and overtime pay, but do not include severance compensation.
  2. Materials and supplies costs, including tools and equipment that are not depreciable under Section 168, which are used or consumed in the performance of SRE activities or the direct support of SRE activities.
  3. Depreciation, amortization or depletion allowances concerning property used in the performance of SRE activities or in the direct support of SRE activities, including property placed in service in a taxable year that begins on or before December 31, 2021.
  4. Costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application.
  5. Certain operation and management costs, including rent, utilities, insurance, taxes, repairs and maintenance, security, and similar overhead with respect to facilities, equipment and other assets used in the performance of SRE activities or the direct support of SRE activities.
  6. Travel costs involving the performance of SRE activities or the direct support of SRE activities.

Additional costs that are considered SRE include those that were originally defined under Treas. Reg. Section 1.174-2(a), and Software Development activities, further defined in this document.

Non-SRE activities defined under Section 174

Costs that are not treated as SRE under the Notice are provided below, regardless of whether these costs may be incident to SRE activities:

  1. Costs paid or incurred by General and Administrative (G&A) service departments or functions that only indirectly support SRE activities;
  2. Interest on debt to finance SRE activities;
  3. Costs to input content into a website;
  4. Costs for website hosting that involves payment of a periodic fee to an Internet service provider in return for hosting a website on its server connected to the Internet;
  5. Costs to register an Internet domain name or trademark;
  6. Amounts representing amortization of SRE expenditures; and
  7. Amounts representing amortization of research or experimental expenditures paid or incurred before January 1, 2022.

Additional costs that are not considered SRE include those that were originally defined as excluded under Treas. Reg. Section 1.174-2(a)(6).

Software development

Upon passage of the TCJA, the definition of R&D under Section 174 was updated to include all Software Development Activities, originally poorly defined under the existing Section 174 code and treasury regulation.

Notice 2023-63 improved and expanded the definition of Computer Software to mean any sequence of code designed to cause a computer to perform a desired set of functions. Computer Software is also defined to include a computer program, a group of programs, and related upgrades and enhancements to a program or set of programs. Upgrades and Enhancements are defined as changes made to existing computer software that result in additional functionality or materially increase the software’s speed and/or efficiency.

The Notice defines activities that are treated as Software Development to include the below items, all of which involve any upgrades and enhancement related to the Software Development Activity:

  1. Planning the development of computer software;
  2. Designing the computer software;
  3. Building a model of the computer software;
  4. Writing source code and converting it to machine-readable code;
  5. Testing the computer software and making the necessary (but only up until the point where the software is placed in service for use in the taxpayer’s trade or business, or technological feasibility has been established and the software is ready for sale or licensing to others); and
  6. In the case of computer software being developed for sale or licensing to others, production of product masters.

In the case of purchased computer software, performance of any of the activities listed above also constitutes Software Development activities. However, purchasing computer software and, thereafter, installing and configuring pre-coded parameters to re-engineer and make the software compatible with the business are not activities that constitute Software Development for Section 174 purposes.

Other activities that do not constitute Software Development are provided below:

  1. Administering training on the use of computer software;
  2. Maintenance activities to the computer software that does not involve upgrades and enhancements;
  3. Data conversion activities, except for activities to develop computer software that facilitates access to existing data or perform data conversion;
  4. Installing the computer software; and
  5. In the case of computer software developed for sale or licensing to others, any activities that occur after technological feasibility has been established and the software is ready for sale or licensing to others.

Previously, taxpayers could rely on Software Development Activities being so similarly aligned to the definition of Section 174 that the costs associated should be afforded the same treatment. Starting after December 31, 2021, Notice 2024-12 states that Rev. Proc. 200-50 pertaining to the treatment of costs for developing software is obsolete.

Contract research R&D

Notice 2023-63 also clarifies the treatment of costs incurred for research performed under contract, specifically addressing whether such costs qualify as SRE expenditures under Section 174.

If the party performing R&D services (“Research Provider”) on behalf of another party (“Research Recipient”) bears the financial risk under the terms of the contract, then costs paid or incurred by the Research Provider related to R&D activities are considered SRE expenditures under Section 174.

If the Research Provider does not bear the financial risk to the research performed, but does have the right to otherwise use or exploit the resulting R&D product for sale, use or license, then costs incurred by the Research Provider are still considered SRE expenditures under Section 174. However, suppose the Research Provider can only obtain the right to use the research results through express permission from the Research Recipient. In that case, the related R&D costs incurred by the Research Provider are not considered SRE under Section 174.

Notice 2024-12 provides that if a research provider does not bear financial risk under the terms of a contract with the recipient of the research (i.e., the taxpayer funding the research activities of a contractor), and the research recipient (taxpayer) obtains exclusive rights to the product being developed, then the costs incurred by the research provider are not R&D costs that would need to be capitalized.

International implications

The definitions outlined by Notice 2023-63 and found in the above also apply to related parties involving a domestic parent and foreign subsidiary.

For example, if the U.S. parent pays its foreign subsidiary on a cost-plus basis to perform R&D activities on behalf of the U.S. parent, and the foreign subsidiary otherwise does not have rights to the research that would allow it to use or exploit the results of the research for sale, lease or license, then the U.S. parent alone would capitalize and amortize the payments as Section 174 with a 15-year amortization period.

The same expenses would also not need to be capitalized and amortized over 15 years at the foreign subsidiary level, thereby avoiding double capitalization.

However, the Notice provides guidance that if, in the above example, the foreign subsidiary retains any rights (as may be required to qualify for certain foreign R&D incentives), then the foreign subsidiary would be required to capitalize the R&D expenses over 15 years on the foreign subsidiary’s books. Furthermore, since the U.S. parent pays its foreign subsidiary for the R&D activities, the U.S. parent would also be required to capitalize the R&D payments made to the foreign subsidiary. Absent any additional guidance, this could be problematic for many U.S. multinationals engaged in foreign R&D activities.

BPM professionals are here to assist you

The rules and calculations behind Section 174 are complex. BPM has resources to help navigate these rule changes for planning purposes, which includes any required modeling activities, navigation of congressional updates and law changes, and consulting services related to allocating costs between the appropriate Section 174 categories for the accurate treatments regarding immediate expensing or capitalization and amortization. We strongly advise working with an experienced advisor to ensure that your company takes advantage of all possible savings and stays abreast of future changes in tax law. To learn more about the appropriate treatment of your R&D costs, contact BPM.

Andre Shevchuck

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Rono Ghosh

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