President Joe Biden signed the Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act of 2022 into law in August. The $280 billion funding package is designed to encourage the domestic manufacture of semiconductor products. The new law offers billions of dollars in subsidies, grants and loans to encourage domestic chip manufacturing capability, as well as a new income tax credit to incentivize research and development in advanced computer technology. Although the law includes several benefits, many manufacturers and trade groups were disappointed the package did not repeal the IRC Section 174 R&D expenditure capitalization requirements of the Tax Cuts and Jobs Act of 2017.
The TCJA provisions for Section 174 eliminate companies' ability to deduct R&D expenses in the year they are incurred. That change, which critics say could disincentivize companies from investing in critically needed R&D activities, is effective for tax years beginning in 2022, despite bipartisan support for its repeal.
What the CHIPS and Science Act does and doesn't do
In addition to $52.7 billion in direct subsidies to U.S. semiconductor chip manufacturers, the CHIPS and Science Act also includes an advanced manufacturing tax credit designed to encourage capital investments in new chip-manufacturing facilities. The law allows companies to claim a credit of 25% of qualified investments in certain tangible property used in the manufacture of semiconductors.
To be eligible, property must be used to manufacture semiconductors directly or manufacture equipment that is needed to make semiconductors. The credit is available for projects that are placed into service after Dec. 31, 2022, and for projects on which construction begins before Jan. 1, 2027.
While the National Association of Manufacturers and tech industry trade groups actively supported the CHIPS and Science Act, some critics worried that the credit is structured in a way that might disproportionally benefit large chip manufacturers. Others wanted the law to include stronger language protecting intellectual property and patent rights for technology developed in federally funded R&D projects.
But the most significant criticism relates to the new law's failure to restore same-year expensing for R&D expenditures, a practice that ended for tax years starting after Dec. 31, 2021. Although a provision to temporarily extend R&D expensing was included in early versions of the bill and garnered bipartisan support, it ultimately was removed from the final CHIPS and Science Act language.
How we got here
The ability to claim an immediate deduction for what the Tax Code defines as "research and experimental" (R&E) expenditures has been a consistent feature of U.S. tax policy since 1954. In that year, Congress enacted Section 174, which allowed a deduction of R&E expenditures as a current business expense in the year incurred. Section 174 defines R&E expenditures as costs related to the development or improvement of a product, which typically include direct expenses such as salaries, supplies and materials; operating costs; patent expenses; and the costs of hiring outside contractors or engineering organizations to conduct research.
Section 174 also included an optional election to capitalize and amortize the expenditures over a period of five years, beginning at the time the company first received an economic benefit from the expenditures. Alternatively, businesses could elect to write off R&D costs over 10 years from the time the costs were incurred, without regard to any economic benefit.
Those options all changed with the TCJA. To offset some of the budgetary impact of the reduced tax rates, the TCJA revised Section 174 and eliminated the ability to treat R&E costs as currently deductible. Beginning with the 2022 tax year, costs incurred for research conducted in the U.S. must be capitalized and amortized over a five-year period, beginning at the midpoint of the year in which they are incurred. Costs for research conducted outside the United States must be amortized over 15 years.
Unless Congress intervenes, companies with significant R&D spend — including virtually all companies in the technology and life sciences sectors — could find a significant increase in taxable income on their 2022 returns. In addition to losing the immediate tax deduction, companies will incur an increased administrative burden to comply with the new amortization requirements.
Business groups point out the incongruity of offering new incentives for semiconductor research while eliminating a broader R&D incentive that has benefited the entire manufacturing sector for more than 65 years. They also point to IRC Section 41, which allows companies to claim a direct tax credit — rather than just a deduction — for qualifying R&D expenses and note that the recently passed Inflation Reduction Act actually expands this incentive for many small-business startups. With several sections of the Tax Code encouraging R&D, they question why Section 174 should be revised in a way that discourages it.
Preparing for compliance
When the restoration of same-year expensing was eliminated from the CHIPS and Science Act, proponents were left to hope that Congress would repeal or delay the TCJA changes as part of a year-end tax extenders bill in December. However, for now, businesses must identity a method of tracking expenditures and where research takes place, which are now subject to amortization.
Although many companies might already track R&D costs to claim the Section 41 R&D tax credit, the qualifications for the Section 174 amortization requirement are broader, and regulations and legislative guidance do not exist to clarify or further define requirements. Companies also might want to reconsider the location of some research projects in order to qualify for the shorter amortization period for domestic R&D expenditures, even as they continue to urge Congress to restore same-year expensing as a valuable tool to help U.S. manufacturers maintain a competitive edge.
