On January 1, a crucial tax change that the stalled Build Back Better Act would have delayed quietly went into effect for calendar year taxpayers. The Build Back Better proposed rule would have delayed the effective date for capitalization and amortization of research and development (R&D) expenditures to tax years beginning after December 31, 2025.

For life sciences companies whose mission depends on discovering new treatments, indications or devices and who spend heavily on R&D, this change has significant tax and financial reporting implications. It particularly affects early-stage companies, who can be hit hard by an unexpected tax liability if they lack the appropriate cash reserves. For more established companies with very large R&D expenses, the cash tax impacts can be a billion-dollar issue. The change comes at a time when investors are keenly focused on investing in new products and services with recent revenue growth due to COVID-19-related innovations.

Taxing R&D

For decades, businesses in the United States have been able to immediately deduct R&D expenses in the year they were incurred. The 2017 Tax Cuts and Jobs Act (TCJA) stipulated that starting in 2022, companies would be required to amortize their R&D costs over five years if the activities are in the U.S. or over 15 years if they take place abroad. The change was intended to raise revenue to offset the decrease in the corporate tax rate implemented by TCJA.

Recognizing this new amortization rule would have major tax and financial reporting implications, Congress responded to the concerns of taxpaying companies by including a provision within BBBA to delay the implementation of the rule until 2025. It’s worth noting that the American Innovation and R&D Competitiveness Act of 2021, if passed, would fully repeal the rule.

Without a legislative change, companies will need to factor TCJA reporting into their estimated tax payments, tax returns, and financial statements beginning in 2022 quarters. Companies reviewing their research costs should keep in mind that the update to the tax code does not only affect companies who currently claim the R&D credit. The code, as updated, covers a broader range of expenditures that includes foreign R&D, certain patents, software development, and other non-R&D tax credit eligible activities. Also, it is based on burdened salary, while the R&D credit is based on W-2 wages. There may be other potential effects to consider, such as the impact on foreign tax credits and other international tax calculations that were enacted within the TCJA.

Financial reporting implications

Assuming mandatory R&D amortization stays in place, companies will need to adjust their income tax provision calculations. After all, the tax benefits of current year expenditures that were once entirely in the current provision are now mostly in the deferred provision. Capitalizing the expenditures rather than expensing them will thus create a deferred tax asset; companies will need to analyze this, along with their other deferred tax assets, to determine if it is likely to be realized.

Analysis of deferred tax assets can be complex. For instance, companies may expect to use the benefit of the amortization in the future, but also happen to generate a separate benefit that they may not be able to use because of timing considerations. Companies that cannot reliably project taxable income sufficient to realize the benefits of the amortization will require a valuation allowance on those deferred tax assets.

Deferral of R&D tax benefits may also affect purchase prices and purchase-price allocations when companies buy in-process research and development. Acquisition of existing tax basis associated with acquired R&D assets in a nontaxable transaction may result in increases in purchase prices and likewise affect deferred taxes identified in the purchase price allocation.

Some companies engaged in joint development, collaboration agreements and/or funding arrangements may face unanticipated consequences. From a tax treatment perspective, a mismatch in timing could arise between revenue recognition for amounts received vs. R&D expenses that might have previously offset such revenues. Such a mismatch could lead to a significant increase in current tax liability, or even a permanent impact.

Ultimately, CFOs and finance leaders would do well to ask themselves: How sensitive are our forecasts of future taxable income? In other words, does the movement to an amortization model jeopardize our ability to realize the benefits of the deferred tax asset?

What this means for software development

Under the new law, software development is treated as specified research. TCJA does not specify what constitutes software development for the purposes of amortization. But software development, including the design, coding, and testing of new or improved software, is generally treated the same way as capitalized R&D costs under these provisions. To the extent that software is utilized as part of a company's R&D activities, it may be necessary to take into account the current-year amortization cost of software within the total R&D expenses.

The change comes as digitization is increasing in the biopharma industry. Many large biopharma companies are investing significant dollars and resources in digital transformation across their organization, not only with respect to enterprise resource planning (ERP), but also in supply chain, clinical operations, and with respect to their field salesforce.

Tax policies can further accelerate growth

For some companies, the impacts of this tax change could extend to both cash tax and the effective tax rate (ETR). For purely domestic companies, the effects may be limited to cash tax, with no effect on the ETR, unless there are changes in a company’s valuation allowance. However, for multinationals, given the number of interdependent, complex international tax calculations impacted by R&D, consideration should be given to potential ETR impacts. The tax change could also impact companies' cash flow projections, which can affect other analyses and may change when a company needs to evaluate additional debt/equity raises. The differing impacts of amortization and current deductibility will likely impact these complex and interdependent calculations.

While the status of BBBA is not yet final, careful modeling of these impacts is advised. In particular, a retroactive deferral does not alleviate the short-term cash tax and reporting challenges, as businesses will be preparing their tax provisions (and likely making their estimated tax payments) based on the requirements in the currently enacted tax law.

Looking ahead

President Biden recently stated it may be necessary to "break up" BBBA; thus the amortization rule delay could still be included in a whittled-down version. Alternatively, Congress may propose an "extenders package," whereby other expiring tax provisions are extended under a procedure separate from a full tax bill.

A coalition of business groups is also urging Congress to extend the R&D deductions. While Congress may act to retroactively defer the mandatory R&D amortization, it is uncertain whether and when this may happen, potentially affecting 2022 reporting.

The cross-over effects of tax policy and accounting and financial reporting are extensive. Close alignment between tax and finance leaders (and Treasury) is a critical and necessary step to plan for possible scenarios ahead of the quarterly tax filing deadlines.