Category: Deductions & Credits; Accounting Periods
& Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Issue Answer Discussion Section 263 denies an immediate deduction for capital expenditures. In general, if an expenditure creates value extending significantly beyond the tax year in which the expenditure is made, then absent some specific rule to the contrary, the expenditure must be capitalized. Section 174 allows the taxpayer to elect immediate deduction of R&D costs. Absent Section 174, it seems to me research and development--at least successful research and development--would normally create an asset having value extending significantly beyond the tax year of its creation, and therefore the related costs would, in the absence of such a special provision, be capitalized under Section 263. The existence of Section 174 and the classification of computer software as R&D removes problem under the general rule of Section 263. Notwithstanding the fact that computer software development costs create an asset with value extending significantly beyond the tax year in which the expenditure is made, the special provisions of Section 174 in effect "trump" the general capitalization rules. If software development costs are to continue in this favored position with respect to the general capitalization rules of Section 263, the link between software development and R&D must remain firmly established. Absent such a link, the general capitalization rules would clearly prevent an immediate deduction. In addition to the general capitalization rules, the Uniform Cost Capitalization (UNICAP) rules, enacted in 1986, require capitalization of a whole series of otherwise deductible expenses related to the production of various kinds of items held for sale to customers in the ordinary course of business. These rules are set forth at Section 263A. There was great concern that the enactment of the UNICAP rules would somehow upset the existing treatment of software development costs. In theory, the UNICAP rules should not apply to custom software development because such software is generally viewed as an intangible asset. In general, intangible assets are outside the reach of UNICAP: Section 263A(b)(1) provides that the UNICAP rules are applicable only to certain real and tangible personal property. Despite the general focus only on tangible property, however, a special rule brings the following intangible assets within the scope of the UNICAP rules: a film, sound recording, video tape, book, or similar property. [Emphasis added.] It was widely feared the phrase "or similar property" could be used as a means of applying the UNICAP rules to computer software, given the obvious similarities to the intangible items specified in Section 263A(b)(1). In 1993, the IRS allayed these fears. The preamble to Regs. Section 1.263A, T.D. 8482, 58 Fed. Reg. 42198 (August 9, 1993), provides in part as follows. Several commentators inquired whether the enactment of Section 263A has affected the Service's administrative position in Rev. Proc. 69-21, 1969-2 C.B. 303, (see Section 601.601(d)(2)(ii)(b) of the Statement of Procedural Rules), that computer software development costs so closely resemble the kind of research and experimental expenditures that fall within the purview of section 174 as to warrant accounting treatment similar to that accorded such costs under section 174. The Service has no present intention of changing its administrative position contained in Rev. Proc. 69-21, but continues to study its viability. Thus, as long as Rev. Proc. 69-21 remains in effect, taxpayers are not required to capitalize (and may currently deduct) computer software development costs. As of yesterday, Rev. Proc. 69-21 was still effective. Accordingly, it would seem for the time being that the taxpayer need not capitalize the costs associated with developing custom-made computer software for sale to customers in the ordinary course of business. I think a word of caution is in order here. It seems fair to say the treatment of computer software development costs has been turbulent to say the least, not so much directly in the area of the capitalization-versus-immediate-deduction question, but rather in the realm of whether computer software development is eligible to be treated as a research and development expenditure. Numerous sets of R&D regulations have been issued and withdrawn (as a result of howling from the software industry) which regulations would have tightened the definition qualified R&D as regards computer software development. While the literal definition of R&D is not directly relevant, at least in the strictest sense, to the overall issue of capitalization, the IRS policy allowing immediate deduction of computer software development costs has as its theoretical underpinning the premise that such costs are very closely akin to research and development. If the Service, or more precisely Treasury, backs away from this position, then the vitality of Rev. Proc. 69-21 would be in serious doubt and with it the conclusion that computer software development costs are immediately deductible. At the moment, it seems the Rev. Proc. 69-21 is in full force, and there is nothing that prevents classification of computer software development as research and development. It seems important for anyone with a software development client to be watchful of possible changes to the existing rules both in the UNICAP and the R&D areas.
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