In an innovation-driven economy, Research and Development (R&D) is the lifeblood of organizations wanting to remain competitive. Whether you’re a global technology organization launching numerous software products at the same time or a pharmaceutical company with a range of drugs in development, managing R&D expenses across several product lines or divisions can be tricky and often misunderstood.
With a lot on the line, poorly managing R&D expenditures can result in budget turmoil, lost tax credits, and perhaps regulatory non-compliance. In this blog today, you will get to know how to successfully manage and optimize R&D spending efficiently while ensuring compliance with accounting rules, tax regulations, and your organization’s policies and procedures. You will also explore R&D amortization and R&D capitalization, among other things.
What are R&D Expenses?
These expenses are incurred by an organization in the discovery and development of new products, services, or processes. Typically, it includes:
- Salaries of researchers and developers.
- The cost of equipment for labs and raw materials.
- Software used in R&D activities.
- Prototyping and testing expenses.
- Third-party consulting and licensing fees.
- Overhead allocation for R&D activities.
R&D expense is generally classified as an operating expense; however, the treatment of it varies based on accounting standards or jurisdiction.
R&D Amortization
The TCJA of 2017 mandates that R&D expenses be amortized for tax purposes. Amortization is the process of timing an expense over time.
Amortization Period
Domestic R&D expense is to be amortized over 5 years, while foreign expenses are amortized over 15 years.
Mid-Year Convention
The amortization must start with a mid-year convention; therefore, only ½ of a year’s worth of amortization can be taken in the first year. The rest is then amortized over the balance of the outlined years.
Impact
This change will increase a company’s taxable income in the short term, as the company can no longer deduct the full expense in the year of expense.
R&D Tax Credit Amortization
The R&D tax credit is a distinct monetary benefit from the R&D expense deduction, and it offers a dollar-for-dollar reduction in tax liability for qualified research activities.
Eligibility
The credit is open to companies of all sizes in almost any industry, not just high-tech firms. An activity has to pass a four-part test to qualify, and that test requires that the activity must be a process of experimentation undertaken for technological purposes, aimed at developing or improving a new or improved product, or in order to eliminate uncertainty.
Interaction with Amortization
The R&D tax credit is separate from the new amortization for the R&D expense, so the amortization does not jeopardize the payment of the credit. Companies may continue to claim the tax credit on their qualified R&D expenditures. That will help to alleviate some of the negative financial burdens associated with the amortization requirement. The R&D tax credit is thus more beneficial now that there is increased tax liability.
Strategic Steps to Manage R&D Expense
1. Develop a Centralized R&D Budget System
Even though your company may have decentralized divisions, you cannot effectively manage R&D expenses without a central oversight model. Centralized control provides the following benefits:
- Consistent standards for the relative allocation of R&D budgets
- Centralized tax documentation
- Even simpler compliance R&D capitalization rules
A centralized R&D office can focus on project proposals to prioritize projects based on return potential, strategic alignment, and funding availability.
2. Use Activity-Based Costing (ABC)
Activity-based costing enables companies to allocate R&D expense based on the actual activities or resources consumed by each product line. This offers a more accurate means of tracking than conventional cost allocation.
Example: A robotics company has hardware prototyping costs allocated to Product Line A and AI software modeling costs allocated to Product Line B, according to what resources were consumed for the product line.
3. Consistently Apply R&D Capitalization Rule
Research and Development (R&D) is treated differently under U.S. GAAP and IFRS:
U.S. GAAP: Research costs are expensed immediately, and development costs can be capitalized in certain situations.
IFRS – IAS 38: Research is expensed, but you can capitalize development costs if it is technologically and financially viable.
While this is homogeneous accounting guidance, it can be articulated differently when:
- Executing similar projects in varying markets
- Planning tax and amortization schedules
- Preparing consolidated international statements
You should ensure that you check for the latest R&D capitalization rule applicable to your region so that you stay compliant.
4. Use R&D Expense Tracking Tools
Utilizing an ERP tool (e.g., SAP, Oracle, or NetSuite) or R&D expense tracking tools (e.g., QuickBooks Projects or Jira) allows you to report, tag, and allocate R&D expenses in real time.
Advantages:
- Real-time visibility across divisions
- Ability to drill down to the activity level
- Reporting appropriate for audit status
- Enhanced claims process for tax credits
5. Plan for R&D Amortization
As per the Tax Cuts and Jobs Act (TCJA) of 2017 in the U.S., there are new regulations for companies with domestic R&D expenses whereby they are required to capitalize and amortize domestic R&D expenses starting in 2022 and over 5 years (15 years for foreign R&D costs).
This applies to all firms and is going to have a very significant impact:
- Higher short-term taxable income
- Lower deductions immediately
- Will greatly increase the opportunity for documentation
As such, R&D amortization schedules must now be included in long-term budgets, forecasting, and tax planning.
6. Maximize the Tax Credit amortization
The R&D tax credit is one of the best tax incentives for innovation companies, but the amortization of R&D tax credits will need good documentation and tracking.
Key documentation requirements include:
- Employee time by project
- Details in the general ledgers
- Nexus between expenses and qualifying research activities
Not only can amortizing the credits over that number of years lower your respective tax burden, but it will also allow you to increase or reinvest those funds back into R&D for other projects or initiatives.
7. Create ROI Metrics by Division
Not every R&D job will end up being successful—but you need to evaluate what has been possible and record the performance anyway. Create ROI metrics specific to a division, such as:
- Time to Market
- Revenue growth resulting from R&D ideas
- Cost savings resulting from innovation
- Patents created and the level of IP value
This will allow justification for ongoing investment or shifting strategies across divisions.
Common Mistakes One Should Avoid
- Improperly mixing capital R&D and expensed R&D
- Failing to apply consistent tax and accounting treatment
- Inadequate documentation of employee labour time and material costs
- Neglecting foreign jurisdiction
- Over-inflating short-term R&D project ROI
Best Practices for Global Businesses
- Global R&D Ledger: Keep an overall ledger that tracks conversions to local currency and GAAP/IFRS.
- Cross-Functional Teams: Involve finance, legal, and engineering team members in R&D budget planning.
- Quarterly Reviews: Assess and judge progress, risks, and potential results of each R&D project.
- Tax Professionals: Bring in tax professionals early in your R&D process to enhance credit and amortization advantages.
Conclusion
Controlling and monitoring R&D expenses across multiple product lines and divisions is complicated. Companies must consider budgets, expenses, capitalization, and amortization while balancing innovation with compliance and financial responsibility. With appropriate systems—based on a solid understanding of both R&D amortization and R&D capitalization rules—companies can maximize their innovative capacity while protecting their financial position.
Successfully managing R&D practices not only creates the opportunity for growth in the future, but it also has a large direct financial impact now! Don’t let negligence or poor accounting practices strip the value from your innovation engine. This is the ideal time for implementing all these practices, irrespective of whether you are an enterprise or a fast-growing small business.
FAQs (Frequently Asked Questions)
What is R&D amortization?
Ans: It is the gradual deduction of research and development costs spread over a few years instead of taking the whole deduction in one go. This is in line with the recent changes in the tax code pertaining to IRS Section 174.
What is R&D Tax Credit Amortization?
Ans: Gradually, a company can amortize the research expenses that are eligible and still submit for credits that are applicable at the same time. This helps our business address initial costs while taking advantage of long-term tax credits.
What are R&D capitalization rules?
Ans: It requires that companies not expense research expenses, but rather that the expenses be recorded as capital assets that are amortized over time. The rules affect how essentially all financial reports need to be prepared, as well as whether the company will take a deduction on the expenses with the IRS.
Under the Current Tax Law, How Long Do R&D Expenses Have to Be Amortized?
Ans: Because of the Tax Cuts and Jobs Act (TCJA), most U.S.-based R&D expenses must be amortized over 5 years, and if it was foreign R&D, you have 15 years to amortize, but starting at the midpoint of the year in which the expense is incurred.
Can a Business Still Immediately Expense R&D Expense?
Ans: No, a business could not fully expense R&D expenses starting in 2022. These expenses must follow the IRS’s new mandatory capitalization and amortization rules.
Also Read: What is the main function of a technology transfer office with respect to collaborative research?
