Tax years beginning after 2022 brought with them an uncomfortable change for many in the video game industry. Section 174 of the Internal Revenue Code, which previously allowed taxpayers to immediately expense their research and development expenses, now required taxpayers to capitalize and amortize those expenditures over a five- or even fifteen-year period.
For many taxpayers, this shift resulted in an unexpected short-term increase in their taxable income because of lower current year deductions.
Put more simply: things that used to be deductible might not be any more – at least not right away.
While the lower deduction will offset over time, taxpayers may want to evaluate some strategies to mitigate the timing difference between paid expenditures on their tax benefits.
What is a Section 174 “specified research or experimental” expenditure?
The Internal Revenue Service defines “specified research or experimental services,” or “SREs” in Treasury Regulations § 1.174-2 as follows:
“expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.”
In other words, Section 174 expenditures relate to costs for activities rooted in what is traditionally described as “hard science” and iterative processes of experimentation. They are not expenses related to creative endeavors, market research, or management activities. The regulations also list additional activities that are not Section 174 expenditures, including quality control, conducting surveys, marketing activities, research into creative works, acquisitions of existing products, or management studies.
However, the newest Section 174 rules also added a new subsection: subsection (c)(3), which requires categorizes “any amount paid or incurred in connection with the development” as an SRE as well, even if that activity does not otherwise meet the “process of experimentation” and other requirements. The IRS then clarified in Notice 2023-63 that it interprets “computer software” liberally, including not only the full range of software purposes and mediums, but also upgrades and enhancements. In short, many of a developer or publisher’s expenditures from ideation to finalizing a video game for sale will be treated as SREs.
These rules get more complex where two parties contract for the development of intellectual property. Where one party, a “research recipient”, contracts for another party, a “research provider,” to develop a product, both parties are incurring expenditures. The research provider is spending money on development, and the research recipient is paying the research provider.
In real world terms, if Party A is paying Party B to develop a new game, whose expenses are SREs?
According to the regulation and subsequent notices, the party who bears the financial risk of the research’s outcome must treat their expenditures as SREs. The other party’s expenses are ordinary business expenses, which are immediately deductible. However, even if the research provider does not bear any financial risk, they may still have SRE expenditures. Where a research provider does not bear financial risk, but their contract with the research recipient grants the research provider rights to commercially exploit the created product, the research provider’s expenditures are still SREs.
In a self-funded game development context, developers will need to make informed decisions about which expenditures might qualify as SREs based on whether they’re building a platform, creating a novel mechanic, or marrying existing technologies with one another. However, where they enter into a “work for hire” agreement with a publisher to fund the game’s development, contractual terms specifying who owns the resulting intellectual property, who bears financial risk, and how each party may be able to exploit the end product may change whose expenditures will actually qualify as SREs. Where a publisher owns the game and all rights to exploit it, without ability to recoup their investment if the game fails to sell well, the publisher will likely face SRE treatment of its investment.
Compliance challenges
To comply with the new capitalization requirements, taxpayers should establish a method for categorizing and tracking development expenditures. That process should ideally include a qualified accountant to compensate for the highly subjective nature of these determinations.
Accurate capitalization will also include separating expenses incurred in the United States, which are subject to a five-year recovery period, from those incurred outside of the United States, which are subject to a fifteen-year recovery period.
Effective compliance should also include monitoring the progression of federal tax legislation. Many tax authorities expected Congress to defer or eliminate this change in the tax law, and discussions continue around a path forward, notwithstanding significant existing challenges to legislating in the current political climate.
Tax planning strategies
To mitigate the short-term negative impact of this change, there are several strategies developers might explore to mitigate the negative impacts of the new Section 174 requirements. Any strategy should be undertaken with the guidance of their finance and accounting teams:
- Minimize SRE expenditures by leveraging existing functional systems and tools or licensing them from third parties, reallocating development time towards “creative” elements of game design.
- Eliminate SRE expenditures by contracting for developed products to be owned and solely exploited by the recipient.
- Tie income recognition to the timing of SRE amortization through scheduled payments, deferred income schemas, or employing accounting methods that tie revenue recognition to expense recognition, such as the “percentage of completion” method set out in Section 460 (which is further discussed in Notice 2023-63, mentioned above).
- Aggressively pursue merger or acquisition opportunities (whether sell-side or buy-side), taking advantage of the future positive tax attributes of coming SRE amortization. Acquiring targets with significant SREs may be attractive for acquirers with future income to absorb.
Additionally, in any year taxpayers recognize significant SRE expenditures, it is likely in their best interest to pursue the Research and Development Tax Credit set out in Section 41. While every SRE expenditure under Section 174 does not qualify as a “qualified research expense” under Section 41, many do, and this credit can be substantial.
Analysis of both Section 41 and 174 is highly contextual, so any of the above strategies may or may not be feasible or helpful for any individual taxpayer, and other strategies exist that may be more helpful. Taxpayers interested in pursuing any of the above strategies, or simply interested in ensuring they are in compliance with the change in law, should discuss their options with a Certified Public Accountant as well as a financial planner or professional tax advisor.
This blog post is for informational purposes only, and should not be construed as professional tax or financial advice. Nothing in this post constitutes a solicitation, recommendation, endorsement, or offer by Odin Law & Media to execute any particular tax strategy, and the reader alone assumes sole responsibility of evaluation the merits and risks associated with the content herein.
