LB&I directive allows examiners to accept R&D expenses as reported on taxpayer financial statements
R&D expenses on taxpayer financial statements
The IRS Large Business and International (LB&I) division has updated an LB&I directive (2017) concerning the research credit under section 41. The updated directive continues to allow IRS examiners to accept research and development (R&D) expenses as reported on taxpayer financial statements, but with several new restrictions and limitations.
Read the updated LB&I directive LB&I-04-0820-0016 (dated September 10, 2020)
This 2020 LB&I directive revises and clarifies the 2017 LB&I directive, and provides LB&I examiners with guidance regarding examinations of the credit claimed by taxpayers for increasing research activities under section 41.
R&D expenses from financial statement
According to the updated LB&I directive, the IRS independently determining the correct amount of research credit imposes a significant burden on LB&I taxpayers and examiners. This directive is intended to provide an efficient methodology for determining “qualified research expenses” (QREs) for LB&I taxpayers that meet certain requirements and allow for more efficient management of LB&I’s audit resources.
If the IRS determines that a taxpayer has satisfied all the requirements of this revised LB&I directive, then this directive provides an administrative solution for LB&I examiners to accept, as sufficient evidence of QREs, the Adjusted ASC 730, Financial Statement R&D for the Credit Year—comprising the R&D costs currently expensed on a taxpayer’s certified audited financial statements pursuant to ASC 730 for U.S. GAAP purposes (“Financial Statement R&D”), subject to certain specified adjustments made to the Financial Statement R&D.
The LB&I directive only applies for LB&I taxpayers (those with assets equal to or greater than $10 million) that follow U.S. GAAP to prepare their certified audited financial statements showing the amount of currently expensed financial statement R&D either as:
- A separate line item on the income statement included in their certified audited financial statements, or
- Separately stated in a note to their certified audited financial statements
This LB&I directive also does not apply unless the taxpayer uses these same U.S. GAAP financial statements to reconcile book income to federal tax income on Schedule M-3.
The 2017 LB&I directive continues to apply to LB&I taxpayers that chose to calculate their QREs using the requirements of that directive on original returns timely filed (including extensions) on or after September 11, 2017, for tax periods ending prior to July 31, 2020. The revised LB&I directive applies to LB&I taxpayers that choose to calculate their QREs using the requirements of this directive on original returns timely filed (including extensions) for tax periods ending on or after July 31, 2020.
Additional details regarding the new restrictions and limitations are described in the LB&I directive.
Summary of changes
The 2020 LB&I directive modifies the 2017 LB&I directive by:
- Expanding the LB&I Commissioner’s discretion for determining taxpayer eligibility. The 2020 LB&I directive removed “will not challenge QREs” language from the 2017 directive. Instead, the 2020 directive now states:
If the IRS determines that a taxpayer has satisfied all the requirements of this revised Directive, then this Directive provides an administrative solution for LB&I examiners to accept, as sufficient evidence of QREs, the Adjusted ASC 730 Financial Statement R&D for the Credit Year.
- Refining the definition of an eligible taxpayer. The 2020 LB&I directive includes an additional requirement that the taxpayer is not eligible unless it uses these same U.S. GAAP financial statements to reconcile book income to federal tax income on Schedule M-3.
- Removing all GAAP Internal-Use Software (ASC 350) expenditures reported in the Financial Statement R&D amount. The 2020 LB&I directive highlights the IRS’s continued focus on treating internal-use software with scrutiny by stating:
For any software development activities performed and which costs are included in U.S. Financial Statement R&D, remove all software development costs for software that is not for sale, lease, or otherwise marketed by the taxpayer. Software sold to related parties or as part of a cost sharing arrangement for internal use is not software for sale, lease or otherwise marketed.
- Identifying additional documentation requirements. Two key changes include: (1) a written narrative of the methodology and calculations for determining the amounts; and (2) substantiation, either by presentation or in writing, of Internal Control Over Financial Reporting (ICFR) designed to mitigate material misstatement of the taxpayer’s expenses reported per financial statements.
- Clarifying exam audit and elevated review process. For example:
If the exam team determines the requirements of this Directive have not been satisfied, the exam team may request information in addition to the documentation requested in Part V of this Directive. The exam team must receive approval from the Territory Manager or his/her delegate to request additional information not listed in Part V of this Directive.
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