The ever-changing landscape of tax laws and regulations can often leave business owners scratching their heads, trying to navigate complex amendments and understand their implications. In Philadelphia, a recent development regarding the treatment of amendments to Internal Revenue Code (IRC) Section 174 has prompted this alert.
IRC section 174 pertains to the deduction of research and experimental (R&E) expenses incurred by businesses. Historically IRC section 174 allowed businesses to deduct these expenses as current expenses rather than capitalizing and amortizing them over time. The purpose behind this provision is to encourage innovation and reward businesses for investing in research and development activities.
The federal Tax Cuts and Jobs Act (TCJA) amended IRC Sec. 174 to require that certain R&E expenses paid/incurred in tax years beginning after December 31, 2021, be capitalized and amortized over a period of five years (domestic research), or 15 years (foreign research) for federal income tax purposes.
In response to amendments made to IRC Section 174, Philadelphia has issued guidance to clarify the tax treatment of R&E expenses for businesses operating within the city's jurisdiction. Philadelphia generally conforms to the IRC on a rolling basis for those taxpayers that elected to calculate their Business Income and Receipts Tax (BIRT) on a Method II basis. Method II filers calculate their BIRT based on federal taxable income. The City also adopts federal amendments to the IRC on a rolling basis and incorporates those changes to the IRC into the city's tax code. However, it's important to note that not all federal amendments are automatically adopted, and Philadelphia may issue its own guidelines regarding the specific provisions that impact local businesses.
Based on the guidance issued by Philadelphia as it relates to IRC section 174, R&D expenses incurred by a business should be handled in the following manner:
- BIRT Method II and Net Profits Tax (NPT). For BIRT Method II taxpayers, Philadelphia will conform to the federal income tax treatment of R&E expenses paid/incurred in tax years beginning after December 31, 2021. For ease of tax administration and compliance, Philadelphia will allow BIRT Method II taxpayers to use the new federal capitalization and amortization rules for the Net Profits Tax.
- BIRT Method I and NPT. If a BIRT Method I taxpayer uses an accounting method which allows R&E expenditures to be expensed in the same year they are spent (as opposed to capitalization and amortization), Philadelphia will allow a full deduction of these expenses for BIRT and NPT.
Business owners and professionals operating in Philadelphia should familiarize themselves with these guidelines and consult with tax professionals to ensure compliance. Adhering to the city's tax regulations and maintaining accurate records will help ensure compliance in the City of Philadelphia. If you have any questions or would like to discuss these guidelines in more detail, please contact a member of our State and Local Tax team.