The new R&D statute contains extremely broad language stating that “any and all” software development must be amortized over five years if done in the United States, or over 15 years if done overseas. On the surface, the shift does not appear to be so awful; some believe that it may even produce more IT jobs in the United States.
But that will not be the case. Many countries have higher R&D credits than the United States. Much of the software development in the United States will transfer to countries like the United Kingdom, where the restrictions are simpler and more lucrative. U.S. businesses will only be used for marketing and sales by tax-savvy companies.
Consider a corporation that lost more than a million dollars but owes more than $300,000 in taxes! What makes this possible? This hypothetical corporation earns around $2.5 million in revenue and spends $1.5 million on software development and $1 million on other expenses in 2022, resulting in a negative cashflow of $1 million. However, because the $1.5 million in development was completed by an Indian team, it will only receive $50,000 from the software development side, leaving a $1,050,000 deduction to offset the $2.5 million in income this year — implying that it owes tax on $1,450,000 in net income, or a bankrupting $304,500 in tax!
Proponents of this tax claim that businesses will still profit from the deduction — only over a longer period of time. Put one of these proponents in front of a corporation that lost a million on operations but owes $300,000 in taxes and see what they say. Because of the critical importance of innovation in fuelling national prosperity, these types of R&D costs have been deductible for nearly as long as the United States has been an income tax. With the current environment of high loan rates and greater regulation, this legislation change will kill the most innovative research and development in the United States on forward-thinking technology like AI and blockchain.
Some of the layoffs in Big Tech may be the result of this rule change. It comes as no surprise: It makes more sense to restructure so that R&D is done by subsidiaries outside of the United States. For blockchain, crypto, and nonfungible token (NFT) companies that are already subject to SEC examination, it appears to be a no-brainer to withdraw from the United States.
It’s difficult to apply this law because there are so many complexities and unanswered problems. For example, if you depreciate a computer, server, miner, or other piece of equipment for R&D, the percentage of depreciation you would be allowed to take in 2022 must be added to the capitalization bucket to be amortized out. This means that if you used this utility in the United States and intended to deduct $50,000 in depreciation from that equipment this year, you would only see $5,000 of that influence your bottom line. This effectively defeats the objective of specific depreciation regulations, which incentivize corporations to invest in equipment but subsequently deny them the benefit.
Another significant risk with this rule is raising funds and developing with a large loss and no present income. If your company fails, the cancellation of debt income on a SAFE note that was not redeemed can trigger taxes if there are no net operating loss carryovers to properly offset the cancellation of debt income. And there is currently no method to accelerate R&D amortization; even if a project is cancelled or a company closes, the expense cannot be removed immediately. As a result, equity investors may not receive monies that they are entitled to. Instead, the funds in the Treasury will be used to pay taxes for a bankrupt company, with founders who got compensation potentially liable for the tax liability or repaying investors.
Everyone in government and the tax industry knew these laws were a problem, and they were set to be abolished on January 3 by a bipartisan measure in Congress. However, the initiative failed when Democrats wanted to boost the Child Tax Credit at the last minute, after everything had been agreed upon, and Republicans refused.
Now it appears that we are trapped with this insane, anti-innovation tax law. A repeal proposal has been reintroduced, although it has received little traction. Unless Congress takes swift action, we may see a significant and unnecessary die-off of digital companies, especially in light of the present fundraising issues for blockchain companies caused by higher interest rates, the crypto winter, and the Silicon Valley Bank disaster.
