Business entities with significant R&D budgets should be prepared for tax law changes effective in 2022.

Although the Tax Cuts and Jobs Act (TCJA) was signed into law in December 2017, several provisions did not take effect for several years. Among them are significant changes around the treatment of research and development (R&D) expenses. Before 2022, businesses were permitted to fully expense the costs of R&D. However, effective Jan. 1, 2022, those expenses may no longer be eligible for an immediate deduction but are to be amortized over five years (for domestic R&D) or even 15 years (for foreign R&D spend)[1]. These amortization requirements increase taxable income and thereby reduce cash flow. The cash flow impact can be significant, especially for Software as a Service (SaaS), technology, life sciences and other companies that conduct a significant amount of R&D. The tax bite will be even bigger for those business entities with significant R&D spend outside the U.S.

Example

ACME Company, our hypothetical client, is a SaaS company providing the leading business enterprise solution in its industry. For simplicity purposes, let’s assume  there are no working capital requirements, no equipment to be purchased or depreciated, and no intangible assets to be amortized. With revenues of $50MM, $5MM in R&D spending, and a 40% EBITDA margin, its net income (using prior tax regulations) is $14.77MM. However, once the TCJA provisions are considered, tax obligations increase and net income declines to $13.73MM, a million dollar impact (see Exhibit 1)

Exhibit 1

New Research and Development Tax Regulations Take a Bite out of Cash Flow

Impact on Value

The income approach, particularly the discounted cash flow (DCF) method, is one of the most commonly used valuation methods in business appraisals. The DCF calculates after-tax cash flows of the business and discounts these cash flows at discount rate based on the cashflow’s riskiness. As shown in the examples, the higher tax obligations under the TCJA R&D tax laws reduce cash flows and, all else equal, reduce value. In our examples in Exhibits 2 and 3, the value differential is $2.5MM on a hypothetical value of approximately $100MM, a 2.5% valuation impact.

Exhibit 2

New Research and Development Tax Regulations Take a Bite out of Cash Flow

Exhibit 3

New Research and Development Tax Regulations Take a Bite out of Cash Flow

Domestic vs. Foreign R&D Spend

The examples above assume that all R&D expenditures are domestic. Many of our SaaS clients use a combination of domestic and foreign resources. Due to the longer amortization horizon (15 years for foreign versus five years for domestic), the cash flow impact is amplified in a scenario where R&D spend is non-domestic.

We’re Here to Help

Business owners and managers should gain a thorough understanding of the cash flow impact of the R&D tax amortization rules in effect since January 1, 2022. If you have questions related to R&D capitalization and its impact on business value, contact your LBMC valuation professional.

Christian Heuer is a Senior Manager with LBMC’s Litigation & Valuation Services team. To learn more, contact him at 615-309-2391 or christian.heuer@lbmc.com.


[1] The 2017 tax reform law, commonly referred to as the Tax Cuts and Jobs Act, eliminated the expensing of R&D costs beginning in 2022 in Section 179(a). House Resolution (HR) 1304, American Innovation and R&D Competitiveness Act of 2021, was introduced in February 2021, to repeal these tax laws; however, the prospects for repeal are uncertain.

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