IRS Section 174 - History and its implications to tech companies:

There have been several articles in reputed publications including the Quartz which state that the changes made to the tax code in IRS Section 174 as part of the Tax Cuts & Jobs Act (TCJA) of 2017 and implemented in 2022 are largely responsible for the mass layoffs in the tech industry.

We at the CFO Office took a look at this from a few different angles and came to a different conclusion, which we will explain in the blog below.

Section 174 prior to 2021 allowed technology companies to make a choice between capitalizing their software development costs OR writing them off as expenses in the years incurred. So yes, you had a short menu to choose from. You as a company could either capitalize and amortize the costs OR write them off as an expense in the year that they occurred.

For those companies electing to capitalize and thus amortize research and experimental (R&E) costs, the amortization period was 5 years. For instance, Software Development costs, subject to certain rules could be capitalized and classified as an asset and sit on the balance sheet. The P&L would only report a (1/5 th) portion of that cost each year as part of the amortization.

Net Financial Impact:

-          Higher Capex and higher assets on the balance sheet

-          Lower Reported Expenses on the P&L

-          Higher Reported Pre-Tax Income and Margins

-          Higher Tax liability and expenses

o   Note Section 41 of the IRS Tax code also allows companies to access R&E tax credits subject to certain rules. So the tax liability and tax expenses could be offset to some extent.

If the companies chose to expense their R&E Costs. The net result would be:

-          Lower Capex (Relative to R&E Capitalization)

-          Higher reported Expenses on the P&L

-          Lower Reported Pre-Tax Income and Margins

-          Lower Tax liability and expenses

o   Note even in this case Section 41 of the IRS Tax code also allows companies to access R&E tax credits subject to certain rules. So, the tax liability and expenses could be offset to some extent.

Changes to Section 174:

The 2017 Tax and Jobs act lowered the corporate income tax rate (from 35% down to 21%) but to offset of this lower tax revenue to the government budget, it was provisioned that immediate expensing of R&E costs would cease beginning 2022.

This is not atypical on how government budget deals are made where an immediate 'benefit' is traded in against a future cost. Hence, per the changes made to section 174, the expensing would give way to capitalization of R&E costs. The goal here would be to force companies, especially those heavily into research and development (software or otherwise) to report lower expense and higher taxable income and hence pay higher corporate taxes.

This puts companies, especially tech companies in a bit of a quandary. On one hand their reported operating profit and margins look better to investors. On the flip side they are now on the hook to incur higher taxes. But the 'higher taxes' depends on the benchmarks they are using. Corporate Tax rates fell from 35% to 21% and lowered the tax base for all corporations. That change occurred in 2017. So when you net it all out, the financial impact is minimal at best if you benchmark back to 2017.

Implications:

At first sight this looks like a trigger for companies to take a second look at their R&D budgets and push more efficiency aka layoffs there.

Question is - Did this change in Section 174 trigger mass layoffs?

There are many variables and hence It is very unclear to point that changes made as part of the TCJA to section 174 as the leading cause of mass layoffs in tech. We say this because on one hand changes made to Section 174 does push companies to revisit their software development resources and push for efficiency and hence “cut fat” / “get fit” and improve productivity. But we doubt if it is the major driver for tech layoffs.

Remember the changes to Section 174 went live in 2022. The layoffs started in mid to late 2022 and accelerated in 2023 and 2024. In our view, this is likely when the changes in section 174 started to show their presence on financials coupled with the obvious indigestion of the binge hiring, talent hoarding from the pandemic peak years of 2020 and 2021.

Add to this rising interest rates in the economy, stock market correction of 2022 and the continued growth in remote work and hence more easy access to cheaper overseas labor. All of those have been contributors as well.  What’s more the biggest tech companies have truly shifted from investing in human capital to hardware capital in the form of GPU’s, Data Centers and the like. So, there is that.

Conclusion:

Section 174 is likely one of the many ingredients that caused the mass layoffs in the tech industry starting 2022 but there were other factors that contributed as well. Like we discussed, rising inflation, rising interest rates / elimination of cheap capital, indigestion from the over-hiring binge of 2021, off shoring and diversion of capital to hardware were also important drivers.

As law makers grapple to rescind changes and offer R&E expensing back to companies, we doubt (assuming these changes pass) if it will change the behavior of tech companies and push them to hire more people. Between the push for efficiency, the capex demands for Artificial Intelligence and the advent of Artificial Intelligence applications, hiring will stay muted regardless of changes to the tax law. From a pure numbers standpoint, the 'damage has been done'. We expect tech companies do be tight and keep leaning on efficiency regardless of what new changes (or retroactive mandates) are made to Section 174.