Cost recovery refers to how the tax system permits businesses to recover the cost of investments through depreciation or amortization. Depreciation and amortization deductions affect taxable income, effective tax rates, and investment decisions.
Cost Recovery’s Role in the Tax Base
Business income taxes apply to a measure of net income defined by tax rules, which usually includes revenues minus costs. While most costs are immediately deductible, cost recovery rules for investments typically require a multiyear period for deducting depreciation (tangible investment) and amortization (intangible investment).
Even though cost recovery rules permit businesses to fully deduct the nominal cost they spend on investment over time, because the deductions are not adjusted for inflation or the time-value of money, they lose value over time. As such, any cost recovery system that requires deductions to be spread out over time does not permit businesses to fully deduct investment costs in real terms. The lack of full cost recovery increases the after-tax cost of capital investment, which can discourage businesses from pursuing otherwise profitable investments, leading to lower levels of capital investment, productivity, and wages.
To avoid placing a tax burden on investment with long cost recovery schedules, some countries provide full expensing, or immediate cost recovery, for certain types of investment. For example, the United States often temporarily provides bonus depreciation, which permits a larger first-year deduction than would be provided under the normal cost recovery system.
Depreciation and Amortization in the United States
Depreciation
Depreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income.
In the United States, Section 168 of the tax code details the Modified Accelerated Cost Recovery System (MACRS), which provides cost recovery periods of 3, 5, 7, 10, 20, 27.5, and 39 years depending on the type of property purchased. Since 2001, short-lived assets (recovery period of 20 years or less) have been eligible for different iterations of temporary bonus depreciation, which allows a certain percentage of the capital cost to be deducted in the first year and the remaining percentage to be deducted according to its regular recovery period.
Section 179 provides a full, immediate deduction for certain investment expenses up to a certain amount; the full deduction phases out dollar for dollar as investment exceeds a certain threshold. (Both the allowed amount and the phaseout threshold adjust for inflation each year.)
Amortization
Amortization applies to intangible assets and spreads the cost of the asset over a time period of its “useful life.”
In the United States, Section 197 details amortization periods for recovering intangible investment costs, such as purchasing a trademark. Most recovery periods are 15 years, regardless of the useful life of the asset.
Section 195 provides rules for deducting startup costs for businesses; $5,000 may be immediately deducted, with remaining costs amortized over 15 years.
Section 174 of the tax code details the cost recovery treatment of research and development (R&D). Before the 2017 Tax Cuts and Jobs Act, the US tax code permitted full and immediate deductions for R&D, but beginning in 2022, it switched to 5- or 15-year amortization.
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