[Federal Register Volume 60, Number 100 (Wednesday, May 24, 1995)]
[Proposed Rules]
[Pages 27453-27460]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-12621]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[INTL-0023-95]
RIN 1545-AT49
Allocation and Apportionment of Research and Experimental
Expenditures
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document provides guidance concerning the allocation and
apportionment of research and experimental expenditures for purposes of
determining taxable income from sources within and without the United
States. This document affects taxpayers that have income from United
States and foreign sources and that have made expenditures for research
and experimentation that the taxpayer deducts under section 174 of the
Internal Revenue Code of 1986. This document also provides notice of a
public hearing on these proposed regulations.
DATES: Written comments must be received by August 22, 1995. Outlines
of topics to be discussed at the public hearing scheduled for September
8, 1995, at 10 a.m. must be received by August 18, 1995.
ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0023-95), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. In the alternative, submissions may be hand
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R
(INTL-0023-95), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue, NW, Washington, DC 20224. The public hearing will
be held in the Auditorium, Internal Revenue Building, 1111 Constitution
Avenue NW, Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Carl
Cooper [[Page 27454]] at (202) 622-3840; concerning submissions,
Michael Slaughter, (202) 622-8543 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
This notice of proposed rulemaking does not contain collections of
information and, therefore, it has not been submitted to the Office of
Management and Budget for review under the Paperwork Reduction Act (44
U.S.C. 3504(h)).
Background and Explanation of Provisions
Section 1.861-8(e)(3) of the Income Tax Regulations provides rules
regarding the allocation and apportionment of research and experimental
expenditures for purposes of determining taxable income from sources
within and without the United States.
This notice of proposed rulemaking proposes three changes to the
existing regulations at Sec. 1.861-8(e)(3).
First, allocation of research and experimental expenditures to
three digit SIC code product categories of gross income would be
permitted. Existing regulations require taxpayers to allocate research
and experimental expenditures to two digit SIC code product categories.
Use of three digit SIC code product categories would enable taxpayers
to allocate research and experimental expenditures to narrower classes
of gross income than the classes of gross income permitted by the
existing regulations.
Second, the percentage of research and experimental expenditures
that may be exclusively apportioned to United States source income
under the sales method of apportionment under Sec. 1.861-8(e)(3)(ii)
would be increased from 30 percent to 50 percent. Thus, where an
apportionment based upon geographic sources of income of a deduction
for research and experimental expenses is necessary and the sales
method of apportionment is elected, an amount equal to 50 percent of
the deduction for research and experimental expenditures shall be
apportioned exclusively to the statutory or residual grouping of gross
income, as the case may be, arising from the geographic source where
the research and experimental activities which account for more than 50
percent of the amount of the deduction were performed.
Third, use of the optional gross income methods of apportionment
would constitute a binding election to use such methods in subsequent
years. The election would not be revocable without the prior consent of
the Commissioner.
These changes would apply to taxable years beginning after December
31, 1995. However, the taxpayer would have the option to apply the new
rules, in their entirety, to taxable years beginning after December 31,
1994.
Examples (3) through (8) of Sec. 1.861-8(g) are conformed to these
changes. Examples (9) through (16) and Example (23) are removed and
reserved.
The three changes are proposed in part on the basis of an economic
study performed by the Treasury Department pursuant to Rev. Proc. 92-
56, 1992-2 C.B. 409, which is being simultaneously published by
Treasury. The Treasury study evaluates the factual relationships
between taxpayer performed research and experimental expenses and
income from foreign sources. The study reviewed evidence of foreign
returns from research and experimental expenditures in the form of both
royalties and the retained earnings and profits of controlled foreign
corporations. Estimates of foreign returns attributable to research and
experimental expenditures were translated into appropriate allocations
and apportionments using two alternative methodologies. One methodology
was based on estimated comparable domestic returns for research and
experimental expenditures. The other methodology simulated the
relationship expected between the current returns from research and
experimental expenditures and the level of current research and
experimental expenditures for taxpayers with ongoing research programs.
The methodologies generated a range of allocations and apportionments
to foreign income that were not inconsistent with the available
evidence. The allocations and apportionments to foreign income which
would result from adoption of these proposed regulations are within
that range and are about 25 percent lower than the allocations and
apportionments to foreign income which result under the current
regulations.
In addition, the proposed regulations provide explicit rules for
allocating and apportioning research and experimental expenses incurred
by a partnership and for computing a partner's sales for purposes of
apportioning research and experimental expenses under the sales method.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply to these regulations, and therefore, a Regulatory Flexibility
Analysis is not required. Pursuant to section 7805(f) of the Internal
Revenue Code, this notice of proposed rulemaking will be submitted to
the Chief Counsel for Advocacy of the Small Business Administration for
comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for September 8, 1995, at 10
a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution
Avenue NW, Washington, DC. Because of access restrictions, visitors
will not be admitted beyond the building lobby more than 15 minutes
before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by August 22, 1995 and submit an outline of the
topics to be discussed and the time to be devoted to each topic (signed
original and eight (8) copies) by August 18, 1995.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information
The principal author of these regulations is Carl Cooper, Office of
the Associate Chief Counsel (International). However, other personnel
from IRS and Treasury participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
[[Page 27455]]
PART 1--INCOME TAXES
Paragraph 1. The authority citation continues to read as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.861-8 is amended by:
1. Revising paragraph (e)(3).
2. Revising paragraph (g), Examples (3) through (8).
3. Removing and reserving paragraph (g), Examples (9) through (16)
and (23).
The revisions read as follows:
Sec. 1.861-8 Computation of taxable income from sources within the
United States and from other sources and activities.
* * * * *
(e) * * *
* * * * *
(3) Research and experimental expenditures--(i) Allocation--(A) In
general. The methods of allocation and apportionment of research and
experimental expenditures set forth in this paragraph (e)(3) recognize
that research and experimentation is an inherently speculative
activity, that findings may contribute unexpected benefits, and that
the gross income derived from successful research and experimentation
must bear the cost of unsuccessful research and experimentation.
Expenditures for research and experimentation which a taxpayer deducts
under section 174 ordinarily shall be considered deductions which are
definitely related to all income reasonably connected with the relevant
broad product category (or categories) of the taxpayer and therefore
allocable to all items of gross income as a class (including income
from sales, royalties, and dividends) related to such product category
(or categories). For purposes of this allocation, the product category
(or categories) which a taxpayer may be considered to have shall be
determined in accordance with the provisions of paragraph (e)(3)(i)(B)
of this section.
(B) Determination of product categories. Ordinarily, a taxpayer's
research and experimental expenditures may be divided between the
relevant product categories. Where research and experimentation is
conducted with respect to more than one product category, the taxpayer
may aggregate the categories for purposes of allocation and
apportionment; however, the taxpayer may not subdivide the categories.
Where research and experimentation is not clearly identified with any
product category (or categories), it will be considered conducted with
respect to all the taxpayer's product categories. A taxpayer shall
determine the relevant product categories by reference to the three
digit classification of the Standard Industrial Classification Manual
(SIC code). A copy may be purchased from the Superintendent of
Documents, United States Government Printing Office, Washington, DC
20402. The individual products included within each category are
enumerated in Executive Office of the President, Office of Management
and Budget, Standard Industrial Classification Manual, 1987 (or later
edition, as available). Once a taxpayer selects a product category for
the first taxable year for which this paragraph (e)(3) is effective
with respect to the taxpayer, it must continue to use that product
category in following years, unless the taxpayer establishes to the
satisfaction of the Commissioner that, due to changes in the relevant
facts, a change in the product category is appropriate. For this
purpose, a change in the taxpayer's selection of a product category
shall include a change from a three digit SIC code category to a two
digit SIC code category, a change from a two digit SIC code category to
a three digit SIC code category, or any other aggregation,
disaggregation or change of a previously selected SIC code category.
The two digit SIC code category ``Wholesale trade'' is not applicable
with respect to sales by the taxpayer of goods and services from any
other of the taxpayer's product categories and is not applicable with
respect to a domestic international sales corporation (DISC) or foreign
sales corporation (FSC) for which the taxpayer is a related supplier of
goods and services from any of the taxpayer's product categories. The
two digit SIC code category ``Retail trade'' is not applicable with
respect to sales by the taxpayer of goods and services from any other
of the taxpayer's product categories, except Wholesale trade, and is
not applicable with respect to a DISC or FSC for which the taxpayer is
a related supplier of goods and services from any other of the
taxpayer's product categories, except Wholesale trade.
(C) Affiliated Group. (1) Except as provided in paragraph
(e)(3)(i)(C)(2) of this section, the allocation and apportionment
required by this paragraph (e)(3) shall be determined as if all members
of the affiliated group (as defined in Sec. 1.861-14T(d)) were a single
corporation. See Sec. 1.861-14T.
(2) For purposes of the allocation and apportionment required by
this paragraph (e)(3), sales and gross income from products produced in
whole or in part in a possession by an electing corporation (within the
meaning of section 936(h)(5)(E)), and dividends from an electing
corporation, shall not be taken into account, except that this
paragraph (e)(3)(i)(C)(2) shall not apply to sales of (and gross income
and dividends attributable to sales of) products with respect to which
an election under section 936(h)(5)(F) is not in effect.
(3) The research and experimental expenditures taken into account
for purposes of this paragraph (e)(3) shall be reduced by the amount of
such expenditures included in computing the cost-sharing amount
(determined under section 936(h)(5)(C)(i)(I)).
(D) Exception. Where research and experimentation is undertaken
solely to meet legal requirements imposed by a political entity with
respect to improvement or marketing of specific products or processes,
and the results cannot reasonably be expected to generate amounts of
gross income (beyond de minimis amounts) outside a single geographic
source, the deduction for such research and experimentation shall be
considered definitely related and therefore allocable only to the
grouping (or groupings) of gross income within that geographic source
as a class (and apportioned, if necessary, between such groupings as
set forth in paragraphs (e)(3)(ii)(B) and (iii) of this section). For
example, where a taxpayer performs tests on a product in response to a
requirement imposed by the U.S. Food and Drug Administration, and the
test results cannot reasonably be expected to generate amounts of gross
income (beyond de minimis amounts) outside the United States, the costs
of testing shall be allocated solely to gross income from sources
within the United States.
(ii) Apportionment of research and experimentation--sales method--
(A) Exclusive apportionment. Where an apportionment based upon
geographic sources of income of a deduction for research and
experimentation is necessary (after applying the exception in paragraph
(e)(3)(i)(D) of this section), an amount equal to fifty percent (50%)
of such deduction for research and experimentation shall be apportioned
exclusively to the statutory grouping of gross income or the residual
grouping of gross income, as the case may be, arising from the
geographic source where the research and experimental activities which
account for more than fifty percent (50%) of the amount of such
deduction were performed. If the fifty percent test of the preceding
sentence is not met, then no part of the deduction shall be apportioned
under this paragraph (e)(3)(ii)(A). This exclusive apportionment
reflects the view that research and experimentation is often most
valuable in the country where it is performed, for two reasons. First,
[[Page 27456]] research and experimentation often benefits a broad
product category, consisting of many individual products, all of which
may be sold in the nearest market but only some of which may be sold in
foreign markets. Second, research and experimentation often is utilized
in the nearest market before it is used in other markets, and in such
cases, has a lower value per unit of sales when used in foreign
markets. The taxpayer may establish to the satisfaction of the
Commissioner that, in its case, one or both of the conditions mentioned
in the preceding sentences warrant a significantly greater percent than
50 percent (50%) because the research and experimentation is reasonably
expected to have very limited or long delayed application outside the
geographic source where it was performed. For purposes of establishing
that only some products within the product category (or categories) are
sold in foreign markets, the taxpayer shall compare the commercial
production of individual products in domestic and foreign markets made
by itself, by uncontrolled parties (as defined under paragraph
(e)(3)(ii)(C) of this section) of products involving intangible
property which was licensed or sold by the taxpayer, and by those
controlled corporations (as defined under paragraph (e)(3)(ii)(D) of
this section) which can reasonably be expected to benefit directly or
indirectly from any of the taxpayer's research expense connected with
the product category (or categories). The individual products compared
for this purpose shall be limited, for nonmanufactured categories,
solely to those enumerated in Executive Office of the President, Office
of Management and Budget Standard Industrial Classification Manual,
1987 (or later edition, as available), and, for manufactured
categories, solely to those enumerated at a 7-digit level in the U.S.
Bureau of the Census, Census of Manufacturers: 1992, Numerical List of
Manufactured Products, 1993 (or later edition, as available). Copies of
both of these documents may be purchased from the Superintendent of
Documents, United States Government Printing Office, Washington, DC
20402. For purposes of establishing the delayed application of research
findings abroad, the taxpayer shall compare the commercial introduction
of its own particular products and processes (not limited by those
listed in the Standard Industrial Classification Manual or the
Numerical List of Manufactured Products) in the United States and
foreign markets, made by itself, by uncontrolled parties (as defined
under paragraph (e)(3)(ii)(C) of this section) of products involving
intangible property which was licensed or sold by the taxpayer, and by
those controlled corporations (as defined under paragraph (e)(3)(ii)(D)
of this section) which can reasonably be expected to benefit, directly
or indirectly, from the taxpayer's research expense. For purposes of
evaluating the delay in the application of research findings in foreign
markets, the taxpayer shall use a safe haven discount rate of 10
percent per year of delay unless he is able to establish to the
satisfaction of the Commissioner, by reference to the cost of money and
the number of years during which economic benefit can be directly
attributable to the results of the taxpayer's research, that another
discount rate is more appropriate.
(B) Remaining apportionment. The amount equal to the remaining
portion of such deduction for research and experimentation, not
apportioned under paragraph (e)(3)(ii)(A) of this section, shall be
apportioned between the statutory grouping (or among the statutory
groupings) within the class of gross income and the residual grouping
within such class in the same proportions that the amount of sales from
the product category (or categories) which resulted in such gross
income within the statutory grouping (or statutory groupings) and in
the residual grouping bear, respectively, to the total amount of sales
from the product category (or categories). For purposes of this
paragraph (e)(3), amounts received from the lease of equipment during a
taxable year shall be regarded as sales receipts for such taxable year.
Amounts apportioned under this paragraph (e)(3) may exceed the amount
of gross income related to the product category within the statutory
grouping. In such case, the excess shall be applied against other gross
income within the statutory grouping. See paragraph (d)(1) of this
section for instances where the apportionment leads to an excess of
deductions over gross income within the statutory grouping.
(C) Sales of uncontrolled parties. For purposes of the
apportionment under paragraph (e)(3)(ii)(B) of this section, the sales
from the product category (or categories) by each party uncontrolled by
the taxpayer, of particular products involving intangible property
which was licensed or sold by the taxpayer to such uncontrolled party
shall be taken fully into account both for determining the taxpayer's
apportionment and for determining the apportionment of any other member
of a controlled group of corporations to which the taxpayer belongs if
the uncontrolled party can reasonably be expected to benefit directly
or indirectly (through any member of the controlled group of
corporations to which the taxpayer belongs) from the research expense
connected with the product category (or categories) of such other
member. In the case of licensed products, if the amount of sales of
such products is unknown (for example, where the licensed product is a
component of a large machine), a reasonable estimate should be made. In
the case of sales of intangible property, and in cases where a
reasonable estimate of sales of licensed products cannot be made, the
sales taken into account shall be an amount which is ten times the
amount received or accrued for the intangible during the taxpayer's
taxable year. For purposes of this paragraph (e)(3)(ii)(C), the term
uncontrolled party means a party which is not a person with a
relationship to the taxpayer (specified in section 267(b)), or is not a
member of a controlled group of corporations to which the taxpayer
belongs (within the meaning of section 993(a)(3) or section 927(d)(4)).
An uncontrolled party can reasonably be expected to benefit from the
research expense of a member of a controlled group of corporations to
which the taxpayer belongs if such member can reasonably be expected to
license, sell, or transfer intangible property to that uncontrolled
party or transfer secret processes to that uncontrolled party, directly
or indirectly, through a member of the controlled group of corporations
to which the taxpayer belongs.
(D) Sales of controlled parties. For purposes of the apportionment
under paragraph (e)(3)(ii)(B) of this section, the sales from the
product category (or categories) of the taxpayer shall be taken fully
into account and the sales from the product category (or categories) of
a corporation controlled by the taxpayer shall be taken into account to
the extent provided in this paragraph (e)(3)(ii)(D) for determining the
taxpayer's apportionment, if such corporation can reasonably be
expected to benefit directly or indirectly (through another member of
the controlled group of corporations to which the taxpayer belongs)
from the taxpayer's research expense connected with the product
category (or categories). However, sales from the product category (or
categories) between or among such controlled corporations or the
taxpayer shall not be taken into account more than once; in such a
situation, the amount sold by the selling corporation to the buying
corporation shall be subtracted from the sales of the buying
corporation. For [[Page 27457]] purposes of this paragraph
(e)(3)(ii)(D), the term a corporation controlled by the taxpayer means
any corporation other than an uncontrolled party as defined in
paragraph (e)(3)(ii)(C) of this section. A corporation controlled by
the taxpayer can reasonably be expected to benefit from the taxpayer's
research expense if the taxpayer can be expected to license, sell, or
transfer intangible property to that corporation or transfer secret
processes to that corporation, either directly or indirectly through a
member of the controlled group of corporations to which the taxpayer
belongs. Past experience with research and experimentation shall be
considered in determining reasonable expectations. However, if the
corporation controlled by the taxpayer has entered into a bona fide
cost-sharing arrangement, in accordance with the provisions of
Sec. 1.482-7, with the taxpayer for the purpose of developing
intangible property, then that corporation shall not reasonably be
expected to benefit from the taxpayer's share of the research expense.
The sales from the product category (or categories) of a corporation
controlled by the taxpayer taken into account shall be equal to the
amount of sales that bear the same proportion to total sales of the
controlled corporation as the taxpayer's direct or indirect ownership,
as defined in section 1563, of the total combined voting power of all
classes of stock entitled to vote of such corporation bears to the
total outstanding combined voting power of all such classes of stock of
such corporation.
(iii) Apportionment of research and experimentation--gross income
methods. In lieu of apportioning the deduction for research and
experimental expense under paragraph (e)(3)(ii) of this section, a
taxpayer may make a binding election pursuant to paragraph
(e)(3)(iii)(C) of this section to apportion such deduction, as
prescribed in paragraph (e)(3)(iii)(A) or (B) of this section, between
the statutory grouping (or among the statutory groupings) of gross
income and the residual grouping of gross income. These optional
methods must be applied to the taxpayer's entire deduction for research
and experimental expense remaining after applying the exception in
paragraph (e)(3)(i)(D) of this section, and may not be applied on a
product category basis. Thus, after the allocation of the taxpayer's
entire deduction for research and experimental expense under paragraph
(e)(3)(i) of this section (by attribution to SIC code categories), the
taxpayer must then apportion as necessary the entire deduction as
allocated by separate amounts to various product categories, using only
the sales method under paragraph (e)(3)(ii) of this section or only the
optional gross income methods under this paragraph (e)(3)(iii). The
taxpayer may not use the sales method for a portion of the deduction
and optional gross income methods for the remainder of the deduction
separately allocated.
(A) Option one. The taxpayer may apportion its research and
experimental expenditures ratably on the basis of gross income between
the statutory grouping (or among the statutory groupings) of gross
income and the residual grouping of gross income in the same
proportions that the amount of gross income in the statutory grouping
(or groupings) and the amount of gross income in the residual grouping
bear, respectively, to the total amount of gross income, if both of the
following two conditions are met.
(1) The amount of research and experimental expense ratably
apportioned to the statutory grouping (or groupings in the aggregate)
is not less than fifty percent (50%) of the amount which would have
been so apportioned if the taxpayer had used the method described in
paragraph (e)(3)(ii) of this section; and
(2) The amount of research and experimental expense ratably
apportioned to the residual grouping is not less than fifty percent
(50%) of the amount which would have been so apportioned if the
taxpayer had used the method described in paragraph (e)(3)(ii) of this
section.
(B) Option two. If, when the amount of research and experimental
expense is apportioned ratably on the basis of gross income, either of
the conditions described in paragraph (e)(3)(iii)(A) (1) or (2) of this
section is not met, the taxpayer may either--
(1) Where the condition of paragraph (e)(3)(iii)(A)(1) of this
section is not met, apportion fifty percent (50%) of the amount of
research and experimental expense which would have been apportioned to
the statutory grouping (or groupings in the aggregate) under paragraph
(e)(3)(ii) of this section to such statutory grouping (or to such
statutory groupings in the aggregate and then among such groupings on
the basis of gross income within each grouping), and apportion the
balance of the amount of research and experimental expenses to the
residual grouping; or
(2) Where the condition of paragraph (e)(3)(iii)(A)(2) of this
section is not met, apportion fifty percent (50%) of the amount of
research and experimental expense which would have been apportioned to
the residual grouping under paragraph (e)(3)(ii) of this section to
such residual grouping, and apportion the balance of the amount of
research and experimental expenses to the statutory grouping (or to the
statutory groupings in the aggregate and then among such groupings
ratably on the basis of gross income within each grouping).
(C) Binding election to use optional gross income methods. A
taxpayer may use either the sales method under paragraph (e)(3)(ii) of
this section or the optional gross income methods under this paragraph
(e)(3)(iii) for its return filed for its first taxable year to which
this paragraph (e)(3) applies. The taxpayer's use of the optional gross
income methods for its return filed for its first taxable year to which
this paragraph (e)(3) applies or for any subsequent taxable year shall
constitute a binding election to use the optional gross income methods
for all taxable years thereafter. The taxpayer's election to use the
optional gross income methods may not be revoked without the prior
consent of the Commissioner.
(iv) Special rules for partnerships. For purposes of applying this
paragraph (e)(3), if research and experimental expenditures are
incurred by a partnership in which the taxpayer is a partner, the
taxpayer's research and experimental expenditures shall include the
taxpayer's distributive share of the partnership's research and
experimental expenditures. In applying the exception for expenditures
undertaken to meet legal requirements under paragraph (e)(3)(i)(D) of
this section and the exclusive apportionment for the sales method under
paragraph (e)(3)(ii)(A) of this section, a partner's distributive share
of research and experimental expenditures incurred by a partnership
shall be treated as incurred by the partner for the same purpose and in
the same location as incurred by the partnership. In applying the
remaining apportionment for the sales method under paragraph
(e)(3)(ii)(B) of this section, a taxpayer's sales from a product
category shall include the taxpayer's share of any sales from the
product category of any partnership in which the taxpayer is a partner.
For purposes of the preceding sentence, a taxpayer's share of sales
shall be proportionate to the taxpayer's distributive share of the
partnership's gross income in the product category, but the sales of
the partnership taken into account by the taxpayer shall in no event be
less than ten times the amount received or accrued for any intangible
from the partnership during the taxpayer's taxable year.
[[Page 27458]]
(v) Examples. Examples (3) through (8) of paragraph (g) of this
section illustrate the allocation and apportionment of research and
experimental deductions.
(vi) Effective date. This paragraph (e)(3) applies to taxable years
beginning after December 31, 1995. However, the taxpayer may at its
option, apply this paragraph (e)(3) in its entirety to taxable years
beginning after December 31, 1994.
* * * * *
(g) * * *
* * * * *
Example 3--Research and Experimentation--(i) Facts. X, a
domestic corporation, is a manufacturer and distributor of small
gasoline engines for lawn mowers. Gasoline engines are a product
within the category, Engines and Turbines (SIC Industry Group 351).
Y, a wholly owned foreign subsidiary of X, also manufactures and
sells these engines abroad. During 1996, X incurred expenditures of
$60,000 on research and experimentation, which it deducts as a
current expense, to invent and patent a new and improved gasoline
engine. All of the research and experimentation was performed in the
United States. In 1996, the domestic sales by X of the new engine
total $500,000 and foreign sales by Y total $300,000. X provides
technology for the manufacture of engines to Y via a license that
requires the payment of an arm's length royalty. In 1996, X's income
is $150,000, of which $140,000 is from domestic sales and $10,000 is
royalties from Y.
(ii) Allocation. The research and experimental expenditures were
incurred in connection with small gasoline engines and they are
definitely related to the items of gross income to which the
research gives rise, namely gross income from the sale of small
gasoline engines in the United States and royalties received from
subsidiary Y, a foreign manufacturer of gasoline engines.
Accordingly, the expenses are allocable to this class of gross
income.
(iii) Apportionment. (A) For purposes of applying the foreign
tax credit limitation, the statutory grouping is general limitation
gross income from sources without the United States and the residual
grouping is general limitation gross income from sources within the
United States. Since the related class of gross income derived from
the use of engine technology consists of both gross income from
sources without the United States (royalties from Y) and gross
income from sources within the United States (gross income from
engine sales), X's deduction of $60,000 for its research and
experimental expenditure must be apportioned between the statutory
and residual grouping before the foreign tax credit limitation may
be determined. Because more than 50 percent of X's research and
experimental activity was performed in the United States, 50 percent
of that deduction can be apportioned exclusively to the residual
grouping of gross income, gross income from sources within the
United States. The remaining 50 percent of the deduction can then be
apportioned between the residual and statutory groupings on the
basis of sales by X and Y. Alternatively, X's deduction for research
and experimentation can be apportioned under the optional gross
income method. The apportionment for 1996 is as follows:
(1) Tentative Apportionment on the Basis of Sales.
(i) Research and experimental expense to be apportioned between
residual and statutory groupings of gross income: $60,000.
(ii) Less: Exclusive apportionment of research and experimental
expense to the residual grouping of gross income ($60,000 x 50
percent): $30,000.
(iii) Research and experimental expense to be apportioned
between residual and statutory groupings of gross income on the
basis of sales: $30,000.
(iv) Apportionment of research and experimental expense to the
residual grouping of gross income ($30,000 x $500,000/
($500,000+$300,000)): $18,750.
(v) Apportionment of research and experimental expense to the
statutory grouping of gross income ($30,000 x $300,000/
($500,000+$300,000)): $11,250.
(vi) Total apportioned deduction for research and
experimentation: $60,000.
(vii) Amount apportioned to the residual grouping
($30,000+$18,750): $48,750.
(viii) Amount apportioned to the statutory grouping: $11,250.
(2) Tentative Apportionment on the Basis of Gross Income.
(i) Research and experimental expense apportioned to sources
within the United States (residual grouping) ($60,000 x $140,000/
($140,000+$10,000)): $56,000.
(ii) Research and experimental expense apportioned to sources
within country Y (statutory grouping) ($60,000 x $10,000/
($140,000+$10,000)): $4,000.
(iii) Amount apportioned to the residual grouping: $56,000.
(iv) Amount apportioned to the statutory grouping: $4,000.
(B) The total research and experimental expense apportioned to
the statutory grouping ($4,000) under the gross income method is
approximately 36 percent of the amount apportioned to the statutory
grouping under the sales method. Thus, X may use option two of the
gross income method (paragraph (e)(3)(iii)(B) of this section) and
apportion to the statutory grouping fifty percent (50%) of the
$11,250 apportioned to that grouping under the sales method. Thus, X
apportions $5,625 of research and experimental expense to the
statutory grouping. X's use of the optional gross income method will
constitute a binding election to use the optional gross income
method for all taxable years thereafter.
Example 4--Research and Experimentation--(i) Facts. Assume the
same facts as in Example 3 except that X also spends $30,000 in 1996
for research on steam turbines, all of which is performed in the
United States, and X has steam turbine sales in the United States of
$400,000. X's foreign subsidiary Y neither manufactures nor sells
steam turbines. The steam turbine research is in addition to the
$60,000 in research which X does on gasoline engines for lawnmowers.
X thus has a deduction of $90,000 for its research activity. X's
gross income is $200,000, of which $140,000 is from sales of
gasoline engines, $50,000 is from sales of steam turbines, and
$10,000 is royalties from Y.
(ii) Allocation. X's research expenses generate income from
sales of small gasoline engines and steam turbines. Both of these
products are in the same three digit SIC code category, Engines and
Turbines (SIC Industry Group 351). Therefore, the deduction is
definitely related to this product category and allocable to all
items of income attributable to it. These items of X's income are
gross income from the sale of small gasoline engines and steam
turbines in the United States and royalties from foreign subsidiary
Y, a foreign manufacturer and seller of small gasoline engines.
(iii) Apportionment. (A) For purposes of applying the foreign
tax credit limitation, the statutory grouping is general limitation
gross income from sources outside the United States and the residual
grouping is general limitation gross income from sources within the
United States. X's deduction of $90,000 must be apportioned between
the statutory and residual groupings. Because more than 50 percent
of X's research and experimental activity was performed in the
United States, 50 percent of that deduction can be apportioned
exclusively to the residual grouping, general limitation gross
income from sources within the United States. The remaining 50
percent of the deduction can then be apportioned between the
residual and statutory groupings on the basis of total sales by X
and Y. Alternatively, X's deduction for research and experimentation
can be apportioned under the optional gross income methods. The
apportionment for 1996 is as follows:
(1) Tentative Apportionment on the Basis of Sales.
(i) Research and experimental expense to be apportioned between
residual and statutory groupings of gross income: $90,000.
(ii) Less: Exclusive apportionment of the research and
experimental expense to the residual grouping of gross income
($90,000 x 50 percent): $45,000.
(iv) Research and experimental expense to be apportioned between
the residual and statutory groupings of gross income on the basis of
sales: $45,000.
(iv) Apportionment of research and experimental expense to the
residual grouping of gross income ($45,000 x ($500,000+400,000)/
($500,000+$400,000+$300,000)): $33,750.
(v) Apportionment of research and experimental expense to the
statutory grouping of gross income ($45,000 x $300,000/
($500,000+$400,000+$300,000)): $11,250.
(vi) Total apportioned deduction for research and
experimentation: $90,000.
(vii) Amount apportioned to the residual grouping
($45,000+$33,750): $78,750.
(viii) Amount apportioned to the statutory grouping: $11,250.
(2) Tentative Apportionment on the Basis of Gross Income.
(i) Research and experimental expense apportioned to sources
within the United States (residual grouping)
[[Page 27459]] ($90,000 x $190,000/($140,000+$50,000+10,000)):
$85,500.
(ii) Research and experimental expense apportioned to sources
within country Y (statutory grouping) ($90,000 x $10,000/
($140,000+$50,000+$10,000)): $4,500.
(iii) Amount apportioned to the residual grouping: $85,500.
(iv) Amount apportioned to the statutory grouping: $4,500.
(B) The total research and experimental expense apportioned to
the statutory grouping ($4,500) under the gross income method is 40
percent of the amount apportioned to the statutory grouping under
the sales method. Thus, X, may use option two of the gross income
method (paragraph (e)(3)(iii)(B) of this section) and apportion to
the statutory grouping fifty percent (50%) of the $11,250
apportioned to that grouping under the sales method. Thus, X
apportions $5,625 of research and experimental expense to the
statutory grouping. X's use of the optional gross income method will
constitute a binding election to use the optional gross income
method for all taxable years thereafter.
Example 5--Research and Experimentation--(i) Facts. Assume the
same facts as in Example 3 except that in 1997 X continues its sales
of the new engines, with sales of $600,000 in the United States and
$400,000 by subsidiary Y. X also acquires a 60 percent ownership
interest in foreign corporation Z and a 100 percent ownership
interest in foreign corporation C. X transfers its engine technology
to Z for a royalty equal to 5 percent of sales, and X enters into an
arm's length cost-sharing arrangement with C to share the funding of
all of X's research activity. In 1997, corporation Z has sales in
country Z equal to $1,000,000. X incurs expense of $80,000 on
research and experimentation in 1997, and in addition, X performs
$15,000 of research on gasoline engines which was funded by the
cost-sharing arrangement with C. All of Z's sales are from the
product category, Engines and Turbines (SIC Industry Group 351). X
performs all of its research in the United States and $20,000 of its
expenditure of $80,000 is made solely to meet pollution standards
mandated by law. X establishes, to the satisfaction of the
Commissioner, that the expenditure in response to pollution
standards is not expected to generate gross income (beyond de
minimis amounts) outside the United States.
(ii) Allocation. The $20,000 of research expense which X
incurred in connection with pollution standards is definitely
related and thus allocable to the residual grouping, general
limitation gross income from sources within the United States. The
remaining $60,000 in research and experimental expenditure incurred
by X is definitely related to all gasoline engines and is therefore
allocable to the class of gross income to which the engines give
rise, gross income from sales in the United States, royalties from
country Y, and royalties from country Z. No part of the $60,000
research expense is allocable to dividends from country C, because
corporation C has already paid, through its cost-sharing
arrangement, for research activity performed by X which may benefit
C.
(iii) Apportionment. For purposes of applying the foreign tax
credit limitation, the statutory grouping is general limitation
gross income from sources without the United States, and the
residual grouping is general limitation gross income from sources
within the United States. X's deduction of $60,000 for its research
and experimental expenditure must be apportioned between these
groupings. Because more than 50 percent of the research and
experimentation was performed in the United States, 50 percent of
the $60,000 deduction can be apportioned exclusively to the residual
grouping. The remaining 50 percent of the deduction can then be
apportioned between the residual and the statutory grouping on the
basis of sales by X, Y, and Z. (If X utilized the optional gross
income methods in 1996, then its use of such methods constituted a
binding election to use the optional gross income methods for all
taxable years thereafter. The optional gross income methods are not
illustrated in this Example 5 (see instead Examples 3 and 4).) Since
X has only a 60 percent ownership interest in corporation Z, only 60
percent of Z's sales (60% of $1,000,000, or $600,000) are included
for purposes of apportionment. The allocation and apportionment for
1997 is as follows:
(A) X's total research expense: $80,000.
(B) Less: Legally mandated research directly allocated to the
residual grouping of gross income: $20,000.
(C) Tentative apportionment on the basis of sales.
(1) Research and experimental expense to be apportioned between
residual and statutory groupings of gross income: $60,000.
(2) Less: Exclusive apportionment of research and experimental
expense to the residual grouping of gross income ($60,000 x 50
percent): $30,000.
(3) Research and experimental expense to be apportioned between
the residual and the statutory grouping on the basis of sales:
$30,000.
(4) Apportionment of research and experimental expense to
general limitation gross income from sources within the United
States (residual grouping) ($30,000 x $600,000/
($600,000+$400,000+$600,000)): $11,250.
(5) Apportionment of research and experimental expense to
general limitation gross income from countries Y and Z (statutory
grouping) ($30,000 x $400,000+$600,000/
($600,000+$400,000+$600,000)): $18,750.
(6) Total apportioned deduction for research and experimentation
($30,000+$30,000): 60,000.
(7) Amount apportioned to the residual grouping
($30,000+$11,250): $41,250.
(8) Amount apportioned to the statutory grouping of sources
within countries Y and Z: $18,750.
Example 6--Research and Experimentation--(i) Facts. X, a
domestic corporation, manufacturers and sells forklift trucks and
other types of materials handling equipment in the United States.
The manufacture and sale of forklift trucks and other materials
handling equipment belongs to the product category, Construction,
Mining, and Materials Handling Machinery and Equipment (SIC Industry
Group 353). X also sells its forklift trucks to a wholesaling
subsidiary located in foreign country Y (but title passes in the
United States), and X manufactures forklift trucks in foreign
country Z. The wholesaling of forklift trucks to country Y also
belongs to X's product category Transportation equipment and,
therefore, may not belong to the product category, Wholesale trade
(SIC Major Group 50 and 51). In 1997, X sold $7,000,000 of forklift
trucks to purchasers in the United States, $3,000,000 of forklift
trucks to the wholesaling subsidiary in Y, and transferred forklift
truck components with an FOB export value of $2,000,000 to its
branch in Z. The branch's sales of finished forklift trucks were
$5,000,000. In response to legally mndated emission control
requirements, X's United States research department has been engaged
in a research project to improve the performance and quality of
engine exhaust systems used on its products in the United States. It
incurs expenses of $100,000 for this purpose in 1997. In the past, X
has customarily adapted the product improvements developed
originally for the domestic market to its forklift trucks
manufactured abroad. During the taxable year 1997, development of an
improved engine exhaust system is completed and X begins installing
the new system during the latter part of the taxable year in
products manufactured and sold in the United States. X continues to
manufacture and sell forklift trucks in foreign countries without
the improved engine exhaust systems.
(ii) Allocation. X's deduction for its research expense is
definitely related to the income to which it gives rise, namely
income from the manufacture and sale of forklift trucks within the
United States and in country Z. Although the research is undertaken
in response to a legal mandate, it can reasonably be expected to
generate gross income from the manufacture and sale of trucks by the
branch in Z. Therefore, the deduction is not allocable solely to
income from X's domestic sales of forklift trucks. It is allocable
to income from such sales and income from the sales of X's branch in
Z.
(iii) Apportionment. For the method of apportionment on the
basis of either sales or gross income, see example 3. However, in
determining the amount of research apportioned to income from
foreign and domestic sources, the net sales of the branch in Z are
$3,000,000 ($5,000,000 less $2,000,000) and the sales within the
United States are $12,000,000 ($7,000,000 plus $3,000,000 plus
$2,000,000).
Example 7--Research and Experimentation--(i) Facts. X, a
domestic corporation, is a drug company which manufactures a wide
variety of pharmaceutical products for sale in the United States.
Pharmaceutical products belong to the product category, Drugs (SIC
Industry Group 283). X exports its pharmaceutical products through a
foreign sales corporation (FSC). X's wholly owned foreign subsidiary
Y also manufactures pharmaceutical products. In 1997, X has domestic
sales of $10,000,000, the FSC has sales of $3,000,000, and Y has
sales of $5,000,000. In that same year, 1997, X incurs
[[Page 27460]] expense of $200,000 on research to test a product in
response to requirements imposed by the United States Food and Drug
Administration (FDA). X is able to show that, even though country Y
imposes certain testing requirements on pharmaceutical products, the
research performed in the United States is not accepted by country Y
for purposes of its own licensing requirements, and the research has
minimal use abroad. X is further able to show that its FSC sells
goods to countries which do not accept or do not require research
performed in the United States for purposes of their own licensing
standards.
(ii) Allocation. Since X's research expense of $200,000 is
undertaken to meet the requirements of the United States Food and
Drug Administration, and since it is reasonable to expect that the
expenditure will not generate gross income (beyond de minimis
amounts) outside the United States, the deduction is definitely
related and thus allocable to the residual grouping.
(iii) Apportionment. No apportionment is necessary since the
entire expense is allocated to the residual grouping, general
limitation gross income from sales within the United States.
Example 8--Research and Experimentation--(i) Facts. X, a
domestic corporation, is engaged in continuous research and
experimentation to improve the quality of the products that it
manufactures and sells, which are floodlights, flashlights, fuse
boxes, and solderless connectors. X incurs and deducts $100,000 of
expenditure for research and experimentation in 1997 which was
performed exclusively in the United States. As a result of this
research activity, X acquires patents which it uses in its own
manufacturing activity. X licenses its floodlight patent to Y and Z,
uncontrolled foreign corporations, for use in their own territories,
countries Y and Z, respectively. Corporation Y pays X an arm's
length royalty of $3,000 plus $0.20 for each floodlight sold. Sales
of floodlights by Y for the taxable year are $135,000 (at $4.50 per
unit) or 30,000 units, and the royalty is $9,000
($3,000+$0.20 x 30,000). Y has sales of other products of $500,000.
Z pays X an arm's length royalty of $3,000 plus $0.30 for each unit
sold. Z manufactures 30,000 floodlights in the taxable year, and the
royalty is $12,000 ($3,000+$0.30 x 30,000). The dollar value of Z's
floodlight sales is not known and cannot be reasonably estimated
because, in this case, the floodlights are not sold separately by Z
but are instead used as a component in Z's manufacture of lighting
equipment for theaters. The sales of all Z's products, including the
lighting equipment for theaters, are $1,000,000. Y and Z each sell
the floodlights exclusively within their respective countries. X's
sales of floodlights for the taxable year are $500,000 and its sales
of its other products, flashlights, fuse boxes, and solderless
connectors, are $400,000. X has gross income of $500,000, consisting
of gross income from domestic sources of $479,000, and royalty
income of $9,000 and $12,000 from foreign corporations Y and Z
respectively.
(ii) Allocation. X's research and experimental expenses are
definitely related to all of the products that it produces, which
are floodlights, flashlights, fuse boxes, and solderless connectors.
All of these products are in the same three digit SIC Code category,
Electric Lighting and Wiring Equipment (SIC Industry Group 364).
Thus, X's research and experimental expenses are allocable to all
items of income attributable to this product category, domestic
sales income and royalty income from the foreign countries in which
corporations Y and Z operate.
(iii) Apportionment. (A) The statutory grouping of gross income
is general limitation income from sources without the United States.
The residual grouping is general limitation gross income from
sources within the United States. X's deduction of $100,000 for its
research expenditures must be apportioned between the groupings. For
apportionment on the basis of sales in accordance with paragraph
(e)(3)(ii) of this section, X is entitled to an exclusive
apportionment of 50 percent of its research and experimental expense
to the residual grouping, general limitation gross income from
sources within the United States, since more than 50 percent of the
research activity was performed in the United States. The remaining
50 percent of the deduction can then be apportioned between the
residual and statutory groupings on the basis of sales. Since Y and
Z are unrelated licensees of X, only their sales of the licensed
product, floodlights, are included for purposes of apportionment.
Floodlight sales of Z are unknown, but are estimated at ten times
royalties from Z, or $120,000. All of X's sales from the entire
product category are included for purposes of apportionment on the
basis of sales. Alternatively, X may apportion its deduction on the
basis of gross income, in accordance with paragraph (e)(3)(iii) of
this section. The apportionment is as follows:
(1) Tentative Apportionment on the basis of sales.
(i) Research and experimental expense to be apportioned between
statutory and residual groupings of gross income: $100,000.
(ii) Less: Exclusive apportionment of research and experimental
expense to the residual groupings of gross income ($100,000 x 50
percent): $50,000.
(iii) Research and experimental expense to be apportioned
between the statutory and residual groupings of gross income on the
basis of sales: $50,000.
(iv) Apportionment of research and experimental expense to the
residual groupings of gross income ($50,000 x $900,000/
($900,000+$135,000+$120,000)): $38,961.
(v) Apportionment of research and experimental expense to the
statutory grouping, royalty income from countries Y and Z
($50,000 x $135,000+$120,000/($900,000+$135,000+$120,000)): $11,039.
(vi) Total apportioned deduction for research and
experimentation: $100,000.
(vii) Amount apportioned to the residual grouping
($50,000+$38,961): $88,961.
(viii) Apportioned to the statutory grouping of sources within
countries Y and Z: $11,039.
(2) Tentative apportionment on gross income basis.
(i) Apportionment of research and experimental expense to the
residual grouping of gross income ($100,000 x $479,000/$500,000):
$95,800.
(ii) Apportionment of research and experimental expense to the
statutory grouping of gross income ($100,000 x $9,000+$12,000/
$500,000): $4,200.
(iii) Amount apportioned to the residual grouping: $95,800.
(iv) Amount apportioned to the statutory grouping of general
limitation income from sources without the United States: $4,200.
(B) Since X's apportionment on the basis of gross income to the
statutory grouping, $4,200, is less than 50 percent of its
apportionment on the basis of sales to the statutory grouping,
$11,039 it may use Option two of paragraph (e)(3)(iii)(B) of this
section and apportion $5,520 (50 percent of $11,039) to the
statutory grouping.
Examples (9) through (16)--[Reserved]
* * * * *
Example (23)--[Reserved]
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-12621 Filed 5-19-95; 9:25 am]
BILLING CODE 4830-01-U