[Federal Register Volume 60, Number 246 (Friday, December 22, 1995)]
[Rules and Regulations]
[Pages 66502-66510]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30901]
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
26 CFR Part 1
[TD 8646]
RIN 1545-AT49
Allocation and Apportionment of Research and Experimental
Expenditures
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
-----------------------------------------------------------------------
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.
EFFECTIVE DATE: January 1, 1996.
FOR FURTHER INFORMATION CONTACT: Carl Cooper at (202) 622-3840 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background and Explanation of Provisions
On May 24, 1995, the IRS published a notice of proposed rulemaking
and notice of public hearing in the Federal Register (60 FR 27453)
proposing amendments to the Income Tax Regulations (26 CFR part 1)
under section 861 of the Internal Revenue Code of 1986. 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 inside and
outside the United States.
The notice of proposed rulemaking proposed three principal changes
to the existing regulations. First, allocation of research and
experimental expenditures to three-digit SIC code product categories of
gross income would be permitted. 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. 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. The three changes were 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), ``The
Relationship Between U.S. Research and Development and Foreign
Income,'' which was published by the Treasury Department simultaneously
with the proposed regulations.
Written comments responding to the notice were received, and a
public hearing was held on September 8, 1995.
Regarding the determination of product categories under Sec. 1.861-
8(e)(3)(i)(B) of the proposed regulations, commenters suggested that
the rule requiring a taxpayer to determine relevant product categories
by reference to the three-digit classification of the Standard
Industrial Classification Manual should be modified to allow
determinations by reference to the five-digit classifications of the
Manual. This suggestion was not adopted, because such a rule would too
narrowly restrict the necessarily broad scope of the deduction. The IRS
continues to believe that research and experimentation is an inherently
speculative activity, that findings may contribute unexpected benefits,
and that gross income derived from successful research and
experimentation must bear the cost of unsuccessful research and
experimentation.
Commenters suggested that the regulations permit taxpayers to
determine product categories by reference to two- or three-digit
categories at the annual election of the taxpayer. This suggestion was
not adopted. The regulations provide that a taxpayer may determine
product categories by reference to two- or three-digit categories. A
taxpayer may aggregate, disaggregate or change a previously selected
SIC code category if the taxpayer establishes to the satisfaction of
the Commissioner that, due to changes in the relevant facts, a change
in product category is appropriate. This rule provides a simple and
workable format for balancing the need for consistency with the desire
for flexibility.
Referring to current Sec. 1.861-8(g) Example 6 (which has been
redesignated Sec. 1.861-17(h) Example 4), commenters suggested that the
regulations allow the use of the Wholesale Trade SIC code category with
respect to sales from any other category. The current Sec. 1.861-8(g)
Example 6 was not correct on this point and does not override the rule
stated parenthetically in the list of two digit SIC code categories in
present Sec. 1.861-8(e)(3)(i)(A) that wholesale trade may not be
combined with other product categories. The final regulations include
this rule along with Example 6 corrected to conform to the rule.
Regarding the exclusive place of performance apportionment rule
under Sec. 1.861-8(e)(3)(ii)(A) of the proposed regulations, commenters
suggested adding a rule providing that if the ratio of foreign research
and experimental expenditures in a three digit SIC code category of all
foreign affiliates of a United States consolidated group over foreign
affiliate sales in that SIC code category exceed fifty percent of the
ratio of United States consolidated group research and experimental
expenditures in that SIC code category over United States consolidated
group sales in that SIC code category, then the United States
consolidated group research and experimental expenditures should be
exclusively apportioned to United States source gross income. This
suggestion has not been adopted. Although a foreign affiliate may incur
substantial research and experimental expenditures in a given product
category, the foreign affiliate may still benefit from the research and
experimental expenditures of the United States consolidated group. See
Perkin-Elmer Corporation v. Commissioner, 103 T.C. 464 (1994).
Regarding the optional gross income methods of apportionment under
Sec. 1.861-8(e)(3)(iii) of the proposed regulations, commenters
suggested that
[[Page 66503]]
the final regulations include a fifty percent exclusive place of
performance apportionment under the optional gross income methods to be
parallel with Sec. 1.861-8(e)(3)(ii)(A). This suggestion has been
adopted in part. Section (b)(1)(ii) of the final regulations includes a
twenty-five percent exclusive place of performance apportionment under
the optional gross income methods. This twenty-five percent exclusive
apportionment ensures that taxpayers electing to use one of the
optional gross income methods also obtain results comparable to those
obtained by taxpayers electing to use the sales method, i.e., an
overall allocation that is twenty-five percent lower on average than
the allocation to foreign source income resulting from the current
regulations. The Treasury Department study does not support a greater
exclusive apportionment.
Commenters suggested that the proposed regulations should be
modified to reduce the floor on the amount of research and experimental
expenditures that must be apportioned to foreign source income under
the optional gross income methods from fifty percent to thirty percent
of the amount that would have been apportioned under the sales method.
This suggestion has not been adopted. The adoption of this suggested
rule in addition to the twenty-five percent exclusive apportionment
rule is not supported by the Treasury Department study.
Commenters suggested the elimination of the binding election to use
the optional gross income methods under Sec. 1.861-8(e)(3)(iii)(C) of
the proposed regulations. Commenters also suggested that the binding
election rule should be modified to provide for a change of method
without the prior consent of the Commissioner after five years' use of
one method. This suggestion, which recognizes the need for consistency
while reducing the administrative burden on taxpayers, has been
adopted.
Commenters suggested that the effective date election under
Sec. 1.861-8(e)(3)(vi) of the proposed regulations permit election by
fiscal year taxpayers whose taxable years begin after August 1, 1994,
but before January 1, 1995. This suggestion has been adopted.
Finally, these provisions, which were previously published as
Sec. 1.861-8(e)(3), have been renumbered and will now be published as
Sec. 1.861-17. This change has been made solely for the purpose of
achieving greater clarity in formatting and is not intended to result
in any additional substantive changes.
Special Analyses
It has been determined that these final regulations are 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,
the notice of proposed rulemaking preceding these final regulations has
been submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
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.
Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
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) to read as set forth below.
2. Removing and reserving paragraph (g), Examples 3 through 16 and
23.
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. For rules regarding the
allocation and apportionment of research and experimental expenditures,
see Sec. 1.861-17.
* * * * *
Par. 3. Section 1.861-17 is added to read as follows:
Sec. 1.861-17 Allocation and apportionment of research and
experimental expenditures.
(a) Allocation--(1) In general. The methods of allocation and
apportionment of research and experimental expenditures set forth in
this section 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 that a taxpayer deducts under section 174 ordinarily
shall be considered deductions that 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) that
a taxpayer may be considered to have shall be determined in accordance
with the provisions of paragraph (a)(2) of this section.
(2) Product categories--(i) Allocation based on 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.
(ii) Use of three digit standard industrial classification codes. 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).
(iii) Consistency. Once a taxpayer selects a product category for
the first taxable year for which this section 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
[[Page 66504]]
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.
(iv) Wholesale trade 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.
(v) Retail trade category. 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.
(3) Affiliated Groups--(i) In general. Except as provided in
paragraph (a)(3)(ii) of this section, the allocation and apportionment
required by this section 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.
(ii) Possessions corporations. (A) For purposes of the allocation
and apportionment required by this section, 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 (a)(3)(ii) 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.
(B) The research and experimental expenditures taken into account
for purposes of this section shall be reduced by the amount of such
expenditures included in computing the cost-sharing amount (determined
under section 936(h)(5)(C)(i)).
(4) Legally mandated research and experimentation. 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 (c) and
(d) 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.
(b) Exclusive apportionment--(1) In general. An exclusive
apportionment shall be made under this paragraph (b), where an
apportionment based upon geographic sources of income of a deduction
for research and experimentation is necessary (after applying the
exception in paragraph (a)(4) of this section).
(i) Exclusive apportionment under the sales method. If the taxpayer
apportions on the sales method under paragraph (c) of this section, an
amount equal to fifty percent 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
of the amount of such deduction were performed.
(ii) Exclusive apportionment under the optional gross income
methods. If the taxpayer apportions on the optional gross income
methods under paragraph (d) of this section, an amount equal to twenty-
five percent of such deduction for research and experimentation shall
be apportioned exclusively to the statutory grouping 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 of the amount of such deduction
were performed.
(iii) Exception. If the applicable fifty percent geographic source
test of the preceding paragraph (b)(1)(i) or (ii) is not met, then no
part of the deduction shall be apportioned under this paragraph (b)(1).
(2) Facts and circumstances supporting an increased exclusive
apportionment--(i) In general. The exclusive apportionment provided for
in paragraph (b)(1) of this section reflects the view that research and
experimentation is often most valuable in the country where it is
performed, for two reasons. First, 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 exclusive allocation percentage than allowed by paragraph
(b)(1) of this section because the research and experimentation is
reasonably expected to have very limited or long delayed application
outside the geographic source where it was performed. Past experience
with research and experimentation may be considered in determining
reasonable expectations.
(ii) Not all products sold in foreign markets. 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 (c)(2)(i) 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 (c)(3)(ii) of this
section) that 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,
[[Page 66505]]
United States Government Printing Office, Washington, DC 20402.
(iii) Delayed application of research findings abroad. 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
(c)(2)(i) of this section) of products involving intangible property
that was licensed or sold by the taxpayer, and by those controlled
corporations (as defined under paragraph (c)(3)(i) of this section)
that 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.
(c) Sales method--(1) In general. The amount equal to the remaining
portion of such deduction for research and experimentation, not
apportioned under paragraph (a)(4) or (b)(1)(i) 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) that 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).
(i) Apportionment in excess of gross income. Amounts apportioned
under this section 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 Sec. 1.861-8(d)(1) for instances where the apportionment
leads to an excess of deductions over gross income within the statutory
grouping.
(ii) Leased property. For purposes of this paragraph (c), amounts
received from the lease of equipment during a taxable year shall be
regarded as sales receipts for such taxable year.
(2) Sales of uncontrolled parties. For purposes of the
apportionment under paragraph (c)(1) of this section, the sales from
the product category (or categories) by each party uncontrolled by the
taxpayer, of particular products involving intangible property that 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. 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. Past
experience with research and experimentation shall be considered in
determining reasonable expectations.
(i) Definition of uncontrolled party. For purposes of this
paragraph (c)(2) the term uncontrolled party means a party that 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
927(d)(4)).
(ii) Licensed products. 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 based on the principles of section 482 should be made.
(iii) Sales of intangible property. In the case of sales of
intangible property, regardless of whether the consideration received
in exchange for the intangible is a fixed amount or is contingent on
the productivity, use, or disposition of the intangible, if the amount
of sales of products utilizing the intangible property is unknown, a
reasonable estimate of sales shall be made annually. If necessary,
appropriate economic analyses shall be used to estimate sales.
(3) Sales of controlled parties. For purposes of the apportionment
under paragraph (c)(1) 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 (c)(3) 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). 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.
(i) Definition of a corporation controlled by the taxpayer. For
purposes of this paragraph (c)(3), the term a corporation controlled by
the taxpayer means any corporation that has a relationship to the
taxpayer specified in section 267(b) or is a member of a controlled
group of corporations to which the taxpayer belongs (within the meaning
of section 993(a)(3) or 927(d)(4).
(ii) Sales to be taken into account. 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 the total sales of the controlled corporation as the
total value of all classes of the stock of such corporation owned
directly or indirectly by the taxpayer, within the meaning of section
1563, bears to the total value of all classes of stock of such
corporation.
(iii) Sales not to be taken into account more than once. 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.
(iv) Effect of cost-sharing arrangements. If the corporation
controlled by the taxpayer has entered
[[Page 66506]]
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.
(d) Gross income methods--(1)(i) In general. In lieu of applying
the sales method of paragraph (c) of this section, the remaining amount
of the deduction for research and experimentation, not apportioned
under paragraph (a)(4) or (b)(1)(ii) of this section, shall be
apportioned as prescribed in paragraphs (d)(2) and (3) of this section,
between the statutory grouping (or among the statutory groupings) of
gross income and the residual grouping of gross income.
(ii) Optional methods to be applied to all research and
experimental expenditures. These optional methods must be applied to
the taxpayer's entire deduction for research and experimental expense
remaining after applying the exception in paragraph (a)(4) 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 (a)(2) 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
(c) of this section or only the optional gross income methods under
this paragraph (d). 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.
(2) 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 the
conditions described in paragraph (d)(2)(i) and (ii) of this section
are both met.
(i) The amount of research and experimental expense ratably
apportioned to the statutory grouping (or groupings in the aggregate)
is not less than fifty percent of the amount that would have been so
apportioned if the taxpayer had used the method described in paragraph
(c) of this section; and
(ii) The amount of research and experimental expense ratably
apportioned to the residual grouping is not less than fifty percent of
the amount that would have been so apportioned if the taxpayer had used
the method described in paragraph (c) of this section.
(3) 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 (d)(2)(i) or (ii) of this section
is not met, the taxpayer may either--
(i) Where the condition of paragraph (d)(2)(i) of this section is
not met, apportion fifty percent of the amount of research and
experimental expense that would have been apportioned to the statutory
grouping (or groupings in the aggregate) under paragraph (c) 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
(ii) Where the condition of paragraph (d)(2)(ii) of this section is
not met, apportion fifty percent of the amount of research and
experimental expense that would have been apportioned to the residual
grouping under paragraph (c) 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).
(e) Binding election--(1) In general. A taxpayer may choose to use
either the sales method under paragraph (c) of this section or the
optional gross income methods under paragraph (d) of this section for
its original return for its first taxable year to which this section
applies. The taxpayer's use of either the sales method or the optional
gross income methods for its return filed for its first taxable year to
which this section applies shall constitute a binding election to use
the method chosen for that year and for four taxable years thereafter.
(2) Change of method. The taxpayer's election of a method may not
be revoked during the period referred to in paragraph (e)(1) of this
section without the prior consent of the Commissioner. After the
expiration of that period, the taxpayer may change methods without the
prior consent of the Commissioner. However, the taxpayer's use of the
new method shall constitute a binding election to use the new method
for its return filed for the first year for which the taxpayer uses the
new method and for four taxable years thereafter. The taxpayer's
election of the new method may not be revoked during that period
without the prior consent of the Commissioner.
(i) Short taxable years. For purposes of this paragraph (e), the
term taxable year includes a taxable year of less than twelve months.
(ii) Affiliated groups. In the case of an affiliated group, the
period referred to in paragraph (e)(1) of this section shall commence
as of the latest taxable year in which any member of the group has
changed methods.
(f) Special rules for partnerships--(1) Research and experimental
expenditures. For purposes of applying this section, 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.
(2) Purpose and location of expenditures. In applying the exception
for expenditures undertaken to meet legal requirements under paragraph
(a)(4) of this section and the exclusive apportionment for the sales
method and the optional gross income methods under paragraph (b) 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.
(3) Apportionment under the sales method. In applying the remaining
apportionment for the sales method under paragraph (c) 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.
(g) Effective date. This section applies to taxable years beginning
after December 31, 1995. However, a taxpayer may at his or her option,
apply this section in its entirety to all taxable years beginning after
August 1, 1994.
(h) Examples. The following examples illustrate the application of
this section:
Example 1--(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
[[Page 66507]]
(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 gross income is $160,000, of which
$140,000 is U.S. source income from domestic sales of gasoline
engines and $10,000 is foreign source royalties from Y, and $10,000
is U.S. source interest income.
(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. The U.S. source interest income is not within this class of
gross income and, therefore, is not taken into account.
(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 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 of small
gasoline engines 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) Exclusive apportionment of research and experimental
expense to the residual grouping of gross income ($60,000 x
25 percent):................................................ $15,000
(ii) Research and experimental expense apportioned to sources
within the United States (residual grouping) ($45,000 x
$140,000/($140,000+$10,000)):............................... $42,000
(iii) Research and experimental expense apportioned to
sources within country Y (statutory grouping) ($45,000 x
$10,000/($140,000+$10,000)):................................ $3,000
(iv) Amount apportioned to the residual grouping:............ $57,000
(v) Amount apportioned to the statutory grouping:............ $3,000
(B) The total research and experimental expense apportioned to
the statutory grouping ($3,000) under the gross income method is
approximately 26 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 (d)(3) 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 methods
will constitute a binding election to use the optional gross income
methods for 1996 and four taxable years thereafter.
Example 2--(i) Facts. Assume the same facts as in Example 1
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 U.S. source income from domestic
sales of gasoline engines, $50,000 is U.S. source income from
domestic sales of steam turbines, and $10,000 is foreign source
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 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, 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 of small gasoline engines and steam turbines 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
(iii) 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
[[Page 66508]]
(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) Exclusive apportionment of research and experimental
expense to the residual grouping of gross income ($90,000 x
25 percent):................................................ $22,500
(ii) Research and experimental expense apportioned to sources
within the United States (residual grouping) ($67,500 x
$190,000/($140,000+$50,000+$10,000)):....................... $64,125
(iii) Research and experimental expense apportioned to
sources within country Y (statutory grouping) ($67,500 x
$10,000/($140,000+$50,000+$10,000)):........................ $3,375
(iv) Amount apportioned to the residual grouping:............ $86,625
(v) Amount apportioned to the statutory grouping:............ $3,375
(B) The total research and experimental expense apportioned to
the statutory grouping ($3,375) under the gross income method is 30
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 (d)(3) 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 methods will constitute a binding
election to use the optional gross income methods for 1996 and four
taxable years thereafter.
Example 3--(i) Facts. Assume the same facts as in Example 1
except that in 1997 X continues its sales of the new engines, with
sales of $600,000 in the United States and $400,000 abroad by
subsidiary Y. X also acquires a 60 percent (by value) 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, 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 of gasoline engines 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 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 of gasoline engines 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 in 1996 and for four taxable years thereafter. If X utilized
the sales method in 1996, then its use of such method constituted a
binding election to use the sales method in 1996 and for four
taxable years thereafter.) The optional gross income methods are not
illustrated in this Example 3 (see instead Examples 1 and 2). 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 groupings on the
basis of sales:............................................. $30,000
(4) Apportionment of research and experimental expense to
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 gross
income from sources within countries Y and Z:............... $18,750
Example 4--Research and Experimentation--(i) Facts. X, a
domestic corporation, manufactures 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
[[Page 66509]]
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 mandated
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). See Sec. 1.861-17(c)(3)(iii).
Example 5--(i) Facts. X, a domestic corporation, is a drug
company that 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
pharmaceutical products of $10,000,000, the FSC has sales of
pharmaceutical products of $3,000,000, and Y has sales of
pharmaceutical products of $5,000,000. In that same year, 1997, X
incurs 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 FSC sells goods
to countries that 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, gross income
from sales within the United States.
Example 6--(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 that was performed exclusively in the United States. As a
result of this research activity, X acquires patents that 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
from sales of floodlights, flashlights, fuse boxes, and solderless
connectors of $479,000, and royalty income of $9,000 and $12,000
from foreign corporations Y and Z respectively. X utilized the
optional gross income methods of apportionment for its return filed
for its first taxable year to which this section applies.
(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 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 (c) of this section, X is
entitled to an exclusive apportionment of 50 percent of its research
and experimental expense to the residual grouping, 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 (d) 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
[[Page 66510]]
(vi) Total apportioned deduction for research and
experimentation:............................................ $100,000
(vii) Amount apportioned to the residual grouping
($50,000+$38,961):.......................................... $88,961
(viii) Amount apportioned to the statutory grouping of
sources within countries Y and Z:........................... $11,039
(2) Tentative Apportionment on Gross Income Basis
(i) Exclusive apportionment of research and experimental
expense to the residual grouping of gross income ($100,000 x
25 percent):................................................ $25,000
(ii) Apportionment of research and experimental expense to
the residual grouping of gross income ($75,000 x $479,000/
$500,000):.................................................. $71,850
(iii) Apportionment of research and experimental expense to
the statutory grouping of gross income ($75,000 x
$9,000+$12,000/$500,000):................................... $3,150
(iv) Amount apportioned to the residual grouping:............ $96,850
(v) Amount apportioned to the statutory grouping of general
limitation income from sources without the United States:... $3,150
(B) Since X has elected to use the optional gross income methods
of apportionment and its apportionment on the basis of gross income
to the statutory grouping, $3,150, is less than 50 percent of its
apportionment on the basis of sales to the statutory grouping,
$11,039, it must use Option two of paragraph (d)(3) of this section
and apportion $5,520 (50 percent of $11,039) to the statutory
grouping.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: December 13, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-30901 Filed 12-21-95; 8:45 am]
BILLING CODE 4830-01-U