Clinton's tax plan: royalty and R&E provisions for multinationals.

As expected, the comprehensive economic plan President Clinton submitted to Congress contains a number of provisions affecting multinational corporations.

One revenue provision that received little attention in the newspapers may have a significant effect on the foreign tax credit limitation of certain companies. It (1) requires the allocation of research and experimentation (R&E) expenses to the place of performance and (2) treats all royalties as passive income for foreign tax credit limitation purposes.

A corporation may offset U.S. taxes with credits for taxes paid to foreign countries, but the foreign tax credits are limited to U.S. tax on foreign source income. In calculating foreign source income, certain expenses (including R&E) must be allocated between U. S. and foreign sources.

Currently, U.S.-based R&E is partially allocated to foreign sources, decreasing the limitation. Under Clinton's proposal U.S.-based R&E expenses would not be allocated to foreign source income - and therefore would increase the foreign tax credit limitation as compared with current law. On the other hand, R&E performed in other countries would be fully allocated foreign source income - decreasing the limitation. Presumably, this would have the effect of encouraging countries to perform R&E activities in the United States.

The foreign tax credit limitation is calculated separately for various income categories or "baskets." These are generally intended to separate income normally subject to high foreign tax rates (for example, operating income) from income normally subject to low tax rates (for example, passive income).

Separating income into baskets limits foreign tax credits by reducing taxpayer's ability to shelter income subject to low foreign tax rates with foreign tax credits attributable to income subject to foreign tax rates exceeding those in the United States.

Royalties usually are subject to low tax rates and generally are included in the passive income basket. However, current law contains exceptions for royalties from unrelated parties earned in an active trade or business and for certain royalties from foreign affiliates. These exceptions allow royalties to be grouped with highly taxed income that, as described above, can shelter them from U.S. taxes.

The Clinton proposal would remove these exceptions and effectively eliminate the sheltering of royalty income. According to the administration, U.S. multinationals faced with losing the benefit of sheltering royalties would be less inclined to license overseas the intangibles created by U.S.-based R&E activities and might instead use these intangibles to manufacture in the United States.

Observation: It's questionable whether the royalty-basket provision represents good tax policy. U.S. companies are encouraged to manufacture products in the United States that are intended to be sold overseas, they may not be able to compete effectively with foreign companies that manufacture close to the intended market

To remain competitive, corporations may choose to continue manufacturing overseas and, furthermore, move their R&E activities overseas as well in order to avoid paying U.S. tax on income attributable to intangibles.