Proposed Section 861 regulations.

On October 19, 1995, Tax Executives Institute filed the following comments with the Internal Revenue Service on proposed regulations under section 861 of the Internal Revenue Code, relating to the allocation and apportionment of research and experimentation expenses for purposes of determining taxable income from U.S. and foreign sources. TEI's comments were prepared under the aegis of its International Tax Committee, whose chair is Philip J Bergquist of Apple Computer, Inc. Materially contributing to the preparation of these comments were Lester D. Ezrati of Hewlett-Packard Co., David D. Gillman of Medtronic, Inc., Raymond G. Rossi of Intel Corp., and Richard L. Sartor of the Boeing Company.

On May 19, 1995, the Internal Revenue Service issued proposed regulations under section 861 of the Internal Revenue Code, relating to the allocation and apportionment of research and experimental expenses for purposes of determining taxable income from U.S. and foreign sources. The proposed regulations would amend regulations issued in 1977 and were published in the May 24, 1995, issue of the Federal Register (60 F.R. 27453) and the June 12, 1995, issue of the Internal Revenue Bulletin (1995-24 I.R.B. 6).(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the Internal Revenue Code relating to the operation of multinational business enterprises, including those in incurring significant research and experimental expenses. We believe that the diversity and professional training of our members enable us to bring an

important, balanced, and practical perspective to the issues relating to Prop. Reg. [sections] 1.861-8.

Introduction

In 1977, the Treasury Department issued regulations under section 861 relating to the allocation and apportionment of U.S. research and experimental (R&E) expenses against foreign income. The 1977 regulations provided two allocation and apportionment methods for research expenses -- the sales method and the optional gross income method. Under the sales method, a 30-percent exclusive apportionment, or "set aside," was accorded to the place of performance of the R&D activities.(2)

The issuance of the 1977 regulations produced a firestorm of protest since they effectively increased the allocation of expenses to foreign-source income and thereby limited the foreign tax credits available to a multinational corporation to offset its U.S. income tax. The controversy prompted Congress in 1981 to enact a temporary moratorium on the application of the Treasury regulations. Since that time, the moratorium has been extended and modified nine times by legislative and administrative actions.(3) The most recent legislation (enacted as part of the Omnibus Budget Reconciliation Act of 1993) allocated 50 percent of foreign-incurred R&E expenses to foreign-source income and 50 percent of U.S.-incurred R&E expenses to domestic-source income; the extension, however, expired for calendar-year taxpayers on December 31, 1994.(4)

The 1977 regulations, which have been in force for fewer than 5 of the 18 years since their promulgation, adversely affected the competitiveness of U.S. multinationals and actually encouraged the offshore migration of R&D activities. The IRS and Treasury have now issued proposed regulations that would bring some much needed certainty to this area, by providing a 50-percent exclusive apportionment for taxpayers using the sales method of allocation.(5) Hence, taxpayers may now have a permanent solution to this contentious matter. TEI commends the IRS and Treasury for re-examining the 30-percent exclusive apportionment rule in the original regulations and for adopting an administratively feasible resolution of this longstanding issue, at least as it relates to the sales method of allocation.

Prop. Reg. [sections] 1.861-8(e)(3)(iii): Gross Income Method

a. Disparate Treatment of Methods. Although the proposed regulations permit taxpayers using the sales method to source 50 percent of their R&E expenses to the United States, they do not provide similar relief for taxpayer using the gross income method. For taxpayers in the latter category, Prop. Reg. [sections] 1.861-(e)(3)(iii) mirrors the 1977 regulations, providing two methods of allocating R&E expenditures on the basis of gross income without any exclusive apportionment.

TEI recommends that the 50-percent be extended to all taxpayers -- those who utilize the gross-income method as well as those who use the sales method. Such an approach would not only maintain parity between the methods, but it is also supported by the historical response to the 1977 regulations and Treasury's own report on the relationship between U.S. R&E expenses and foreign income.

In enacting and extending the moratorium on the implementation of the 1977 regulations, Congress has consistently extended the exclusive apportionment rule to gross-income-method taxpayers. The IRS has also treated the two methods consistently, extending the set aside to both the sales and gross income methods in Rev. Proc. 92-56. Most recently, Assistant Treasury Secretary Leslie B. Samuels expressed the Clinton Administration's support for a revenue neutral extension of section 864(f), under which the same exclusive apportionment percentage would apply to both methods. See Hearings before the House Ways and Means Committee on Miscellaneous Revenue Issues, 104th Cong., 1st Sess., reprinted in 98 BNA Daily Tax Report at L-1, L-14 (July 31, 1995) (Statement of Assistant Treasury Secretary Leslie B. Samuels).

Moreover, on the same day the proposed regulations were issued, Treasury released a study entitled The Relationship Between U.S. Research and Development and Foreign Income. The study provides --

[W]hile the 1977 regulations

may be correct on average,

they may be unfair to a significant

number of taxpayers

whose domestic R&D has little

application abroad. Reducing

allocations to foreign

income by about 25 percent

compared to the 1977 regulations,

which is equivalent to

relying on the lower part of

the range of estimated allocations,

would reduce the

potential that the regulations

are unfair to many taxpayers

while being within

the range of allocations that

cannot be rejected in view of

the uncertainty of the evidence.(6)

Hence, the Treasury Department itself acknowledges that the 1977 regulations were too restrictive in their allocation of R&E expenses. The fairness deemed paramount in the Treasury report can best be effected by extending the application of the set aside to the gross-income method of allocation. Without such parity, taxpayers using the gross-income method will effectively lose a portion of their research expense deduction. As currently written, the proposed regulations will force companies using the gross income method to accept either the risk of double taxation or to move their R&D operations offshore.(7) Such a choice is neither desirable nor equitable. The Institute recommends that the gross income method of allocation be revised to include the exclusive apportionment formula.

b. Binding Election. Prop. Reg. [sections] 1.861-8(e)(3)(iii)(c) provides that the taxpayer's use of the optional gross-income methods for its return filed for the first taxable year to which the proposed regulations apply will constitute a binding election for all subsequent years. A similar requirement is not imposed, however, on taxpayers using the sales method of allocation. No reason is given for the binding election requirement, which was not included in the 1977 regulations or in any subsequent legislative or regulatory moratorium. TEI believes that the change is ill-advised and unwarranted.

The 1977 regulations provided for alternative methods to account for differences in facts and circumstances that could occur from one year to the next. To now require taxpayers utilizing the gross income method to "lock-in" that choice ignores the policy reasons that prompted the IRS and Treasury to provide in 1977 for two methods." The relationship between research expenditures and sales or gross income may be inconsistent from year to year as global market penetration strategies are pursued. The general rules acknowledge that factual relationships will change over time.

More fundamentally, there is no tax or accounting policy that is served by the binding election provision. The section 861-8 rules are not a method of accounting, which generally relates to shifting items of income and deductions between taxable periods. Use of either the gross income or sales method of allocation in one year will not affect the use of that method in the subsequent year. Taxpayers should be permitted each year to choose the method that best reduces double taxation. TEI strongly recommends that the binding election requirement be eliminated.

Prop Reg. [sections] 1.861-8(e)(3)(vi): Effective Date

Prop. Reg. [sections] 1.861-8(e)((3)(vi) provides that the regulations will be effective for taxable years beginning after December 31, 1995. At the election of the taxpayer, the regulations may also be effective for taxable years beginning after December 31, 1994.

The proposed regulations thus give calendar-year taxpayers the option to apply the regulations to their first taxable year following the most recent moratorium. In contrast, certain fiscal-year taxpayers -- whose taxable years begin after August 1, 1994, but before January 1, 1995 -- will suffer a one-year "gap" during which the 1977 regulations will apply. This gap may simply be the result of a drafting oversight. TEI recommends that the final regulations provide an election to all taxpayers to apply the regulations to their first taxable year beginning after the most recent moratorium.

Prop. Reg. [sections] 1.861-8(e)(3)(i)(B): Determination of Product Categories

Prop. Reg. [sections] 1.861-8(e)(3)(i)(b) provides that a taxpayer shall determine the relevant product categories by reference to the three-digit classification of the Standard Industrial Classification Manual (SIC codes). This provision reflects a much needed change from the 1977 regulations, which required the use of two-digit SIC codes. The Institute recommends that the IRS and Treasury permit taxpayers an election to narrow the product categories even further. The use of four-digit SIC code categories would permit more companies to segregate their R&E expenses and accomplish a more accurate matching of such costs between U.S. and foreign source income. Furthermore, the use of the product categories could be binding unless a change is approved by the Commissioner.(9)

With respect to the application of the proposed regulations to foreign sales corporations (FSCs) and domestic international sales corporations (DISCS), we recommend that the final regulations reflect the decision in St. Jude Medical, Inc. v. Commissioner, 34 F.2d 1394 (8th Cir. Sept. 9, 1994), non-acq. 1995-7 I.R.B. 4. In that case, the appellate court held that the mandated use of SIC categories is inconsistent with Congress's intent to permit the determination of a DISC's combined taxable income (CTI) on a product or product-line basis. The final regulations should modify Prop. Reg. [sections] 1.861-8(e)(3)(i)(b) to provide that the use of SIC code categories is not mandatory for FSCs and DISCS that compute CTI on such basis. See also Treas. Reg. [sections] 1.936-6(a)(1), Question 1 (the Secretary may issue rulings determining the proper SIC category under which a particular product is to be classified for purposes of the section 936 cost-sharing option).

Finally, with respect to the application of the proposed regulations to section 936 corporations, we recommend that the final regulations clarify that companies electing the profit-split method of computing taxable income may also adjust the amount of R&E expenditures taken into account under Prop. Reg. [sections] 1.861-(e)(3). Consequently, Prop. Reg. [sections] 1.861-8(e)(3)(i)(c)(3) should be modified read, as follows:

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 either the cost

sharing amount (determined

under section 936(h)(5)(c)(i)(i))

or the profit split amount (determined

under section

936(h)(5)(c)(ii)).

Prop. Reg. [sections] 1.861-8(g), Example 6: Research and Experimentation

Prop. Reg. [sections] 1.861-8(g), Example 6 contains several changes from the example provided in the 1977 regulations. Under the proposed regulations, a domestic corporation (X) manufactures and sells forklift trucks and other equipment in the United States, which is under the SIC Industry Group 353 (Construction, Mining, and Materials Handling Machinery and Equipment). X also sells forklifts to a wholesaling subsidiary located in country Y and manufactures such trucks through a branch in country Z. Complying with certain U.S. emission control laws, X's U.S. research department engages in a project to improve the performance of the engine exhaust system. The system is added to the forklifts manufactured and sold in the United States, but not in country Y The example concludes that, although the research is undertaken in response to a U.S. law, the deduction is not solely allocable to U.S. income because of the benefit from the sale of the vehicles by the branch in Z.

The example includes two changes from the 1977 regulations. First, the example provides for passage of title in the United States, rather than in the foreign country. This leaves open the question of how R&E is allocated with respect to export sales when title passes abroad. TEI believes that this change may have been inadvertent, since the change is not discussed in the preamble. If the change is intentional, TEI believes that its effect should be confined to the context of the modified example. Thus, sales where title passes abroad should be U.S.-sourced for purposes of R&D expense allocation calculations, since the product of the research is manufactured in the United States.

The example also eliminates the special treatment for wholesale trade sales, deleting a sentence in the 1977 regulations providing that R&E deductions would not be allocable to the wholesale sales of the subsidiary because such sales are in a different product category. This change is also not discussed in the preamble. Presumably, wholesale sales should still be considered not subject to an R&D expense allocation.(10)

The Institute recommends that the IRS clarify that these two changes in the textual language of Example 6 were unintentional or, in any event, do not change the results attained under Example 6 of the 1977 regulations.

Conclusion

TEI appreciates this opportunity to comment on the proposed regulations under section 861 of the Code, relating to the allocation and apportionment of research and experimentation expenses. If you have any questions, please do not hesitate to contact Philip J. Bergquist, chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone].

(1) For simplicity's sake, the proposed regulations are referred to as the proposed regulations"; specific provisions of the proposed regulations are cited as "Prop. Reg. [sections]." The current Treasury regulations are referred to as the "1977 regulations' and specific portions are cited as "Treas. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin. (2) Treas. Reg. [sections] 1.861-8(e)(3)(ii)(a) provides for use of the sales method of allocation, permitting the taxpayer to allocate 30 percent of its total R&E expenditures based on where the research is conducted; the balance of the R&E expenditures is apportioned to various categories of income based on sales. The 1977 regulations also provide for an apportionment of R&E expenses based on optional gross income methods. See Treas. Reg. [sections] 1.861-8(e)(3)(iii). (3) Under most of the extensions, 64 percent of U.S.-incurred R&E expenses was allocated to U.S.-source income, and 64 percent of foreign-incurred R&E expenses was allocated to foreign-source income. The remaining expenses were allocated and apportioned on the basis of either sales or gross income, subject to the condition that, if income-based apportionment were used, the amount apportioned to foreign-source income could be no less that 30 percent of the amount that would have been apportioned to foreign-source income had the sales method been used. The 64-percent apportionment was effected by legislation through the first six months of a taxpayer's first taxable year beginning after August 1, 1991. The IRS administratively extended the 64-percent rule in Rev. Proc. 92-56, 1992-2 C.B. 409, for an additional 18 months. The percentage was lowered by legislation to 50 percent in 1993. (4) Revised section 864(f) applied to a taxpayer's first taxable year beginning on or before August 1, 1994, i.e., the first year following the taxpayer's last year to which Rev. Rul. 92-56 applied. (5) Prop. Reg. [sections] 1.861-8(e)(3)(ii). (6) See U.S. Department of Treasury, The Relationship Between US. Research and Development and Foreign Income, reprinted in 98 BNA Daily Tax Report at L-9, L-13 (May 22, 1995) (footnote omitted) (emphasis added) (hereinafter cited as the "Treasury Report"). (7) See H.R. Rep. No. 97-201, 97th Cong., 1st Sess. 130-32 (1981) (discussing the competitive reasons for imposing the first moratorium). (8) Cf. Treasury Report at L-9 to L-10. (9) The final regulations should clarify that the use of the three- (or even four-digit code is not mandatory; taxpayers should retain the option to use two-digit codes. (10) The proposed regulations also seem confused concerning X's product category, referring in one part to "Wholesale trade" and in another to "Transportation equipment." The reference to transportation equipment may have been carried over from the 1977 regulations and should be deleted.