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IRS issues proposed regulations on allocation and apportionment of research and experimental expenditures.

On Dec. 21, 1995, the Treasury Department issued new proposed regulations that provide further guidance on the correct method of allocating research and experimental expenses between U.S.-source and foreign-source income. The new proposed regulations make three changes to the previously issued 1977 regulations with regards to the allocation of these expenses. The new rules should be more favorable to taxpayers in an excess foreign tax credit (FTC) position.

The excess FTC limitation usually occurs because of a higher foreign tax rate compared to the US. tax rate. The allowable FTC is limited to the U.S. tax on the net foreign-source income. The most obvious tax strategy for clients in an excess FTC position is to either increase foreign-source income or allocate as little expense to the foreign-source income, as possible. If a taxpayer is successful in shifting as little expense as possible overseas, its net US. tax may decrease by increasing the allowable FTC.

Regs. Sec. 1.861-8 sets forth detailed rules for allocating and apportioning expenses, including research and development (R&D) expenses. Under the 1977 regulations, expenditures for R&D are related to all income reasonably connected with a taxpayers specific broad product categories. Taxpayers had to allocate income into specified product categories that are based on a two-digit Standard Industrial Classification System (SIC), and then match the related research expenses with that income. The product categories were found in Regs. Sec. 1.861-8(e)(3)(i)(A).

An exception to the aforementioned product category allocation rule under Regs. Sec. 1.861-8(e)(3)(i)(B) related to government-mandated R&D expenditures. Under this exception, any research expenses incurred because of government requirements would be allocated directly to gross income arising in that particular geographical area. Any research expenses remaining after the mandated allocation had to be apportioned between foreign and US. sources within the applicable product category. Two available methods were provided to achieve this goal: the sales method or die gross income method.

The sales method contained an exclusive apportionment rule, under which 30% of research costs were automatically allocated to the place where the research was undertaken (under the theory that the research activities are most beneficial to the geographical area in which they are performed). After allocating research expenses under the exclusive apportionment rule, the remaining expenses were allocated in proportion to U.S. sales compared to foreign sales.

Subject to certain limitations, the 1977 regulations permit taxpayers to elect to apportion research expenses under one of two options under the gross income method. By using one of these options, a taxpayer cannot reduce the allocation of research expenses to foreign sources by more than 50% of the amount that would be apportioned under the sales method. Under the first option, research expenses are allocated proportionately between foreign and U.S. gross income. If a ratable apportionment based on this option of the gross income method is used, but fails the 50% test, under the second option of the gross income method, the allocation is set at 50% of the amount that would have been apportioned under the sales method. The exclusive apportionment rule does not apply to the optional gross income method. Use of the gross income method is an annual election and is binding on all members of an affiliated group.

Overallocation of research expenses to foreign-source Income has been the main criticism of the 1977 regulations. Corporations with excess FTCs have claimed that the regulations have an unfair effect on their US. research activities. US. companies that were performing more research abroad tended to pay less foreign taxes than US. companies performing research in the US.

As a consequence, Congress enacted several temporary overrides throughout the 1980s, while studies were conducted to assess the overall impact of the 1977 regulations. In 1981, a two-year moratorium was placed on the regulations until the Treasury Department could complete its study; this moratorium was extended two more times until 1986. In 1986, Congress enacted changes to the exclusive apportionment percentage and the availability to use the optional gross income method. The Technical and Miscellaneous Revenue Act of 1988 incorporated the "64 percent rule." Under this rule, 64% of research expenses incurred in the U.S. could be allocated to the US., with the balance allocated to foreign-source income. This rule was codified under Sec. 864(f) in 1989. This rule was extended until the expiration of Sec. 864(f); however, the Service allowed taxpayers to use either the 1977 rules or a transition method (Rev. Proc. 92-56). The Omnibus Reconciliation Act of 1993 extended the allocation rules in Sec. 864(f), but changed the exclusive apportionment percentage back to 50% from 64%.

The 1995 proposed regulations make three changes to the 1977 regulations. The first change allows taxpayers to determine product categories by a three-digit SIC code (Prop. Regs. Sec. 1,861-17(a)(2)(ii)). Use of the three-digit SIC code would allow taxpayers to allocate research expenses to narrower classes of gross income.

Second, the percentage of research and expenditures that may be exclusively allocated under the sales method increases from 30% to 50% (Prop. Regs. Sec. 1.861-17(b)(1)(i)). Thus, if 50% or more of research expenses is conducted in the US., 50% of the research expense can be exclusively allocated to US. gross income. However, if there is no place where more than 50% of research is performed, there is no exclusive allocation and all expenses are allocated based on sales.

Finally, use of the optional gross income method or sales method would constitute a binding election to use such allocation method in future years (Prop. Regs. Sec. 1.861-17(e)). A change in method without IRS consent is allowed after five years of using the same method.

The first change relating to SIC codes should benefit most taxpayers, the use of three-digit SIC codes would allow a more accurate classification of allocating research expenditures and reduce the allocation of research expenditures to income from unrelated products. The second change relating to the increase in the exclusive allocation percentage from 30% to 50% would benefit companies that conduct a significant percentage (i.e., more than 50%) of their research in the US. Also, the new regulations differ from Sec. 864(f). Under Sec. 864(f), 50% of research expenses was automatically allocated to where the research was performed. Under the new regulations, 50% is allocated directly to U.S. sources and none to foreign sources. Therefore, the new regulations benefit companies that perform some, but less than 50%, of their research offshore.

The new regulations are effective for tax years beginning after Dec. 31, 1995. However, taxpayers may apply the regulations to tax years beginning after Aug. 1, 1994. Consideration should be given to taking advantage of this option.
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Author:Goodman, Mark E.
Publication:The Tax Adviser
Date:Sep 1, 1996
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