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    "title": "1975/12/22 - Economic Policy Board",
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    "ocrText": "The original documents are located in Box 54, folder \"1975/12/22 - Economic Policy Board\"\nof the James M. Cannon Files at the Gerald R. Ford Presidential Library.\nCopyright Notice\nThe copyright law of the United States (Title 17, United States Code) governs the making of\nphotocopies or other reproductions of copyrighted material. Gerald Ford donated to the United\nStates of America his copyrights in all of his unpublished writings in National Archives collections.\nWorks prepared by U.S. Government employees as part of their official duties are in the public\ndomain. The copyrights to materials written by other individuals or organizations are presumed to\nremain with them. If you think any of the information displayed in the PDF is subject to a valid\ncopyright claim, please contact the Gerald R. Ford Presidential Library.\nDigitized from Box 54 of the James M. Cannon Files at the Gerald R. Ford Presidential Library\nECONOMIC POLICY BOARD MEETING\nMonday, December 22, 1975\nThe Roosevelt Room\n8:30 a.m.\nDecember 19, 1975\nECONOMIC POLICY BOARD\nEXECUTIVE COMMITTEE\nProposed Agenda\nMonday, December 22, 1975\n1. 1976 Collective Bargaining Negotiations\nCWPS\n2. Status of State of the Union Preparation\nSeidman\nTuesday, December 23, 1975\n1. Report of Task Force on Tax Policy and In-\nJones\nternational Investment\nWednesday, December 24, 1975\nNo Executive Committee Meeting\nThursday, December 25, 1975\nNo Executive Committee Meeting\nFriday, December 26, 1975\nNo Executive Committee Meeting\nSaturday, December 20, 1975\nSpecial Session on Economic Forecast for 1977 Budget\nRoosevelt Room 9:00 a.m.\nPrincipals Only\nOF\nTHE\nTREASURY THE\nDEPARTMENT OF THE TREASURY\nWASHINGTON, D.C. 20220\n1789\nASSISTANT SECRETARY\nDecember 19, 1975\nMEMORANDUM FOR EXECUTIVE COMMITTEE, ECONOMIC POLICY BOARD\nFROM:\nSidney Lones\nSubject:\nPreliminary Report of EPB Task Force on Tax\nPolicy and International Investment on the\nAllocation of Research and Development Expenses\nBetween United States and Foreign Source Income.\nAttached is the Task Force report which:\n1. Summarizes the background of the problem;\n2. Identifies 8 issues to be resolved;\n3. Presents arguments associated with the various options\nunder each issue; and\n4. Presents revenue estimates and examples of the specific\nproblems.\nAttachment\nDecember 22, 1975\nALLOCATION OF RESEARCH AND DEVELOPMENT EXPENSE\nBETWEEN UNITED STATES AND FOREIGN SOURCE INCOME\nThe Internal Revenue Code has provided since the\n1920's that all current deductions must be allocated\nto domestic or foreign source income unless they can-\nnot definitely be related thereto, in which case they\nmust be allocated between domestic and foreign source\nincome on a ratable basis.\nThe Treasury has a responsibility to issue regula-\ntions that clarify and explain existing statutory law.\nSeveral years ago, following taxpayer concern that agents\nlacked guidelines for allocating expenses, the Treasury\nDepartment prepared more detailed allocation regulations\nwhich were issued in proposed form in April 1973. This\nFall, IRS agents were instructed by the Internal Revenue\nService not to cite or apply the proposed regulations.\nThe most controversial aspects of these proposed regula-\ntions concern the allocation of current research and\ndevelopment expenses.\nThe Internal Revenue Code, since 1954, has permitted\na United States business to elect either to claim a current\nbusiness deduction for research and development expenses\nor to capitalize and amortize such expenses. The current\nbusiness deduction alternative was legislated in part to\nprovide an incentive for research and development ex-\npenditures.\nPatents and other forms of technology developed by\na United States company may be used in foreign branch\noperations (which is relatively uncommon), sold or.\nlicensed to an unrelated third party, or transferred\nto a foreign affiliate. Under current U.S. tax law, a\ntransfer to an affiliate may take the form of (i) a\nsale for payment at fair market value, (ii) a royalty\nlicense for an arm's length royalty, or (iii) a tax-free\ntransfer to a subsidiary where the property is to be used\nin manufacturing operations by the subsidiary.\n- 2 -\nThe proposed Treasury regulations require allocation\nof current research and development expenses against royal-\nties from licensees and dividends from subsidiaries where\nthe research gives rise or \"can reasonably be expected\"\nto give rise to foreign source income, for example, divi-\ndends from subsidiaries that have received tax-free trans-\nfers of technology in the past.\nIt should be stressed that deductions for research\nand development are allowed by the United States in all\ncases. The issue here is the extent to which these de-\nductions should be allocated to foreign as opposed to\ndomestic source income for such purposes as calculating\nthe foreign tax credit.\nThe United States credit for foreign income taxes\nimposed on foreign source income is limited by law to the\namount of United States tax imposed on foreign source\nincome. If deductions are not allocated to foreign source\nincome, then those deductions reduce only United States\ntax on United States source income. Meanwhile, United\nStates tax on the foreign source income could be fully\noffset by foreign income tax. The long-term effect is\nthat foreign countries may be able to increase their tax\nrevenues at the expense of the United States Treasury.\nDepending on foreign laws, this principle can of course\nalso apply to technology transfers to the United States.\nAt the present time royalties paid to the United States\nare approximately ten times those paid from the United\nStates.\nIf deductions are allocated to foreign source income\nby the United States, but not recognized by the foreign\ncountry when it imposes its tax, the immediate result is\na higher effective worldwide tax rate, with the taxpayer\nin the middle.\nUnder the proposed regulations, items of expense which\ncan clearly be determined to relate to either domestic or\nforeign source income are allocated on that basis. Where\n- 3 -\nexpenses are not clearly related to either domestic or\nforeign source income, they are to be allocated between\nthe two sources on some comparable basis. For example,\nresearch and development expenses may be allocated between\ndomestic sales income of the parent and dividends it receives\nfrom a foreign subsidiary on the basis of the number of units\nsold by the parent and by the foreign subsidiary or on the\nbasis of gross receipts of the parent and the subsidiary.\nA few companies, for example, firms in the automobile\nindustry, have historically instituted cost sharing agree-\nments with their foreign affiliates and are reimbursed for\nportions of domestic research and development expense.\nThese industries believe that they have little problem\nwith the proposed regulations. The feasibility of such\narrangements may be affected by specific characteristics\nof a particular industry, such as the comparability of\nproducts sold at home and abroad. A number of other com-\npanies have not had such agreements and have not allocated\nany research and development expense to foreign source in-\ncome on the theory that it was basically incurred for\ndomestic use. Others have allocated varying amounts with-\nout uniform guidance. The proposed regulations have the\ngreatest impact on high technology industries with large\nresearch budgets, extensive foreign source income, and\nforeign taxes equal to the foreign tax credit limit.\nIf applied in 1974 and assuming foreign countries do\nnot permit increases in allowable deductions, the proposed\nregulations could result in the loss of $1.1 - $1.5 billion\nin foreign tax credits and a corresponding increase in the\nU.S. tax burden (Appendix 9). This burden would fall on\nhigh technology industries. Some firms have suggested that\nincreased allocations and the attendant U.S. tax burden\nwould force them to perform less research and, over time,\nto move research to their foreign subsidiaries, since that\nwould assure full deductions abroad. It is exceedingly\ndifficult to estimate the number of research jobs that\nwould be shifted abroad. However, in connection with the\ntax impact and the shift of research to foreign countries,\nthe following points should be noted:\n- 4 -\n- The main goal of the proposed allocation regulations\nis to clarify and explain existing statutory law. The pro-\nposed regulations do have a revenue raising impact, but\nthis is not their main goal.\n- During the past two decades, some multinational\nfirms have already devoted larger portions of their research\nbudgets to research in Canada, Western Europe, and Japan.\nThis change has been induced by the availability of skilled\nforeign scientists, the advantages of proximity to foreign\nmarkets, and by local tax and subsidy measures designed to\nencourage R&D activity.\n- The interaction of United States withholding taxes\non royalties paid abroad and foreign withholding taxes on\ndividends paid to the United States may in certain cases\nmake shifts of research abroad undesirable.\nThe major issues are set forth below in the order\nappropriate for resolution. Pro and con arguments, and\nmethods of implementation, are given in the appendices.\nImplementation of major policy decisions in this area may\nrequire new legislation to achieve desired results.\n- 5 -\nISSUES TO BE RESOLVED\n1. How should R&D deductions be allocated?\nOPTIONS:\nA. R&D expenses should be allocated entirely to\nU.S. source income (Appendix 1-A).\nB. Only \"clearly related\" R&D expenses should be\nallocated to foreign source income. An example\nof clearly related R&D expense would be the\ndevelopment of a specific process undertaken\nat the request of a foreign affiliate. All\nother R&D expenses should be allocated to\nUnited States source income (Appendix 1-B).\nC. \"Clearly related\" R&D expenses should be\nallocated to domestic or foreign source\nincome. All R&D that is not clearly related\nto either domestic or foreign source income\nshould be allocated between United States\nincome and foreign source income on some\nreasonable basis (Appendix 1-c).\nD. The proposed regulations should be withdrawn,\nwith no new regulatory or legislative guid-\nance for Internal Revenue Service agents or\ntaxpayers (Appendix 1-D).\nRECOMMENDATION:\n2. If R&D is to be allocated between domestic and foreign\nsource income under Option 1-c, how should this be done?\nOPTIONS:\nA. On the basis of gross income from foreign and domestic\nsources (Appendix 2-A).\n- 6 -\nB. on the basis of comparable items of income,\ne.g., at the election of the taxpayer com-\nparison of foreign and domestic: (1) sales,\n(2) net income, (3) number of units sold;\nor (4) actual and constructive royalties\n(Appendix 2-B).\nC. R&D expenses should be allocated only to\nitems of income which can reasonably be\nexpected to benefit from R&D expenditures.\nNo allocations would be made to dividend\nincome since all transfers of technology to\nforeign affiliates would be an arm's length\nlicense or sale and would be treated as tax-\nable events (Appendix 2-c).\nRECOMMENDATION:\n3. While a current business deduction is allowed by\nthe Code for R&D, should the taxpayer have the option of\ncapitalizing the expense and amortizing it over time for\npurposes of allocating it between U.S. and foreign source\nincome? (Appendix 3).\nRECOMMENDATION:\n4. When should major changes in allocation methods be\nimplemented?\nOPTIONS:\nA. The allocation method should apply prospectively\n(Appendix 4-A).\nB. The allocation method should apply prospectively\nafter a grace period (Appendix 4-A).\n- 7 -\nC. The allocation method should be retroactive\n(Appendix 4-B).\nRECOMMENDATION:\n5. Should the allocation method apply only in those cases\nwhere foreign governments agree to permit deduction of the\nallocated expenses? (Appendix 5)\nRECOMMENDATION:\n6. Should the same principles be applied to United States\nbranches and subsidiaries of foreign corporations, thus per-\nmitting United States branches and subsidiaries a deduction\nfor a proportionate share of research expenses incurred by\nforeign home offices or parent companies? (Appendix 6)\nRECOMMENDATION:\n7. Should any revised allocation regulations be submitted\nin proposed form for further public comment prior to being\nissued in final form? (Appendix 7)\nRECOMMENDATION:\n8. Should any change in the allocation method be postponed\nuntil more of the economic effects of the change can be\nstudied, including the effects on transfers abroad or possible\nreduction in R&D? (Appendix 8) .\nRECOMMENDATION:\nAPPENDIX 1-A\nOPTION:\nR&D expenses should be allocated entirely to\nU.S. source income.\nPRO:\nSince some allocation is presently\nrequired, this option would provide a\nclear United States tax incentive for U.S.- -\nbased multinational firms to conduct their\nR&D activities in the United States. There\nwould be no reduction of the foreign tax\ncredit, even though the research results\nwere used abroad. This option acknowledges\nthat R&D activities principally benefit the\ncountry of location, directly and through\nspillover effects, and it is least likely\nto encourage a shift of R&D abroad. Since\nthis option requires no allocation it re-\nduces potential double taxation.\nCON:\nThis option makes no attempt to allocate\nR&D expenses in a manner which reasonably\nreflects the economic benefits conferred\nthrough such R&D. Rather, this option\nenables foreign countries to raise their\neffective tax rates at the expense of the\nUnited States Treasury. That is, the total\nallocation of R&D expenses against United\nStates income would result in a transfer of\ntax revenues from the United States to foreign\ntreasuries. All R&D expenses would be re-\nflected in lower U.S. taxes on U.S. source\nincome. Foreign countries need recognize\nno expenses associated with the development\nof know-how. The net result is that foreign\ntaxes could be aggressively raised at the\nexpense of the U.S. Treasury.\nIMPLEMENTION:\nThis option would require new statutory\nlanguage. The present statute requires that\nall current deductions, including R&D, be\nallocated between domestic and foreign source\nincome. An exception to the statute would be\nneeded for R&D expenses.\nAPPENDIX 1-B\nOPTION:\nOnly \"clearly related\" R&D expenses should\nbe allocated to foreign source income. All\nother R&D expenses would be allocated to U.S.\nsource income.\nPRO:\nThis option ensures that at least the expense\nof R&D performed in the United States at the\nrequest of a foreign affiliate or unrelated\nfirm would be charged against the income re-\nceived by the U.S. company from that firm.\nThis seems reasonable, since otherwise the\ntax claims of the foreign government could\nprevent the United States from recouping the\nlost tax revenue attributable to the R&D\ndeduction. This option presumes that R&D\nexpenses which are not \"clearly related\" to\nforeign source income should be allocated to\nU.S. source income. This treatment recognizes\nthat R&D conducted in the United States\nprincipally benefits industry located here.\nThis option would cause less of a \"double\ntax\" burden and would be less of an induce-\nment for the transfer of R&D activities\nabroad than the proposed regulations.\nCON:\nOnly a small portion of total R&D expenses\nare \"clearly related\" to foreign source income.\nthus, the bulk of R&D results would be made\navailable to foreign countries with no foreign\ntax recognition given to the underlying expense.\nForeign countries would be able to raise their\neffective tax rates at the expense of the\nUnited States Treasury.\nIMPLEMENTATION:\nThis option would require new statutory\nlanguage. In the Treasury's view, the present\nstatute requires that deductions which are not\ndefinitely related to foreign or U.S. source\nincome be ratably allocated between the two.\nAPPENDIX 1-c\nOPTION:\nAll R&D that cannot be clearly allocated to\neither domestic or foreign source income\nshould be allocated between United States\nincome and foreign source income on some\nreasonable basis.\nPRO:\nThis option provides for a reasonable\nallocation of R&D costs between domestic\nand foreign source income. Foreign tax\nauthorities are thereby encouraged to give\nproper tax recognition to the expenses\nassociated with royalty income. The U.S.\ntaxpayer is not asked to bear the entire bur-\nden of R&D expenses, when many of the findings\nare used abroad.\nCON:\nThis option immediately raises the problem\nof defining a \"reasonable\" basis of alloca-\ntion and therefore may give rise to sub-\nstantial disputes and litigation over what-\never definition is chosen. Other questions\nthis option raises include: Should a mar-\nginal cost or a full cost approach be used?;\nshould R&D be capitalized and amortized for\npurposes of allocation, or deducted currently?;\nwhat about R&D expense that produces no findings?;\nand so forth. Should the same method of appor-\ntionment be applied to income from a foreign\nbranch, to royalties from related and unrelated\nforeign licensees, and to dividends from\nforeign subsidiaries to whom technology has\nbeen or may be transferred? Any allocation\nformula is inherently arbitrary and may not\nmeet the circumstances of particular firms.\nWorse, the chosen formula may attribute too\nmuch R&D expense to foreign source income, and\nthereby encourage R&D activities to leave the\nUnited States.\nIMPLEMENTATION:\nThis option can be implemented by the proposed\nregulations or any modification of the pro-\nposed regulations which provides for a reason-\nable allocation of R&D expense between domestic\nand foreign source income.\nAPPENDIX 1-D\nOPTION:\nThe proposed regulations should be withdrawn,\nwith no new regulatory or legislative\nguidance.\nPRO:\nThe statute has been on the books for many\nyears. During this time, United States cor-\nporations have worked out their own systems\nfor allocating R&D expense between domestic\nand foreign income. Any general rule will\ndo violence to the circumstances of particular\ncompanies, and would invite extensive litiga-\ntion.\nCON:\nThe existing law is arbitrarily applied from\ncompany to company, depending on historical\naccident, and past and present audits. The\nIRS agents have no clear guidance, and thus\nallocation methods for a particular firm may\nchange with a change in agents. This is an\nentirely unsatisfactory arrangement from the\nstandpoint of tax administration. Firms are\nentitled to greater certainty and uniformity\nin the tax treatment of a major expense. The\nTreasury has an obligation to clarify statutory\nlaw. In the absence of regulations, Congress\nmay act in a manner unfavorable to corpora-\ntions with large R&D expense.\nIMPLEMENTATION:\nThe implementation will require withdrawal\nof the presently proposed regulations.\nAPPENDIX 2-A\nOPTION:\nAllocation should be on the basis of gross\nincome from foreign and domestic sources.\nPRO:\nAllocation on the basis of gross income has\nlong been used by taxpayers and recognized\nby the courts as an acceptable method. It\nis a simple and relatively easy method to\napply. Many firms insist that they will\nsuccessfully challenge in the courts any\nallocation method other than on the basis of\ngross income. The gross income method has\nthe characteristic of assigning the bulk of\nR&D expense to U.S. source income since\ngross income from foreign sources is usually\n\"net\" types of income (dividends, interest,\nand royalties), while gross income from\ndomestic sources is usually \"gross\" types\nof income (business receipts). Accordingly,\nthis method will have less of an impact on\nthe level and location of R&D activity than\nthe proposed regulations.\nCON:\nAllocation on the basis of gross income mixes\napples and oranges. Foreign and domestic\ngross income are entirely different in type:\nForeign gross income is essentially net\nprofit (i.e. dividends, interest, royalties),\nwhile domestic gross income is essentially\ngross receipts (sales). Thus allocation on\nthe basis of gross income would assign an in-\nordinately large amount of R&D expense to the\nproduction of U.S. source income. Moreover,\nthe factual connection between R&D and gross\nincome is weak. The fruits of R&D show up,\nnot necessarily in gross income, but rather\nin actual and constructive royalties and\nroyalty-type income.\nIMPLEMENTATION:\nThis option could be implemented by reformulat-\ning the proposed regulation to adopt alloca-\ntion on the basis of gross income. However,\nthe draftsmen of the proposed regulation\nregard allocation of the basis of gross income\nas a highly inappropriate method, inconsistent\nwith the intent of the statute.\nAPPENDIX 2-B\nOPTION:\nAllocation should be on the basis of comparable\nitems of income.\nPRO:\nThis option would divide R&D expense between\ndomestic and foreign income on the basis of\nsimilar types of income flows. There would be\nno problem of mixing apples and oranges. The\nunderlying theory is that R&D expenses, a type\nof overhead cost, would be related to the kinds\nof income that they can reasonably be expected\nto produce. Moreover, if the corporation is\npermitted to elect between alternative methods\nof allocation, provided only that the alloca-\ntion formula involves similar types of income\nat home and abroad, it can select that method\nwhich best reflects its own experience.\nCON:\nThis option does not properly match allocated\nexpenses with related income. Rather, in most\ncases, R&D expenses will be allocated currently,\nwhile the income generated through such ex-\npenditures will not be realized, if at all,\nuntil the future. Moreover, this option\nexacerbates this mismatch by treating foreign\nsubsidiaries on a consolidated basis for expense\nallocation purposes, while at the same time\ntreating them on a separate basis for other pur-\nposes of the tax law.\nThis option does not recognize the value to\nthe United States of locating R&D facilities in\nthis country. The benefits of U.S. -based R&D\nextend beyond the income produced within the\ncorporate family. Accordingly, it is inappro-\npriate to allocate R&D expense strictly on the\nbasis of corporate income flows. Further, this\noption entails considerable accounting com-\nplexity, as suggested by the examples in the\nproposed regulations.\nIMPLEMENTATION:\nThis option is similar to the proposed regulation,\nexcept that it provides for the elective use of\nactual and constructive royalties as a basis for\nallocation.\nAPPENDIX 2-C\nOPTION:\nR&D expenses should be allocated only to\nitems of income which can reasonably be\nexpected to benefit from R&D expenditures.\nNo allocations would be made to dividend\nincome. All transfers would be taxable events.\nPRO:\nThis approach eliminates the difficult con-\nceptual problem of determining in which\ncases, and to what extent, R&D should be\nallocated to dividends from foreign sub-\nsidiaries. Since the foreign affiliate\nwill have purchased or obtained a license\nof the property at a fair market value,\nthe earnings produced by the foreign sub-\nsidiary are generated out of its own capital\nand assets for which it has paid value.\nThus, there is no conceptual need for re-\nquiring further allocations of R&D against\ndividends subsequently paid by the subsidiary.\nThis option is consistent with the United\nStates tax principles which provide for tax\ndeferral and for the separate identity of\nsubsidiaries. It is also consistent with\nthe broad scheme of transfers abroad of in-\ncome-producing property. Unlike the gross-\nto-gross method, it more finely tunes the\nallocation of R&D expenses to the appropriate\nincome without sacrificing that method's\nadministrative simplicity. At the same time\nit avoids the complexity and unrealistic\nformulas engendered by some of the other\napproaches. The double tax impact of the pro-\nposed regulations would be substantially mitigated.\nCON:\nThere can be problems of valuation of a patent,\nor know-how for recognition of gain on transfer.\nThis is a concept not now in use, some aspects\nof which would require additional analysis be-\nfore it could be made operative.\nIMPLEMENTION:\nIt is possible that all technology transfers\ncould be made taxable under the present authority\nof the Commissioner. However, since there would\nbe some question as to such authority, and since\ntaxpayers may object that this has not been\nexisting practice, it may be necessary to obtain\n- 2 -\na statutory amendment. Other aspects of\nthis approach may be accomplished under\nexisting law.\nAPPENDIX 3\nOPTION:\nWhile a current business expense deduction\nis allowed by the Code for R & D, should the\ntaxpayer have the option of capitalizing\nthe expense and amortizing it over time\nfor purposes of allocating it between U.S.\nand foreign source income?\nPRO:\nThis option is addressed to one of the major\nobjections to the proposed regulations - that\nR&D activities do not generate foreign source\nincome until after the findings have been ex-\nploited domestically and thus it is unfair to\nrequire an immediate allocation of the full\nR&D expenditure to foreign source income. By\npermitting R&D expenses to be capitalized and\nthen amortized over time, the allocation to\nforeign source income can be made to correspond\nmore closely to the actual generation of for-\neign source income by the R&D expenditure.\nForeign tax authorities may thus be encouraged\nto give proper recognition to the allocation.\nThis makes sound economic sense, although the\naccounting profession has recently held that\nR&D expenditures should be expensed rather\nthan capitalized for purposes of determining\nnet income. This opinion, however, does not\nextend to the allocation issue. Moreover,\nthe impact of allocation could be phased in\nslowly over time, since the amortized amount\nof 1977 R&D expense, for example, would be\na small portion of total 1977 R&D outlays.\nCON:\nThis option merely postpones the full effect\nof R&D allocation without resolving the under-\nlying questions of the proper method of allo-\ncation. It provides taxpayers with the best\nof both worlds: they could claim a current\ndeduction for R&D expense and yet capitalize\nR&D expense for purposes of allocation. More-\nover, the option would create administrative\ncomplexity for both taxpayers and the Treasury.\n- 2 -\nFor example, what time period would be allowed\nfor amortization? How should the amortized\nexpenditures be apportioned among the time\nperiods (straight line, industry experience,\nor some other basis) ?\nIMPLEMENTATION:\nThe option, if made elective by the taxpayer,\nmight be implemented by appropriate modifi-\ncation of the proposed regulations. However,\nthe Internal Revenue Service believes that\nstatutory language might be required to per-\nmit the use of a capitalization and amortiza-\ntion approach to allocation.\nAPPENDIX 4-A\nOPTION:\nThe allocation method should apply prospectively\nor should apply prospectively after a grace\nperiod.\nPRO:\nSince the final allocation regulations could\nrepresent a significant departure from present\npractices, they should apply prospectively in\norder to minimize any undue hardships on tax-\npayers and permit them time to accomodate their\nactivities and recordkeeping to the new require-\nments. Whether or not a grace period should\nalso be provided depends on the choice of\nmethod and the degree by which such method\ndiffers from existing practices.\nCON:\nThe final regulations are merely an amplifica-\ntion of the statute and previously enunciated\npolicy. They reflect the allocation of expenses\nwhich taxpayers should have been making in the\npast. Hence, making their application prospec-\ntive absolves those taxpayers who did not com-\nply in the past and unfairly prejudices those\ntaxpayers who have complied. Moreover, prospec-\ntive application of the regulation leaves un-\nresolved questions over the existing rule.\nIMPLEMENTATION:\nProspective effect to the allocation regulations\nmay be provided by regulation.\nAPPENDIX 4-B\nOPTION:\nThe allocation method should apply retro-\nactively.\nPRO:\nThe final regulations are merely an amplifica-\ntion of the statute and previously enunciated\npolicy. They reflect the allocation of expenses\nwhich taxpayers should have been making in the\npast. Hence, making their application retro-\nactive will treat all taxpayers equally.\nMoreover, retroactive application of the\nregulation will resolve questions over the\nexisting rule.\nCON:\nSince the final allocation regulations could\nrepresent a significant departure from present\npractices, they should not apply retroactively\nin order to minimize any undue hardships on\ntaxpayers and permit them time to accommodate\ntheir activities and recordkeeping to the new\nrequirements.\nIMPLEMENTATION.\nRetroactive effect to the allocation regulations\nmay be provided by regulation.\nAPPENDIX 5\nOPTION:\nShould the allocation method apply only in\nthose cases where foreign governments agree\nto permit deduction of the allocated expenses?\nPRO:\nForeign taxing jurisdictions will generally\nnot permit deduction for additional R&D\nexpenses incurred in the U.S. and allocated\nto foreign source income; nor will they\npermit the U.S. parent company to charge a\ngreater royalty to the foreign income-pro-\nducing entity. Accordingly, any increase\nin the R&D expense allocated to foreign\nsource income will reduce the amount of\nforeign tax that is creditable, and thus\nmay well generate excess and unutilized\nforeign tax credits resulting in a form of\ndouble taxation. In order to mitigate these\neffects, the allocation of R&D expenses should\nbe limited to cases where deduction is per-\nmitted by the foreign taxing jurisdiction.\nCON:\nThis option leaves the determination of United\nStates expense allocations to foreign taxing\njurisdictions, and since most foreign govern-\nments will not permit additional deductions,\nthe allocation rule would have little effect.\nMoreover, no effective means is provided by\nwhich to encourage foreign governments to\npermit deduction for the allocated expenses.\nFor example, there would be no incentive for\ntaxpayers to pressure foreign governments to\nchange their rules.\nIMPLEMENTATION:\nThis option will require new statutory language\nsince the present statute requires allocation\nin all cases.\nAPPENDIX 6\nOPTION:\nThe same allocation principles should be\napplied to U.S. branches and subsidiaries\nof foreign corporations.\nPRO:\nPermitting U.S. branches and subsidiaries to\nreimburse R&D expenses incurred abroad by\nforeign parent companies may encourage other\ncountries to be more willing to allow deductions\nfor R&D expenses incurred in the U.S. or may be\nused as a bargaining chip to negotiate recipro-\ncal treatment. Moreover, such a rule would\nrepresent a consistent application of the\nUnited States position on the allocation of\nexpenses to foreign income.\nCON:\nThis option raises serious questions of tax\npolicy. For example, how strong is the United\nStates policy which does not permit deduction\nof expenses unless they benefit the taxpayer\nand are made on an arm's length basis?\nThe answer will depend upon the final allo-\ncation rule that is adopted. Under usual\nUnited States concepts a branch might be\nentitled to a pro: rata allocation of expenses,\nwhile a subsidiary could not deduct expenses\nincurred by the parent unless it were entitled\nto the benefits of the research under an arms\nlength arrangement. Such a rule would also\ngive foreign companies a competitive advantage\nin those cases where they can deduct the\nallocated expense for United States tax pur-\nposes, are not required to allocate by the\nforeign country, and hence can also deduct the\nfull expense for foreign tax purposes.\nIMPLEMENTATION:\nThis option may require a statutory change\nor may be provided for by treaty.\nAPPENDIX 7\nOPTION:\nAny revised allocation regulations should be\nsubmitted in proposed form for further public\ncomment.\nPRO:\nThe magnitude and wide-ranging scope of the\nexpense allocation regulations may have a\nserious economic impact on United States tax-\npayers. Thus, to the extent any revised regu-\nlations are issued which differ materially from\nthose published in the past, taxpayers should be\nprovided an opportunity to comment and to present\ntheir problems in order to assure these regu-\nlations do not inadvertently create irreparable\nand unwarranted economic harm.\nCON:\nProposed allocation regulations have been\ncirculating for many years, and the basic issues\nraised by such allocation have been long known.\nAccordingly, taxpayers have had ample opportunity\nto make their comments and problems known. Fail-\nure to publish these regulations in final form\nmerely delays resolution of the basic problem --\nthe lack of clear guidance as to the appropriate\nmethod of allocating expenses.\nIMPLEMENTATION:\nNo statutory change is required. This is merely\nan administrative determination.\nAPPENDIX 8\nOPTION:\nPostpone any changes until more of the economic\nimpact of the change can be studied.\nPRO:\nSince we do not presently know the full economic\nimpact of either the present allocation method,\nthe method in the proposed regulations, or the\nmethod in any of the alternatives thereto; and\nsince that impact could be substantial, we should\nnot make any decisions until the economic impact\ncan be studied.\nCON:\nIn the first instance, the Treasury Department\nhas an obligation to issue regulations as\nguidance for taxpayers in applying the statute,\nwhether or not the economic consequences of\nthose regulations are known beforehand. More-\nover, in this case delay will not increase our\nknowledge. It will not be possible to estimate\nthe effects of any expense allocation regulations\nbefore they are implemented because taxpayers\ndo not keep their accounts in a manner which\npermits a determination of the amounts of\nR&D expense which would be allocated under\nvarying allocation methods. Even if such a\ndetermination could be made, no estimate of\nthe degree to which shift of R&D will occur is\npossible because such shifts are determined by\na variety of unquantifiable and unpredictable\nfactors such as the action of foreign governments\nor the substitutability of research personnel.\nIMPLEMENTATION:\nThis option may be accomplished administratively.\nAPPENDIX 9\nRevenue Estimate\nApportionment of Research and Development Expenditures\nBetween United States and Foreign Source Income\nIt is estimated that the apportionment of research and\ndevelopment (R&D) expenses for the year 1974 on the basis\nof the proposed regulations would have reduced the allowable\nforeign tax credit and therefore would have increased U.S.\nTreasury tax revenues by between $1.1 and $1.5 billion.\nThe estimate was derived as follows.\nResearch and Development Expenditures\nIn 1974, U.S. industry spent about $13.9 billion of\nprivate funds for research and development. 1/ According\nto the National Science Foundation, large companies, i.e.,\nthose with 10,000 or more employees, account for about 83\npercent of the R&D expenditures. 2/ The large companies\ndominate U.S. investment abroad. Therefore, 83 percent of\nthe $13.9 billion, or about $11.5 billion in 1974 R&D\nexpenditures, is assumed to be affected by the proposed\nallocation to foreign source income.\nSales: Worldwide and Domestic\nAccording to Fortune, consolidated sales of large\ncorporations, i.e., those with 10,000 or more employees,\ntotalled about $800 billion in 1974. 3/ This figure needs\nto be apportioned between domestic and foreign sales.\n1/ U.S. Department of Commerce, Bureau of the Census,\nStatistical Abstract, 1975, p. 548.\n2/ U.S. National Science Foundation, Research and Development\nin Industry 1970, p. 11.\n3/ \"Fortune Directory of the 500 Largest Industrial Corporations,\"\nFortune, May 1975, pp. 208-235. This is the sales figure\nfor the top 400 corporations since they are the ones with\n10,000 or more employees.\n- 2 -\nThe 1966 and 1970 special surveys of 298 large U.S.\nmultinational companies (MNCs) by the Bureau of Economic\nAnalysis provide data for such an apportionment. The 298\nMNCs in the survey consist of 298 U.S. reporters (the U.S.\nparents of the MNCs) and their 5,237 majority-owned foreign\naffiliates. Using these data, a recent article estimated\nMNC consolidated worldwide sales, defined as: (1) sales by\nthe U.S. reporter to unaffiliated U.S. and foreign residents;\nplus (2) sales by its majority-owned foreign affiliates to\nunaffiliated U.S. residents and to unaffiliated foreign\nresidents other than sales to minority-owned foreign\naffiliates of the MNC. 4/ The 1966 and 1970 estimates are:\nAll Industries\n1966\n1970\nWorldwide Consolidated Sales\n100.0%\n100.0%\nSales to U.S. residents\nas percent of total\n78.5\n74.7\nSales to foreigners as\npercent of total\n21.5\n25.3\nSince sales to foreigners grew faster than sales to U.S.\nresidents, the 1974 percentages were estimated using simple\nextrapolation as:\nAll Industries\n1974\nWorldwide Consolidated Sales\n100.0\nSales to U.S. residents as\npercent of total\n70.2\nSales to foreigners as\npercent of total\n29.8\nThus, it is estimated that the $800 billion in 1974\nsales of large corporations was comprised of $562 billion\n($800 X 702) in domestic sales and $238 billion ($800 X .298)\n4/ Leonard A. Lupo, \"Worldwide Sales by U.S. Multinational\nCompanies, \" Survey of Current Business, January 1973,\npp. 33-39.\n- 3 -\nin foreign sales.\nAllocable R&D Expenditures\nAssuming the apportionment of R&D expenditures on a\nsales basis was chosen on the basis of the proposed regu-\nlations, the apportionment of the $11.5 billion would be as\nfollows:\nR&D X\nForeign Sales\n=\nR&D Allocation to Foreign\nWorldwide Sales Source Income\n(billions)\n$11. 5 X\n$238\n=\n$3.4 billion\n$800\nOn this basis about $3.4 billion in R&D expenditures would\nbe apportioned to foreign source income.\nAs extreme assumptions, suppose that: (a) presently\nno R&D expense is apportioned to foreign source income;\n(b) all affected companies pay foreign taxes in an amount\nequal to the U.S. foreign tax credit limit. Then the\nchange in the U.S. foreign tax credit limit represents\nthe additional tax liability to the U.S. Treasury. The\nchange in the foreign tax credit limit is given by:\nU.S. tax\nForeign source income - Apportioned R&D expense\nWorldwide income\nX\nbefore\ncredits\n-\nForeign source income\nU.S. tax\nChange in\nX\n=\nWorldwide income\nbefore credits\nforeign tax\ncredit limit\nTax Credit Reduction\nThis apportionment would reduce the limit on the foreign\ntax credit, and thereby provide the U.S. Treasury with a\nrevenue gain. The foreign tax credit is limited to U.S. tax\nliability on worldwide income times a fraction, the numerator\nof which is taxable income from sources outside the U.S. and\nthe denominator of which is total worldwide income.\n- 4 -\nThis may be rewritten as:\nU.S. tax before credits\n-\nX Apportioned R&D expense\nWorldwide income\n= Change in foreign tax credit limit\nOr: 5/\n- .44 X $3.4 billion = - $1.5 billion.\nThe figure of $1.5 billion for 1974 represents an upper\nestimate of the loss in foreign tax credits and the gain\nin Treasury revenues.\nAlternative Method\nA somewhat lower estimate of $1.1 billion can be derived\nfrom the results of a survey of 75 corporations having foreign\noperations who are included in the Fortune listing of the\ntop 150 U.S. industrial corporations. The survey, conducted\nby five of the major accounting firms, obtained adequate\ninformation from 41 of the 75 corporations.\nIt was estimated that these corporations spent $2.88\nbillion on research and development and that the proposed\nregulation would reduce their allowable foreign tax credit\nby $283 million. If the 400 large corporations which spent\n$11.5 billion in private funds on R&D in 1974 experienced\na similar reduction in their allowable foreign tax credits,\nthe total reduction would be:\n- $11.5\n2.88 X $283 = -$1.1 billion\nThis figure is lower than the estimate based on\naggregate data because that estimate made no allowance\nfor the present apportionment of R&D expense to foreign\nsource income, nor did it reflect the fact that the foreign\n5/ The factor of 44 is based on data contained in\nStatistical Abstract, 1975, P. 499.\n- 5 -\ntaxes paid by some companies are less than the U.S. foreign\ntax credit limit.\nEven the alternative estimate of $1.1 billion may be.\nexaggerated because some firms may now classify doubtful\nitems in the R&D expenditure account in order to produce\na large number for public relations purposes. However, if\nfirms are required to allocate R&D expenses to foreign source\nincome, some of the doubtful items presently classified as\nR&D may be placed elsewhere in the business accounts. More-\nover, firms may be able to establish that much R&D is \"clearly\nrelated\" to the U.S. market; for example, testing to obtain\nU.S. approval of a new drug. This characterization would reduce\nthe allocation of R&D expense to foreign source income and there-\nfore reduce the gain in U.S. Treasury revenues.\nAPPENDIX 10\nDecember 12, 1975\nEXAMPLE\nThe following example is illustrative of the\nproblem.\nA United States company X, manufactures and\nsells toasters in the United States, and two wholly\nowned foreign subsidiaries of X, A and B, manufacture\nand sell toasters abroad. All toaster research and\ndevelopment is carried on by X in the United States.\nThis research produces results which are commercially\napplicable throughout the world. X transfers patents\ndeveloped through its R & D to A as a tax-free con-\ntribution of capital and licenses specific patents\nand know-how on successful research to B for an\nannual royalty of five percent of B's gross income.\nExcept for the royalty charges there is no reimburse-\nment for the research undertaken in the United States.\nFor 1975, the following additional facts apply:\nX\nA\nB\nGross income from\n$1850\n$1000\n$1000\nmanufacturing\nRoyalty income from B\n50\n--\n--\nDividend from A\n100\n--\n-\nTOTAL GROSS INCOME\n2000\n1000\n1000\nR & D expenses\n(200)\n--\n---\nOther expenses\n(800)\n(500)\n(500)\nTaxable income\n1000\n500\n500\nTax at 50%\n(500)\n(250)\n(250)\nNET INCOME\n$ 500\n$ 250\n$ 250\nNUMBER OF TOASTERS\nPRODUCED\n100\n50\n50\n- 2 -\nBased on these facts, and applying three alternative\nmethods of allocating X's research and development expenses\nto foreign source income, X's foreign tax credit would be\nas follows:\nAllocation\nAllocation\nof R & D on\nbased on the\nthe basis of\nratio of toasters\nthe ratio of\nproduced abroad\nforeign source\nto total world-\nNo alloca-\ngross income\nwide toaster\ntion of\nto total gross\nproduction\nR & D\nincome\nCreditable\nforeign\ntaxes 1/\n$ 50\n$ 50\n$ 50\nR & D\nexpenses\nallocated\nto foreign\nsource income\nNone\n15 2/\n100³/\nU.S. foreign\ntax credit\nlimitation 4/\n75\n67.50\n25\nExcess foreign\ntax credits\nNone\nNone\n25\nAs illustrated through this example, both under the\nno allocation and gross income allocation approaches, virtually\nall of the research and development expense is deducted\nagainst United States source income and U.S. taxes on that\nincome are correspondingly reduced. Moreover, dividends paid\nto the parent company incur no additional U.S. tax because\nof the foreign tax credit.\nFor footnotes see page 4,\n- 3 -\nHowever, if significant allocations of research\nand expense are made, the dividend income from the\nforeign subsidiaries would be substantially reduced\nand excess foreign tax credits would be generated.\nIndeed, a full allocation of research costs on the\nbasis of worldwide sales would mean that the sub-\nsidiaries are not earning the profits claimed by\nthem and foreign taxes would be reduced or even\neliminated. Foreign governments would thus resist\nclaims to reimburse the parent.\n- 4 -\nFootnotes:\n1/ The only creditable foreign taxes available to X\nare those deemed paid by X with respect to the\ndividend from A. The formula is: dividend X taxes paid\nA 'saccu- by A\nmulated\nprofits\nfor the\nyear\nThus,\n100\nX 250 = $50.\n500\n2/ The formula is foreign source gross income X R & D\ntotal gross income\nexpense\nThus, 150 X 200 = $15.\n2000\n3/ The formula is foreign toaster production X R &\nD\nworldwide toaster produc-\nexpense\ntion\nThus, 100\n200\nX 200 = $100.\n4/ Assuming that X elects the overall credit limitation,\nthe formula is foreign source taxable\nincome\nX U. S. tax\ntotal taxable income\nliability\nThus, with no allocation this is: 150 X 500 = $75.\n1000\nwith gross to gross alloca-\ntion:\n(150-15) X 500 = $ 67.50\n1000\nand with units of production\nallocation:\n(150-100) x500 = $ 25.\n1000\nAPPENDIX 11\nHistorical Note on Allocation/Deduction Regulations\nThe existing allocation regulations under section 861\nwere proposed in 1956 and adopted in 1957. They give\nminimal guidance to taxpayers and to revenue agents as\nto the handling of various types of expenses. Somewhat\nmore detailed regulations were proposed on August 2, 1966.\nThese proposed regulations were withdrawn with the issuance\nof new proposed regulations in April, 1973."
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