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The original documents are located in Box 54, folder "1975/12/22 - Economic Policy Board"
of the James M. Cannon Files at the Gerald R. Ford Presidential Library.
Copyright Notice
The copyright law of the United States (Title 17, United States Code) governs the making of
photocopies or other reproductions of copyrighted material. Gerald Ford donated to the United
States of America his copyrights in all of his unpublished writings in National Archives collections.
Works prepared by U.S. Government employees as part of their official duties are in the public
domain. The copyrights to materials written by other individuals or organizations are presumed to
remain with them. If you think any of the information displayed in the PDF is subject to a valid
copyright claim, please contact the Gerald R. Ford Presidential Library.
Digitized from Box 54 of the James M. Cannon Files at the Gerald R. Ford Presidential Library
ECONOMIC POLICY BOARD MEETING
Monday, December 22, 1975
The Roosevelt Room
8:30 a.m.
December 19, 1975
ECONOMIC POLICY BOARD
EXECUTIVE COMMITTEE
Proposed Agenda
Monday, December 22, 1975
1. 1976 Collective Bargaining Negotiations
CWPS
2. Status of State of the Union Preparation
Seidman
Tuesday, December 23, 1975
1. Report of Task Force on Tax Policy and In-
Jones
ternational Investment
Wednesday, December 24, 1975
No Executive Committee Meeting
Thursday, December 25, 1975
No Executive Committee Meeting
Friday, December 26, 1975
No Executive Committee Meeting
Saturday, December 20, 1975
Special Session on Economic Forecast for 1977 Budget
Roosevelt Room 9:00 a.m.
Principals Only
OF
THE
TREASURY THE
DEPARTMENT OF THE TREASURY
WASHINGTON, D.C. 20220
1789
ASSISTANT SECRETARY
December 19, 1975
MEMORANDUM FOR EXECUTIVE COMMITTEE, ECONOMIC POLICY BOARD
FROM:
Sidney Lones
Subject:
Preliminary Report of EPB Task Force on Tax
Policy and International Investment on the
Allocation of Research and Development Expenses
Between United States and Foreign Source Income.
Attached is the Task Force report which:
1. Summarizes the background of the problem;
2. Identifies 8 issues to be resolved;
3. Presents arguments associated with the various options
under each issue; and
4. Presents revenue estimates and examples of the specific
problems.
Attachment
December 22, 1975
ALLOCATION OF RESEARCH AND DEVELOPMENT EXPENSE
BETWEEN UNITED STATES AND FOREIGN SOURCE INCOME
The Internal Revenue Code has provided since the
1920's that all current deductions must be allocated
to domestic or foreign source income unless they can-
not definitely be related thereto, in which case they
must be allocated between domestic and foreign source
income on a ratable basis.
The Treasury has a responsibility to issue regula-
tions that clarify and explain existing statutory law.
Several years ago, following taxpayer concern that agents
lacked guidelines for allocating expenses, the Treasury
Department prepared more detailed allocation regulations
which were issued in proposed form in April 1973. This
Fall, IRS agents were instructed by the Internal Revenue
Service not to cite or apply the proposed regulations.
The most controversial aspects of these proposed regula-
tions concern the allocation of current research and
development expenses.
The Internal Revenue Code, since 1954, has permitted
a United States business to elect either to claim a current
business deduction for research and development expenses
or to capitalize and amortize such expenses. The current
business deduction alternative was legislated in part to
provide an incentive for research and development ex-
penditures.
Patents and other forms of technology developed by
a United States company may be used in foreign branch
operations (which is relatively uncommon), sold or.
licensed to an unrelated third party, or transferred
to a foreign affiliate. Under current U.S. tax law, a
transfer to an affiliate may take the form of (i) a
sale for payment at fair market value, (ii) a royalty
license for an arm's length royalty, or (iii) a tax-free
transfer to a subsidiary where the property is to be used
in manufacturing operations by the subsidiary.
- 2 -
The proposed Treasury regulations require allocation
of current research and development expenses against royal-
ties from licensees and dividends from subsidiaries where
the research gives rise or "can reasonably be expected"
to give rise to foreign source income, for example, divi-
dends from subsidiaries that have received tax-free trans-
fers of technology in the past.
It should be stressed that deductions for research
and development are allowed by the United States in all
cases. The issue here is the extent to which these de-
ductions should be allocated to foreign as opposed to
domestic source income for such purposes as calculating
the foreign tax credit.
The United States credit for foreign income taxes
imposed on foreign source income is limited by law to the
amount of United States tax imposed on foreign source
income. If deductions are not allocated to foreign source
income, then those deductions reduce only United States
tax on United States source income. Meanwhile, United
States tax on the foreign source income could be fully
offset by foreign income tax. The long-term effect is
that foreign countries may be able to increase their tax
revenues at the expense of the United States Treasury.
Depending on foreign laws, this principle can of course
also apply to technology transfers to the United States.
At the present time royalties paid to the United States
are approximately ten times those paid from the United
States.
If deductions are allocated to foreign source income
by the United States, but not recognized by the foreign
country when it imposes its tax, the immediate result is
a higher effective worldwide tax rate, with the taxpayer
in the middle.
Under the proposed regulations, items of expense which
can clearly be determined to relate to either domestic or
foreign source income are allocated on that basis. Where
- 3 -
expenses are not clearly related to either domestic or
foreign source income, they are to be allocated between
the two sources on some comparable basis. For example,
research and development expenses may be allocated between
domestic sales income of the parent and dividends it receives
from a foreign subsidiary on the basis of the number of units
sold by the parent and by the foreign subsidiary or on the
basis of gross receipts of the parent and the subsidiary.
A few companies, for example, firms in the automobile
industry, have historically instituted cost sharing agree-
ments with their foreign affiliates and are reimbursed for
portions of domestic research and development expense.
These industries believe that they have little problem
with the proposed regulations. The feasibility of such
arrangements may be affected by specific characteristics
of a particular industry, such as the comparability of
products sold at home and abroad. A number of other com-
panies have not had such agreements and have not allocated
any research and development expense to foreign source in-
come on the theory that it was basically incurred for
domestic use. Others have allocated varying amounts with-
out uniform guidance. The proposed regulations have the
greatest impact on high technology industries with large
research budgets, extensive foreign source income, and
foreign taxes equal to the foreign tax credit limit.
If applied in 1974 and assuming foreign countries do
not permit increases in allowable deductions, the proposed
regulations could result in the loss of $1.1 - $1.5 billion
in foreign tax credits and a corresponding increase in the
U.S. tax burden (Appendix 9). This burden would fall on
high technology industries. Some firms have suggested that
increased allocations and the attendant U.S. tax burden
would force them to perform less research and, over time,
to move research to their foreign subsidiaries, since that
would assure full deductions abroad. It is exceedingly
difficult to estimate the number of research jobs that
would be shifted abroad. However, in connection with the
tax impact and the shift of research to foreign countries,
the following points should be noted:
- 4 -
- The main goal of the proposed allocation regulations
is to clarify and explain existing statutory law. The pro-
posed regulations do have a revenue raising impact, but
this is not their main goal.
- During the past two decades, some multinational
firms have already devoted larger portions of their research
budgets to research in Canada, Western Europe, and Japan.
This change has been induced by the availability of skilled
foreign scientists, the advantages of proximity to foreign
markets, and by local tax and subsidy measures designed to
encourage R&D activity.
- The interaction of United States withholding taxes
on royalties paid abroad and foreign withholding taxes on
dividends paid to the United States may in certain cases
make shifts of research abroad undesirable.
The major issues are set forth below in the order
appropriate for resolution. Pro and con arguments, and
methods of implementation, are given in the appendices.
Implementation of major policy decisions in this area may
require new legislation to achieve desired results.
- 5 -
ISSUES TO BE RESOLVED
1. How should R&D deductions be allocated?
OPTIONS:
A. R&D expenses should be allocated entirely to
U.S. source income (Appendix 1-A).
B. Only "clearly related" R&D expenses should be
allocated to foreign source income. An example
of clearly related R&D expense would be the
development of a specific process undertaken
at the request of a foreign affiliate. All
other R&D expenses should be allocated to
United States source income (Appendix 1-B).
C. "Clearly related" R&D expenses should be
allocated to domestic or foreign source
income. All R&D that is not clearly related
to either domestic or foreign source income
should be allocated between United States
income and foreign source income on some
reasonable basis (Appendix 1-c).
D. The proposed regulations should be withdrawn,
with no new regulatory or legislative guid-
ance for Internal Revenue Service agents or
taxpayers (Appendix 1-D).
RECOMMENDATION:
2. If R&D is to be allocated between domestic and foreign
source income under Option 1-c, how should this be done?
OPTIONS:
A. On the basis of gross income from foreign and domestic
sources (Appendix 2-A).
- 6 -
B. on the basis of comparable items of income,
e.g., at the election of the taxpayer com-
parison of foreign and domestic: (1) sales,
(2) net income, (3) number of units sold;
or (4) actual and constructive royalties
(Appendix 2-B).
C. R&D expenses should be allocated only to
items of income which can reasonably be
expected to benefit from R&D expenditures.
No allocations would be made to dividend
income since all transfers of technology to
foreign affiliates would be an arm's length
license or sale and would be treated as tax-
able events (Appendix 2-c).
RECOMMENDATION:
3. While a current business deduction is allowed by
the Code for R&D, should the taxpayer have the option of
capitalizing the expense and amortizing it over time for
purposes of allocating it between U.S. and foreign source
income? (Appendix 3).
RECOMMENDATION:
4. When should major changes in allocation methods be
implemented?
OPTIONS:
A. The allocation method should apply prospectively
(Appendix 4-A).
B. The allocation method should apply prospectively
after a grace period (Appendix 4-A).
- 7 -
C. The allocation method should be retroactive
(Appendix 4-B).
RECOMMENDATION:
5. Should the allocation method apply only in those cases
where foreign governments agree to permit deduction of the
allocated expenses? (Appendix 5)
RECOMMENDATION:
6. Should the same principles be applied to United States
branches and subsidiaries of foreign corporations, thus per-
mitting United States branches and subsidiaries a deduction
for a proportionate share of research expenses incurred by
foreign home offices or parent companies? (Appendix 6)
RECOMMENDATION:
7. Should any revised allocation regulations be submitted
in proposed form for further public comment prior to being
issued in final form? (Appendix 7)
RECOMMENDATION:
8. Should any change in the allocation method be postponed
until more of the economic effects of the change can be
studied, including the effects on transfers abroad or possible
reduction in R&D? (Appendix 8) .
RECOMMENDATION:
APPENDIX 1-A
OPTION:
R&D expenses should be allocated entirely to
U.S. source income.
PRO:
Since some allocation is presently
required, this option would provide a
clear United States tax incentive for U.S.- -
based multinational firms to conduct their
R&D activities in the United States. There
would be no reduction of the foreign tax
credit, even though the research results
were used abroad. This option acknowledges
that R&D activities principally benefit the
country of location, directly and through
spillover effects, and it is least likely
to encourage a shift of R&D abroad. Since
this option requires no allocation it re-
duces potential double taxation.
CON:
This option makes no attempt to allocate
R&D expenses in a manner which reasonably
reflects the economic benefits conferred
through such R&D. Rather, this option
enables foreign countries to raise their
effective tax rates at the expense of the
United States Treasury. That is, the total
allocation of R&D expenses against United
States income would result in a transfer of
tax revenues from the United States to foreign
treasuries. All R&D expenses would be re-
flected in lower U.S. taxes on U.S. source
income. Foreign countries need recognize
no expenses associated with the development
of know-how. The net result is that foreign
taxes could be aggressively raised at the
expense of the U.S. Treasury.
IMPLEMENTION:
This option would require new statutory
language. The present statute requires that
all current deductions, including R&D, be
allocated between domestic and foreign source
income. An exception to the statute would be
needed for R&D expenses.
APPENDIX 1-B
OPTION:
Only "clearly related" R&D expenses should
be allocated to foreign source income. All
other R&D expenses would be allocated to U.S.
source income.
PRO:
This option ensures that at least the expense
of R&D performed in the United States at the
request of a foreign affiliate or unrelated
firm would be charged against the income re-
ceived by the U.S. company from that firm.
This seems reasonable, since otherwise the
tax claims of the foreign government could
prevent the United States from recouping the
lost tax revenue attributable to the R&D
deduction. This option presumes that R&D
expenses which are not "clearly related" to
foreign source income should be allocated to
U.S. source income. This treatment recognizes
that R&D conducted in the United States
principally benefits industry located here.
This option would cause less of a "double
tax" burden and would be less of an induce-
ment for the transfer of R&D activities
abroad than the proposed regulations.
CON:
Only a small portion of total R&D expenses
are "clearly related" to foreign source income.
thus, the bulk of R&D results would be made
available to foreign countries with no foreign
tax recognition given to the underlying expense.
Foreign countries would be able to raise their
effective tax rates at the expense of the
United States Treasury.
IMPLEMENTATION:
This option would require new statutory
language. In the Treasury's view, the present
statute requires that deductions which are not
definitely related to foreign or U.S. source
income be ratably allocated between the two.
APPENDIX 1-c
OPTION:
All R&D that cannot be clearly allocated to
either domestic or foreign source income
should be allocated between United States
income and foreign source income on some
reasonable basis.
PRO:
This option provides for a reasonable
allocation of R&D costs between domestic
and foreign source income. Foreign tax
authorities are thereby encouraged to give
proper tax recognition to the expenses
associated with royalty income. The U.S.
taxpayer is not asked to bear the entire bur-
den of R&D expenses, when many of the findings
are used abroad.
CON:
This option immediately raises the problem
of defining a "reasonable" basis of alloca-
tion and therefore may give rise to sub-
stantial disputes and litigation over what-
ever definition is chosen. Other questions
this option raises include: Should a mar-
ginal cost or a full cost approach be used?;
should R&D be capitalized and amortized for
purposes of allocation, or deducted currently?;
what about R&D expense that produces no findings?;
and so forth. Should the same method of appor-
tionment be applied to income from a foreign
branch, to royalties from related and unrelated
foreign licensees, and to dividends from
foreign subsidiaries to whom technology has
been or may be transferred? Any allocation
formula is inherently arbitrary and may not
meet the circumstances of particular firms.
Worse, the chosen formula may attribute too
much R&D expense to foreign source income, and
thereby encourage R&D activities to leave the
United States.
IMPLEMENTATION:
This option can be implemented by the proposed
regulations or any modification of the pro-
posed regulations which provides for a reason-
able allocation of R&D expense between domestic
and foreign source income.
APPENDIX 1-D
OPTION:
The proposed regulations should be withdrawn,
with no new regulatory or legislative
guidance.
PRO:
The statute has been on the books for many
years. During this time, United States cor-
porations have worked out their own systems
for allocating R&D expense between domestic
and foreign income. Any general rule will
do violence to the circumstances of particular
companies, and would invite extensive litiga-
tion.
CON:
The existing law is arbitrarily applied from
company to company, depending on historical
accident, and past and present audits. The
IRS agents have no clear guidance, and thus
allocation methods for a particular firm may
change with a change in agents. This is an
entirely unsatisfactory arrangement from the
standpoint of tax administration. Firms are
entitled to greater certainty and uniformity
in the tax treatment of a major expense. The
Treasury has an obligation to clarify statutory
law. In the absence of regulations, Congress
may act in a manner unfavorable to corpora-
tions with large R&D expense.
IMPLEMENTATION:
The implementation will require withdrawal
of the presently proposed regulations.
APPENDIX 2-A
OPTION:
Allocation should be on the basis of gross
income from foreign and domestic sources.
PRO:
Allocation on the basis of gross income has
long been used by taxpayers and recognized
by the courts as an acceptable method. It
is a simple and relatively easy method to
apply. Many firms insist that they will
successfully challenge in the courts any
allocation method other than on the basis of
gross income. The gross income method has
the characteristic of assigning the bulk of
R&D expense to U.S. source income since
gross income from foreign sources is usually
"net" types of income (dividends, interest,
and royalties), while gross income from
domestic sources is usually "gross" types
of income (business receipts). Accordingly,
this method will have less of an impact on
the level and location of R&D activity than
the proposed regulations.
CON:
Allocation on the basis of gross income mixes
apples and oranges. Foreign and domestic
gross income are entirely different in type:
Foreign gross income is essentially net
profit (i.e. dividends, interest, royalties),
while domestic gross income is essentially
gross receipts (sales). Thus allocation on
the basis of gross income would assign an in-
ordinately large amount of R&D expense to the
production of U.S. source income. Moreover,
the factual connection between R&D and gross
income is weak. The fruits of R&D show up,
not necessarily in gross income, but rather
in actual and constructive royalties and
royalty-type income.
IMPLEMENTATION:
This option could be implemented by reformulat-
ing the proposed regulation to adopt alloca-
tion on the basis of gross income. However,
the draftsmen of the proposed regulation
regard allocation of the basis of gross income
as a highly inappropriate method, inconsistent
with the intent of the statute.
APPENDIX 2-B
OPTION:
Allocation should be on the basis of comparable
items of income.
PRO:
This option would divide R&D expense between
domestic and foreign income on the basis of
similar types of income flows. There would be
no problem of mixing apples and oranges. The
underlying theory is that R&D expenses, a type
of overhead cost, would be related to the kinds
of income that they can reasonably be expected
to produce. Moreover, if the corporation is
permitted to elect between alternative methods
of allocation, provided only that the alloca-
tion formula involves similar types of income
at home and abroad, it can select that method
which best reflects its own experience.
CON:
This option does not properly match allocated
expenses with related income. Rather, in most
cases, R&D expenses will be allocated currently,
while the income generated through such ex-
penditures will not be realized, if at all,
until the future. Moreover, this option
exacerbates this mismatch by treating foreign
subsidiaries on a consolidated basis for expense
allocation purposes, while at the same time
treating them on a separate basis for other pur-
poses of the tax law.
This option does not recognize the value to
the United States of locating R&D facilities in
this country. The benefits of U.S. -based R&D
extend beyond the income produced within the
corporate family. Accordingly, it is inappro-
priate to allocate R&D expense strictly on the
basis of corporate income flows. Further, this
option entails considerable accounting com-
plexity, as suggested by the examples in the
proposed regulations.
IMPLEMENTATION:
This option is similar to the proposed regulation,
except that it provides for the elective use of
actual and constructive royalties as a basis for
allocation.
APPENDIX 2-C
OPTION:
R&D expenses should be allocated only to
items of income which can reasonably be
expected to benefit from R&D expenditures.
No allocations would be made to dividend
income. All transfers would be taxable events.
PRO:
This approach eliminates the difficult con-
ceptual problem of determining in which
cases, and to what extent, R&D should be
allocated to dividends from foreign sub-
sidiaries. Since the foreign affiliate
will have purchased or obtained a license
of the property at a fair market value,
the earnings produced by the foreign sub-
sidiary are generated out of its own capital
and assets for which it has paid value.
Thus, there is no conceptual need for re-
quiring further allocations of R&D against
dividends subsequently paid by the subsidiary.
This option is consistent with the United
States tax principles which provide for tax
deferral and for the separate identity of
subsidiaries. It is also consistent with
the broad scheme of transfers abroad of in-
come-producing property. Unlike the gross-
to-gross method, it more finely tunes the
allocation of R&D expenses to the appropriate
income without sacrificing that method's
administrative simplicity. At the same time
it avoids the complexity and unrealistic
formulas engendered by some of the other
approaches. The double tax impact of the pro-
posed regulations would be substantially mitigated.
CON:
There can be problems of valuation of a patent,
or know-how for recognition of gain on transfer.
This is a concept not now in use, some aspects
of which would require additional analysis be-
fore it could be made operative.
IMPLEMENTION:
It is possible that all technology transfers
could be made taxable under the present authority
of the Commissioner. However, since there would
be some question as to such authority, and since
taxpayers may object that this has not been
existing practice, it may be necessary to obtain
- 2 -
a statutory amendment. Other aspects of
this approach may be accomplished under
existing law.
APPENDIX 3
OPTION:
While a current business expense deduction
is allowed by the Code for R & D, should the
taxpayer have the option of capitalizing
the expense and amortizing it over time
for purposes of allocating it between U.S.
and foreign source income?
PRO:
This option is addressed to one of the major
objections to the proposed regulations - that
R&D activities do not generate foreign source
income until after the findings have been ex-
ploited domestically and thus it is unfair to
require an immediate allocation of the full
R&D expenditure to foreign source income. By
permitting R&D expenses to be capitalized and
then amortized over time, the allocation to
foreign source income can be made to correspond
more closely to the actual generation of for-
eign source income by the R&D expenditure.
Foreign tax authorities may thus be encouraged
to give proper recognition to the allocation.
This makes sound economic sense, although the
accounting profession has recently held that
R&D expenditures should be expensed rather
than capitalized for purposes of determining
net income. This opinion, however, does not
extend to the allocation issue. Moreover,
the impact of allocation could be phased in
slowly over time, since the amortized amount
of 1977 R&D expense, for example, would be
a small portion of total 1977 R&D outlays.
CON:
This option merely postpones the full effect
of R&D allocation without resolving the under-
lying questions of the proper method of allo-
cation. It provides taxpayers with the best
of both worlds: they could claim a current
deduction for R&D expense and yet capitalize
R&D expense for purposes of allocation. More-
over, the option would create administrative
complexity for both taxpayers and the Treasury.
- 2 -
For example, what time period would be allowed
for amortization? How should the amortized
expenditures be apportioned among the time
periods (straight line, industry experience,
or some other basis) ?
IMPLEMENTATION:
The option, if made elective by the taxpayer,
might be implemented by appropriate modifi-
cation of the proposed regulations. However,
the Internal Revenue Service believes that
statutory language might be required to per-
mit the use of a capitalization and amortiza-
tion approach to allocation.
APPENDIX 4-A
OPTION:
The allocation method should apply prospectively
or should apply prospectively after a grace
period.
PRO:
Since the final allocation regulations could
represent a significant departure from present
practices, they should apply prospectively in
order to minimize any undue hardships on tax-
payers and permit them time to accomodate their
activities and recordkeeping to the new require-
ments. Whether or not a grace period should
also be provided depends on the choice of
method and the degree by which such method
differs from existing practices.
CON:
The final regulations are merely an amplifica-
tion of the statute and previously enunciated
policy. They reflect the allocation of expenses
which taxpayers should have been making in the
past. Hence, making their application prospec-
tive absolves those taxpayers who did not com-
ply in the past and unfairly prejudices those
taxpayers who have complied. Moreover, prospec-
tive application of the regulation leaves un-
resolved questions over the existing rule.
IMPLEMENTATION:
Prospective effect to the allocation regulations
may be provided by regulation.
APPENDIX 4-B
OPTION:
The allocation method should apply retro-
actively.
PRO:
The final regulations are merely an amplifica-
tion of the statute and previously enunciated
policy. They reflect the allocation of expenses
which taxpayers should have been making in the
past. Hence, making their application retro-
active will treat all taxpayers equally.
Moreover, retroactive application of the
regulation will resolve questions over the
existing rule.
CON:
Since the final allocation regulations could
represent a significant departure from present
practices, they should not apply retroactively
in order to minimize any undue hardships on
taxpayers and permit them time to accommodate
their activities and recordkeeping to the new
requirements.
IMPLEMENTATION.
Retroactive effect to the allocation regulations
may be provided by regulation.
APPENDIX 5
OPTION:
Should the allocation method apply only in
those cases where foreign governments agree
to permit deduction of the allocated expenses?
PRO:
Foreign taxing jurisdictions will generally
not permit deduction for additional R&D
expenses incurred in the U.S. and allocated
to foreign source income; nor will they
permit the U.S. parent company to charge a
greater royalty to the foreign income-pro-
ducing entity. Accordingly, any increase
in the R&D expense allocated to foreign
source income will reduce the amount of
foreign tax that is creditable, and thus
may well generate excess and unutilized
foreign tax credits resulting in a form of
double taxation. In order to mitigate these
effects, the allocation of R&D expenses should
be limited to cases where deduction is per-
mitted by the foreign taxing jurisdiction.
CON:
This option leaves the determination of United
States expense allocations to foreign taxing
jurisdictions, and since most foreign govern-
ments will not permit additional deductions,
the allocation rule would have little effect.
Moreover, no effective means is provided by
which to encourage foreign governments to
permit deduction for the allocated expenses.
For example, there would be no incentive for
taxpayers to pressure foreign governments to
change their rules.
IMPLEMENTATION:
This option will require new statutory language
since the present statute requires allocation
in all cases.
APPENDIX 6
OPTION:
The same allocation principles should be
applied to U.S. branches and subsidiaries
of foreign corporations.
PRO:
Permitting U.S. branches and subsidiaries to
reimburse R&D expenses incurred abroad by
foreign parent companies may encourage other
countries to be more willing to allow deductions
for R&D expenses incurred in the U.S. or may be
used as a bargaining chip to negotiate recipro-
cal treatment. Moreover, such a rule would
represent a consistent application of the
United States position on the allocation of
expenses to foreign income.
CON:
This option raises serious questions of tax
policy. For example, how strong is the United
States policy which does not permit deduction
of expenses unless they benefit the taxpayer
and are made on an arm's length basis?
The answer will depend upon the final allo-
cation rule that is adopted. Under usual
United States concepts a branch might be
entitled to a pro: rata allocation of expenses,
while a subsidiary could not deduct expenses
incurred by the parent unless it were entitled
to the benefits of the research under an arms
length arrangement. Such a rule would also
give foreign companies a competitive advantage
in those cases where they can deduct the
allocated expense for United States tax pur-
poses, are not required to allocate by the
foreign country, and hence can also deduct the
full expense for foreign tax purposes.
IMPLEMENTATION:
This option may require a statutory change
or may be provided for by treaty.
APPENDIX 7
OPTION:
Any revised allocation regulations should be
submitted in proposed form for further public
comment.
PRO:
The magnitude and wide-ranging scope of the
expense allocation regulations may have a
serious economic impact on United States tax-
payers. Thus, to the extent any revised regu-
lations are issued which differ materially from
those published in the past, taxpayers should be
provided an opportunity to comment and to present
their problems in order to assure these regu-
lations do not inadvertently create irreparable
and unwarranted economic harm.
CON:
Proposed allocation regulations have been
circulating for many years, and the basic issues
raised by such allocation have been long known.
Accordingly, taxpayers have had ample opportunity
to make their comments and problems known. Fail-
ure to publish these regulations in final form
merely delays resolution of the basic problem --
the lack of clear guidance as to the appropriate
method of allocating expenses.
IMPLEMENTATION:
No statutory change is required. This is merely
an administrative determination.
APPENDIX 8
OPTION:
Postpone any changes until more of the economic
impact of the change can be studied.
PRO:
Since we do not presently know the full economic
impact of either the present allocation method,
the method in the proposed regulations, or the
method in any of the alternatives thereto; and
since that impact could be substantial, we should
not make any decisions until the economic impact
can be studied.
CON:
In the first instance, the Treasury Department
has an obligation to issue regulations as
guidance for taxpayers in applying the statute,
whether or not the economic consequences of
those regulations are known beforehand. More-
over, in this case delay will not increase our
knowledge. It will not be possible to estimate
the effects of any expense allocation regulations
before they are implemented because taxpayers
do not keep their accounts in a manner which
permits a determination of the amounts of
R&D expense which would be allocated under
varying allocation methods. Even if such a
determination could be made, no estimate of
the degree to which shift of R&D will occur is
possible because such shifts are determined by
a variety of unquantifiable and unpredictable
factors such as the action of foreign governments
or the substitutability of research personnel.
IMPLEMENTATION:
This option may be accomplished administratively.
APPENDIX 9
Revenue Estimate
Apportionment of Research and Development Expenditures
Between United States and Foreign Source Income
It is estimated that the apportionment of research and
development (R&D) expenses for the year 1974 on the basis
of the proposed regulations would have reduced the allowable
foreign tax credit and therefore would have increased U.S.
Treasury tax revenues by between $1.1 and $1.5 billion.
The estimate was derived as follows.
Research and Development Expenditures
In 1974, U.S. industry spent about $13.9 billion of
private funds for research and development. 1/ According
to the National Science Foundation, large companies, i.e.,
those with 10,000 or more employees, account for about 83
percent of the R&D expenditures. 2/ The large companies
dominate U.S. investment abroad. Therefore, 83 percent of
the $13.9 billion, or about $11.5 billion in 1974 R&D
expenditures, is assumed to be affected by the proposed
allocation to foreign source income.
Sales: Worldwide and Domestic
According to Fortune, consolidated sales of large
corporations, i.e., those with 10,000 or more employees,
totalled about $800 billion in 1974. 3/ This figure needs
to be apportioned between domestic and foreign sales.
1/ U.S. Department of Commerce, Bureau of the Census,
Statistical Abstract, 1975, p. 548.
2/ U.S. National Science Foundation, Research and Development
in Industry 1970, p. 11.
3/ "Fortune Directory of the 500 Largest Industrial Corporations,"
Fortune, May 1975, pp. 208-235. This is the sales figure
for the top 400 corporations since they are the ones with
10,000 or more employees.
- 2 -
The 1966 and 1970 special surveys of 298 large U.S.
multinational companies (MNCs) by the Bureau of Economic
Analysis provide data for such an apportionment. The 298
MNCs in the survey consist of 298 U.S. reporters (the U.S.
parents of the MNCs) and their 5,237 majority-owned foreign
affiliates. Using these data, a recent article estimated
MNC consolidated worldwide sales, defined as: (1) sales by
the U.S. reporter to unaffiliated U.S. and foreign residents;
plus (2) sales by its majority-owned foreign affiliates to
unaffiliated U.S. residents and to unaffiliated foreign
residents other than sales to minority-owned foreign
affiliates of the MNC. 4/ The 1966 and 1970 estimates are:
All Industries
1966
1970
Worldwide Consolidated Sales
100.0%
100.0%
Sales to U.S. residents
as percent of total
78.5
74.7
Sales to foreigners as
percent of total
21.5
25.3
Since sales to foreigners grew faster than sales to U.S.
residents, the 1974 percentages were estimated using simple
extrapolation as:
All Industries
1974
Worldwide Consolidated Sales
100.0
Sales to U.S. residents as
percent of total
70.2
Sales to foreigners as
percent of total
29.8
Thus, it is estimated that the $800 billion in 1974
sales of large corporations was comprised of $562 billion
($800 X 702) in domestic sales and $238 billion ($800 X .298)
4/ Leonard A. Lupo, "Worldwide Sales by U.S. Multinational
Companies, " Survey of Current Business, January 1973,
pp. 33-39.
- 3 -
in foreign sales.
Allocable R&D Expenditures
Assuming the apportionment of R&D expenditures on a
sales basis was chosen on the basis of the proposed regu-
lations, the apportionment of the $11.5 billion would be as
follows:
R&D X
Foreign Sales
=
R&D Allocation to Foreign
Worldwide Sales Source Income
(billions)
$11. 5 X
$238
=
$3.4 billion
$800
On this basis about $3.4 billion in R&D expenditures would
be apportioned to foreign source income.
As extreme assumptions, suppose that: (a) presently
no R&D expense is apportioned to foreign source income;
(b) all affected companies pay foreign taxes in an amount
equal to the U.S. foreign tax credit limit. Then the
change in the U.S. foreign tax credit limit represents
the additional tax liability to the U.S. Treasury. The
change in the foreign tax credit limit is given by:
U.S. tax
Foreign source income - Apportioned R&D expense
Worldwide income
X
before
credits
-
Foreign source income
U.S. tax
Change in
X
=
Worldwide income
before credits
foreign tax
credit limit
Tax Credit Reduction
This apportionment would reduce the limit on the foreign
tax credit, and thereby provide the U.S. Treasury with a
revenue gain. The foreign tax credit is limited to U.S. tax
liability on worldwide income times a fraction, the numerator
of which is taxable income from sources outside the U.S. and
the denominator of which is total worldwide income.
- 4 -
This may be rewritten as:
U.S. tax before credits
-
X Apportioned R&D expense
Worldwide income
= Change in foreign tax credit limit
Or: 5/
- .44 X $3.4 billion = - $1.5 billion.
The figure of $1.5 billion for 1974 represents an upper
estimate of the loss in foreign tax credits and the gain
in Treasury revenues.
Alternative Method
A somewhat lower estimate of $1.1 billion can be derived
from the results of a survey of 75 corporations having foreign
operations who are included in the Fortune listing of the
top 150 U.S. industrial corporations. The survey, conducted
by five of the major accounting firms, obtained adequate
information from 41 of the 75 corporations.
It was estimated that these corporations spent $2.88
billion on research and development and that the proposed
regulation would reduce their allowable foreign tax credit
by $283 million. If the 400 large corporations which spent
$11.5 billion in private funds on R&D in 1974 experienced
a similar reduction in their allowable foreign tax credits,
the total reduction would be:
- $11.5
2.88 X $283 = -$1.1 billion
This figure is lower than the estimate based on
aggregate data because that estimate made no allowance
for the present apportionment of R&D expense to foreign
source income, nor did it reflect the fact that the foreign
5/ The factor of 44 is based on data contained in
Statistical Abstract, 1975, P. 499.
- 5 -
taxes paid by some companies are less than the U.S. foreign
tax credit limit.
Even the alternative estimate of $1.1 billion may be.
exaggerated because some firms may now classify doubtful
items in the R&D expenditure account in order to produce
a large number for public relations purposes. However, if
firms are required to allocate R&D expenses to foreign source
income, some of the doubtful items presently classified as
R&D may be placed elsewhere in the business accounts. More-
over, firms may be able to establish that much R&D is "clearly
related" to the U.S. market; for example, testing to obtain
U.S. approval of a new drug. This characterization would reduce
the allocation of R&D expense to foreign source income and there-
fore reduce the gain in U.S. Treasury revenues.
APPENDIX 10
December 12, 1975
EXAMPLE
The following example is illustrative of the
problem.
A United States company X, manufactures and
sells toasters in the United States, and two wholly
owned foreign subsidiaries of X, A and B, manufacture
and sell toasters abroad. All toaster research and
development is carried on by X in the United States.
This research produces results which are commercially
applicable throughout the world. X transfers patents
developed through its R & D to A as a tax-free con-
tribution of capital and licenses specific patents
and know-how on successful research to B for an
annual royalty of five percent of B's gross income.
Except for the royalty charges there is no reimburse-
ment for the research undertaken in the United States.
For 1975, the following additional facts apply:
X
A
B
Gross income from
$1850
$1000
$1000
manufacturing
Royalty income from B
50
--
--
Dividend from A
100
--
-
TOTAL GROSS INCOME
2000
1000
1000
R & D expenses
(200)
--
---
Other expenses
(800)
(500)
(500)
Taxable income
1000
500
500
Tax at 50%
(500)
(250)
(250)
NET INCOME
$ 500
$ 250
$ 250
NUMBER OF TOASTERS
PRODUCED
100
50
50
- 2 -
Based on these facts, and applying three alternative
methods of allocating X's research and development expenses
to foreign source income, X's foreign tax credit would be
as follows:
Allocation
Allocation
of R & D on
based on the
the basis of
ratio of toasters
the ratio of
produced abroad
foreign source
to total world-
No alloca-
gross income
wide toaster
tion of
to total gross
production
R & D
income
Creditable
foreign
taxes 1/
$ 50
$ 50
$ 50
R & D
expenses
allocated
to foreign
source income
None
15 2/
100³/
U.S. foreign
tax credit
limitation 4/
75
67.50
25
Excess foreign
tax credits
None
None
25
As illustrated through this example, both under the
no allocation and gross income allocation approaches, virtually
all of the research and development expense is deducted
against United States source income and U.S. taxes on that
income are correspondingly reduced. Moreover, dividends paid
to the parent company incur no additional U.S. tax because
of the foreign tax credit.
For footnotes see page 4,
- 3 -
However, if significant allocations of research
and expense are made, the dividend income from the
foreign subsidiaries would be substantially reduced
and excess foreign tax credits would be generated.
Indeed, a full allocation of research costs on the
basis of worldwide sales would mean that the sub-
sidiaries are not earning the profits claimed by
them and foreign taxes would be reduced or even
eliminated. Foreign governments would thus resist
claims to reimburse the parent.
- 4 -
Footnotes:
1/ The only creditable foreign taxes available to X
are those deemed paid by X with respect to the
dividend from A. The formula is: dividend X taxes paid
A 'saccu- by A
mulated
profits
for the
year
Thus,
100
X 250 = $50.
500
2/ The formula is foreign source gross income X R & D
total gross income
expense
Thus, 150 X 200 = $15.
2000
3/ The formula is foreign toaster production X R &
D
worldwide toaster produc-
expense
tion
Thus, 100
200
X 200 = $100.
4/ Assuming that X elects the overall credit limitation,
the formula is foreign source taxable
income
X U. S. tax
total taxable income
liability
Thus, with no allocation this is: 150 X 500 = $75.
1000
with gross to gross alloca-
tion:
(150-15) X 500 = $ 67.50
1000
and with units of production
allocation:
(150-100) x500 = $ 25.
1000
APPENDIX 11
Historical Note on Allocation/Deduction Regulations
The existing allocation regulations under section 861
were proposed in 1956 and adopted in 1957. They give
minimal guidance to taxpayers and to revenue agents as
to the handling of various types of expenses. Somewhat
more detailed regulations were proposed on August 2, 1966.
These proposed regulations were withdrawn with the issuance
of new proposed regulations in April, 1973.