a firm's tax credit by 20 cents in the current year, with no effect on its base calculation in subsequent years. Thus, the present-law incremental research credit has the potential (as does a flat credit) to have a marginal effective rate of credit equal to the statutory rate of credit. Firms with qualified expenditures less than the base amount Unlike a flat credit, however, an incremental credit does not provide an incentive for all firms undertaking qualified research expenditures. Many firms have current-year qualified expenditures below the base amount. These firms receive no tax credit and have an effective rate of credit of zero. Although there is no revenue cost associated with firms with qualified expenditures below base, there may be a distortion in the allocation of resources as a result of these uneven incentives. Inadequate tax liability and other limitations If a firm has no current tax liability, or if the firm is subject to the alternative minimum tax (AMT) or the general business credit limitation, the research credit must be carried forward for use against future-year tax liabilities. The inability to use a tax credit immediately reduces its value according to the length of time between when it actually is earned and the time it actually is used to reduce tax liability.45 Base limitation Under present law, firms with research expenditures substantially in excess of their base amount may be subject to the 50-percent limitation. In general, although these firms receive the largest amount of credit when measured as a percentage of their total qualified research expenditures, their marginal effective rate of credit is exactly one half of the statutory credit rate of 20 percent (i.e., firms on the base limitation effectively are governed by a 10percent credit rate). Average effective rate of the credit Although the statutory rate of the research credit is currently 20 percent, it is likely that the average marginal effective rate may be substantially below 20 percent, even though the restructured research credit does not have a moving base. Reasonable assumptions about the frequency that firms are subject to various limitations discussed above yields estimates of an average effective rate of credit between 25 and 40 percent below the statutory rate i.e., between 12 and 15 percent. Table 5 summarizes the expected increase in qualified research expenditures for a variety of assumptions about price elasticities and average marginal effective rates of credit, assuming $30 billion 46 in aggregate qualified research expenditures. 45 As with any tax credit that is carried forward, its full incentive effect could be restored, absent other limitations, by allowing the credit to accumulate interest that is paid by the Treasury to the taxpayer when the credit ultimately is utilized. 46 In 1988, qualified research expenditures for Subchapter C corporations were approximately $22 billion. Table 5.-Projected Increase in Qualified Research Expenditures, Given $30 Billion of Qualified Research Expenditures, Under Various Assumptions about the Price Elasticity of R&D and the Effective Rate of Credit Stability of the research credit over time Although the moving-base incremental research tax credit under prior law had many undesirable features, one advantage it had over the current fixed-base credit concerns the evolution of each firm's base over time. A moving-average base can never substantially vary from a firm's actual experience for a sustained period of time. (In other words, a moving-average base design can be viewed as inherently "self-correcting.") For example, under prior law, if a firm decided to double its research expenditures (either permanently or at least for several years), the firm's calculated research base amount also would double after three years. In contrast, under the present-law research credit, if a firm doubles its research budget, the firm's base amount will not double unless, eventually, its gross receipts increase commensurately. Since sales growth over a long time frame will rarely track research growth as well as the previous three year's research growth, it can be expected that over time each firm's base will "drift" from the firm's actual current qualified research expenditures. Therefore, increasingly over time there will be a larger number of firms either substantially above or below their calculated base. This could gradually create an undesirable situation where many firms receive no credit and have no reasonable prospect of ever receiving a credit, while other firms receive large credits (despite the 50-percent base limitation). Thus, over time, it can be expected that, for those firms eligible for the credit, the average marginal effective rate of credit will decline while the revenue cost to the Government increases. Cycling of research expenditures As under the prior-law research credit structure, many firms currently have a substantial tax incentive to cycle or bunch their qualified research expenditures. For example, suppose a firm before enactment of the research credit had planned to spend $100 on qualified research expenditures in each of two succeeding years. Suppose also that the firm had a base of $90 in both of those years. If the firm maintained expenditures at $100, it would earn $2 of credit in each of the two years. However, if the firm reduced its expenditures to $70 in the first year and increased its qualified research expenditures to $130 in the following year (thereby still con ducting $200 of research over the 2-year period), the taxpayer would earn $8 of tax credit.47 Although the tax advantages of cycling can be large, many observers believe it will not take place to a significant degree, because it is difficult to shift (either by delay or acceleration) from one year to another qualified research expenditures, which consist in large part of salaries of scientists and other highly skilled labor.48 Administration of the credit The GAO recently has testified that the revised credit remains difficult for the IRS to administer. The GAO reports that the IRS view is that it is "required to make difficult technical judgments in audits concerning whether research was directed to produce truly innovative products or processes." While the IRS employs engineers in such audits, the companies engaged in the research typically have technical personnel with greater expertise and, as would be expected, personnel with greater expertise regarding the specific research conducted by the company under audit. Such audits create a burden for both the IRS and taxpayers. The credit generally requires taxpayers to maintain records more detailed than those necessary to support the deduction of research expenses under section 174.49 b. The university basic research credit The university basic research credit is a fixed-base credit with many of the same economic properties as the more generally available research tax credit. The university basic research credit is targeted to basic research performed by educational institutions and certain other non-profit scientific organizations, which may result in more economic benefits since the spillover benefits of basic research to society as a whole often are larger than benefits derived from applied research.50 Apparently, there has been no empirical research assessing the effectiveness of the university basic research credit. 47 This is derived as follows: $8 is 20 percent of the difference between $130 and $90. 48 Although supplies used in research also generally are eligible for the credit, this does not include real property or depreciable property (such as a computer). 49 Natwar M. Gandhi, Associate Director Tax Policy and Adminsitration Issues, General Government Division, U.S. General Accounting Office, "Testimony before the Subcommittee on Taxation and Internal Revenue Service Oversight, Committee on Finance, United States Senate," April 3, 1995. 50 Some observers have noted, however, that many of the results of basic research provide benefits not only to the United States but to the economies of other countries. 2. Allocation of research expenses to U.S. and foreign income (sec. 864(f) of the Code) Overview This item of the pamphlet reviews the rules for allocating and apportioning deductions for research expenses between U.S. and foreign source income. A temporary statutory research allocation rule remains in effect for some fiscal year taxpayers, but expired generally for taxable years beginning after August 1, 1994. Extending the statutory research allocation rule would tend to increase taxpayers' foreign tax credit limitations. If no extension of the statutory allocation rule is enacted, the effect of research expenses on the foreign tax credit limitation will be determined by reference to regulations in effect since 1977, as they may be amended by the Treasury from time to time in the future. The 1977 regulation generally permits taxpayers to automatically allocate at least 30 percent of U.S.-performed research expense against U.S. source income. If the statutory rule is extended, the effect of research expenses on the foreign tax credit limitation will be determined by reference to Code section 864(f). This Code section contains a modification of allocation rules originally enacted in 1988 on a temporary basis and extended, also on a temporary basis, in 1989, 1990, and 1991 by statute, and in 1992 by Revenue Procedure. As explained below, this Code section would permit taxpayers to allocate at least 50 percent of U.S.-performed research expense against U.S. source income. The allocation rules of section 864(f) are, in general, more generous to taxpayers than the allocation rules of the 1977 regulation. The practical tax effect of any particular research allocation rule on any particular taxpayer depends on the level of its excess foreign tax credits. Businesses find themselves in an excess credit or excess limitation position based on a myriad of other aspects of the U.S. and foreign tax laws, any of which can change: for example, rates of income tax imposed by foreign governments, U.S. rules for sourcing items of gross income, and U.S. rules for allocating deductions other than research expenses. An increase in the foreign tax credit limitation of a U.S.-based multinational company with excess foreign tax credits tend to reduce its U.S. tax liability. As explained further below, a great deal of consideration has been given in the past 20 or more years to various alternative research allocation rules and the policies supporting each alternative. Perhaps the least generous such alternative, from the taxpayer's viewpoint, was embodied in 1973 proposed regulations. The most generous alternative, permitting 100 percent of U.S.-performed research expense to be allocated to U.S. source income, was enacted in 1981 and extended on a temporary basis in 1984 and 1985. A third alternative, permitting 50 percent of U.S.-performed research expense to be allocated to U.S. source income, was enacted on a temporary basis in 1986. A fourth alternative, permitting 67 percent of U.S.-performed research expense to be allocated to U.S. source income, was tentatively agreed to by the Administration and industry in 1987, was passed by the House of Representatives and favorably reported by the Senate Committee on Finance, but was not included in final legislation. The following sections of this pamphlet discuss the history of all of the above research allocation alternatives, their practical impacts on taxpayers (see Tables 6-8 below), and the various tax policy arguments raised on their behalf. Of course, the alternatives described do not exhaust the possibilities for future enactments; the Congress and the President could in the future enact statutory research allocation rules that differ in some way from all of the above-mentioned alternatives. Present Law Foreign income and the foreign tax credit Introduction U.S. persons 51 are taxable on their worldwide income, including their foreign income.52 That is, the taxable income reported on the U.S. tax return of a U.S. person includes both U.S. and foreign income. A U.S. person who earns foreign income may incur foreign income tax. The United States allows U.S. persons subject to the regular income tax to take full, dollar-for-dollar credit for foreign income taxes. This credit directly reduces U.S. tax. The purpose of the foreign tax credit is to prevent U.S. taxpayers from paying tax twice on their foreign income-once to the foreign country where the income arises and again to the United States as part of the taxpayer's worldwide income. This foreign tax credit system embodies the principle that the country where a taxpayer conducts a business activity (or earns any income), known as the source country, has the first right to tax any or all of that income even if it is not the taxpayer's home country. Under this principle, the taxpayer's country of residence has a residual right to tax that income; that is, the residence country taxes foreign income only to the extent that the residence country income tax rate exceeds the source country rate. As a practical matter, the residence country tax on foreign income often is wholly eliminated. Some countries avoid double taxation by exempting foreign source income from tax altogether. Most developed countries, however, including the United States, minimize double taxation through a foreign tax credit system, providing a dollar-for-dollar credit against home country tax liability for income taxes paid to a foreign country. Both the exemption system and the foreign tax credit system require a determination of what income is domestic and what income is foreign. Foreign tax credit limitation Purpose. A fundamental premise of the U.S. foreign tax credit system is that foreign taxes should not offset the U.S. tax on U.S. source income. Accordingly, a statutory formula limits the foreign tax credit so that the credit will offset only the U.S. tax on the taxpayer's foreign income. As a result of the limitation, the U.S. tax 51 U.S. persons are U.S. citizens, resident aliens, domestic partnerships, domestic corporations, and, generally, domestic trusts and estates (sec. 7701(a)(30)). 52 Foreign earned income of a qualified U.S. individual may be exempt from U.S. income tax under section 911. |