system generally departs from capital-export neutrality where firms operate in foreign countries that levy an income tax greater than the U.S. tax on foreign source income.

Without the foreign tax credit limitation, foreign countries could effectively levy a tax on U.S. source income by raising their tax rates above the U.S. rate. Because of the credit, the U.S. Treasury would absorb the additional foreign tax burden. That is, post-credit U.S. taxes owed on U.S. source income would be reduced.

Computing the foreign tax credit. The limitation generally operates by separating the taxpayer's U.S. tax liability on worldwide income, computed before foreign tax credits ("pre-credit U.S. tax"), into two categories: tax on U.S. source taxable income and tax on foreign source taxable income.53 Computing the limitation involves computing the ratio of foreign source taxable income to worldwide taxable income. This fraction is multiplied by the pre-credit U.S. tax. The product of this multiplication represents the amount of pre-credit U.S. taxes associated with foreign income. This amount is the upper limit on the foreign tax credit. Note that this upper limit rises proportionately with any rise in the portion of the taxpayer's worldwide taxable income that is treated as foreign source taxable income.

In a typical case, a corporate taxpayer might take a foreign tax credit for either foreign income taxes paid or the U.S. corporate tax rate times foreign taxable income, whichever is less. Generally speaking, as U.S. tax rates go down (relative to foreign rates), the more likely it becomes that pre-credit U.S. tax on foreign source income will be less than foreign taxes actually paid.

Examples. The following example illustrates the computation of the foreign tax credit limitation:

Assume that the U.S. taxpayer has foreign source taxable income of $300 and U.S. source taxable income of $200, for total taxable income of $500. Assume further that the pre-credit U.S. tax on the $500 is $175 (i.e., 35 percent of $500).

Since 60 percent ($300/$500) of the taxpayer's total worldwide taxable income is from foreign sources, the foreign tax credit is limited to $105, or 60 percent of the $175 pre-credit U.S. tax. Thus, if foreign taxes paid exceed $105, only $105 of foreign tax credit will be allowed (the excess taxes paid may be carried to other years). If the taxpayer has paid less than $105 in foreign taxes, the taxpayer will have a foreign tax credit equal to the amount of the taxes paid.

The manner in which the foreign tax credit limitation prevents foreign countries from effectively levying a tax on U.S. source income and protects the U.S. Treasury's right to tax U.S. source income may be illustrated as follows:

Assume that each of two U.S. corporations earns $100 of U.S. income and faces an average U.S. income tax rate of 35 percent. One of them earns no foreign income. The other earns $100 of foreign income and pays $50 of foreign tax on that income.

The taxpayer with no foreign income owes $35 of U.S. tax. The taxpayer with foreign income has pre-credit U.S. tax of $70 (on

53 A series of separate limitations further subdivides the tax on different types of foreign source income.

$200 of worldwide income). That taxpayer would owe $20 of U.S. tax if there were no foreign tax credit limitation-the $70 pre-credit U.S. tax less the $50 credit. High foreign taxes imposed by a foreign government would reduce the U.S. tax paid on U.S. income from $35 to $20. The limitation prevents such reduction of the U.S. tax base.

Excess foreign tax credits

Excess foreign tax credits exist when the amount of creditable foreign income taxes paid or accrued in a given year exceeds the taxpayer's foreign tax credit limitation. Excess credits can be expected to arise where the effective income tax rate imposed (or deemed to be imposed) by a foreign country on income of a U.S. taxpayer is higher than the U.S. income tax rate.

Excess credits can arise, for example, from differences in the deduction allocation rules of the United States and those of other countries. For example, in those cases where a foreign country does not allocate a deduction for U.S.-performed research to income taxed within that country, and the United States does, the foreign taxes will be higher than if the foreign country allowed the research deduction, and may exceed the foreign tax credit limitation. Excess credits can arise for a variety of other reasons. Differences between the income-sourcing rules of the United States and those of other countries may result in U.S. treatment of income taxed by another country as domestic income for purposes of the foreign tax credit. Timing differences in the reporting of income and deductions under U.S. and foreign tax laws may result in a taxpayer's being unable to utilize some foreign tax credits in a year in which income is reported in a foreign country but not in the United States. Domestic losses may reduce worldwide taxable income and pre-credit U.S. tax and, hence, the amount of foreign tax credits that can be used currently.

One way taxpayers may reduce excess credits is to shift foreign operations to a foreign country with an effective income tax rate equal to or lower than the U.S. income tax rate. Another method is to use self-help to reduce the taxpayer's effective foreign income tax rates in the foreign countries where it currently operates. A third alternative is to bring the foreign operations located in a high-tax foreign country back to the United States.

Source rules for income and deductions-in general

As explained above, taxable income from foreign sources times. pre-credit U.S. tax constitutes the numerator of the fraction that determines the foreign tax credit limitation. Thus the foreign tax credit limitation increases proportionately when foreign source taxable income increases. Taxable income from foreign sources is computed by (1) determining the items of gross income that are from foreign sources, and then (2) subtracting from that amount of gross income that portion of the taxpayer's deductions that are allocable to foreign source gross income. The following discussion addresses first the sourcing of items of gross income, and then the allocation of items of expense.

Sourcing items of income.-The greater the portion of a taxpayer's gross income that the taxpayer derives from foreign sources

(or the lesser the portion it derives from U.S. sources), the greater will be the foreign tax credit limitation. Sections 861 and 862 list items of gross income that arise from sources within the United States ("U.S. source gross income" or "U.S. gross income") and from sources outside the United States ("foreign source gross income" or "foreign gross income"), respectively. Under section 861, U.S. gross income includes, generally, income from sales of inventory property manufactured in the United States and sold in the United States, wages and salaries for work done in the United States, rent paid for property located in the United States, dividends paid by U.S. corporations, and interest paid by U.S. persons. Under section 862, foreign gross income includes income from the sale outside the United States of inventory property manufactured outside the United States, royalties from the use outside the United States of patents, secret processes, and similar properties, and dividends. paid by certain foreign corporations. Sections 865 and 988 provide rules for determining the source of income from sales and other dispositions of certain types of personal property.

Allocating and apportioning items of expense; Code rules in general. After determining the amount of gross foreign source and U.S. source income, taxpayers must determine net (or taxable) foreign source and U.S. source income. This determination brings deductible expenses into play. The smaller the portion of any particular deduction of a taxpayer that is allocated to foreign source gross income (or the greater the portion allocated to domestic source gross income), the greater will be the taxpayer's foreign tax credit limitation.

Generally, under sections 861 and 862, taxable income from U.S. or foreign sources is determined by deducting from the items of gross income treated as arising from U.S. or foreign sources, as the case may be, (1) those expenses, losses, and other deductions properly apportioned or allocated to those particular items and (2) a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income (secs. 861(b), 862(b)).54

Under these principles, for example, a taxpayer with $100 of U.S. source gross income, $80 of expense properly allocated to U.S. source gross income, $100 of foreign source gross income, $70 of expense properly allocated to foreign source gross income, and $10 of expense that cannot definitely be allocated to U.S. or foreign source gross income, will split that $10 proportionately (in this case, evenly) between U.S. and foreign gross income. The taxpayer will thus have $15 of U.S. source taxable income ($100-$80-$5) and $25 of foreign source taxable income ($100-$70-$5).

The Code generally articulates only the broad principles of how expenses reduce U.S. and foreign income, leaving it up to the Treasury to provide detailed rules for the allocation and apportionment of expenses.

54 Section 863 specifies that items of gross income, expenses, losses, and deductions other than those specified in sections 861 and 862 are to be allocated or apportioned to sources within or outside of the United States under regulations prescribed by the Secretary of the Treasury. Section 863 also contains general rules for computing taxable income when gross income derives from sources partly within and partly outside of the United States, as well as source rules for transportation income, space and ocean income, and international communications income.

Regulatory rules for expense allocation-in general.-Treasury Regulation sections 1.861-8 and 1.861-8T through 1.861-14T (“the Regulations") apply in determining foreign source taxable income for calculation of the foreign tax credit limitation.55 They provide specific rules for the treatment of expenses, losses, and certain other deductions. Generally, as the first step in calculating foreign source income, the Regulations require a taxpayer to allocate his deductions to individual "classes" of gross income.56

When a particular expense relates to a class of gross income including both U.S. and foreign source income, the Regulations generally prescribe no single method for apportioning deductions between the two. The Regulations state that the method used in apportioning a deduction must reflect the factual relationship between the deduction and the gross income. The Regulations contain a nonexclusive list of bases and factors to consider. Some of these relevant bases and factors are: a comparison of units sold (between sales yielding foreign source and sales yielding U.S. source gross income), a comparison of profit contributions, a comparison of gross sales or receipts, and a comparison of amounts of gross income. The Regulations' list contemplates that the higher the proportion of foreign sales or foreign gross income (for example), the greater, logically, the proportion of expenses attributable to foreign source in

come.

Several types of deductions are considered not definitely related to any gross income under the Regulations. These include, for example, the deductions for medical expenses and (unless currently proposed regulations become final) charitable contributions. These deductions reduce foreign and U.S. gross income pro rata.

The Regulations set forth detailed allocation and apportionment rules for certain types of deductions, including those for interest, research and development expenditures, stewardship expenses, and legal and accounting fees and expenses. (A detailed discussion of the rules for research deductions appears in "Allocation and apportionment rules for research deduction," below.) 57

Insofar as the Regulations apply specifically to research expenses, they were promulgated in their present form in 1977.58

55 They also apply in determining the taxable income of a taxpayer from specific sources and activities for purposes of a number of other "operative" Code sections. The operative section for the foreign tax credit limitation is section 904(a).

56 These classes include royalties, dividends, compensation for services, and gross income derived from business. A taxpayer must allocate his deductions on the basis of the factual relationships that exist between his deductions and his classes of gross income. The Regulations express this factual relationship concept this way: a deduction generally reduces a class of gross income if the deduction is incurred as a result of, or incident to, an activity, or in connection with property, from which the class of gross income has been, is, or could reasonably have been expected to be derived. If a deduction does not bear a definite relationship to a class of gross income, it is ordinarily treated as definitely related and allocable to all of the taxpayer's gross income; "all of the taxpayer's gross income" is then considered a class of gross income for purposes of applying the remainder of the Regulations. After a deduction has been allocated to a class of gross income, it is apportioned between a "statutory grouping" of gross income within the class, such as foreign source gross income, and a "residual grouping," consisting of all other gross income in the class. The statutory grouping depends on the operative Code section. For example, when the operative Code section is 904(a) (relating to the foreign tax credit limitation), the statutory grouping is foreign source gross income.

57 In addition, the Regulations provide rules relating to deductions in excess of gross income; exempt, excluded, and eliminated income; substantiation of allocations and apportionments; and intercompany pricing adjustments under section 482 or other sections of the Code.

58 Treasury issued temporary regulation sec. 1.861-8T, regarding the allocation and apportionment of various expenses other than interest, in 1988. These regulations are generally applicable to taxable years beginning after December 31, 1986 (Treas. Reg. secs. 1.861-8T(h) and

They incorporate a number of significant modifications to a 1973 proposed revision 59 of the original Regulations, which were adopted in 1957.60 These modifications were made in response to taxpayer comments on the proposed 1973 revision.61

Allocation and apportionment rules for research deductions Overview

To the extent there are permanent rules in this area, they are contained in the regulation promulgated in 1977. These are the rules that would apply if the statutory rule were not extended. The permanent rule set forth in the regulations is described in this portion of the pamphlet. The Legislative Background portion of the pamphlet describes the statutory allocation rule set forth in section 864(f), as well as alternative allocation rules that have been considered or enacted in the process of arriving at section 864(f).

The research Regulation (section 1.861-8(e)(3))

In general.-The research_rules of Treasury Regulation sec. 1.861-8(e)(3) ("the research Regulation") embody to some extent each of three approaches for allocation and apportionment of research expenses. One approach, the place-of-performance method, assumes that these deductions relate straight-forwardly to the place where the research occurs. Another approach, the sales (or gross receipts) method, apportions the burden of research expense among the sources of the taxpayer's sales receipts. A third approach, the gross income method, apportions research expense among the sources of the taxpayer's gross income. (The Analysis section, following, examines the strengths and weaknesses of these approaches.)

The research Regulation takes as its premise that research "is an inherently speculative activity, that findings may contribute unexpected benefits, and that the gross income derived from successful research and development must bear the cost of unsuccessful research and development." The research Regulation prescribes rules for allocating and apportioning these expenses between U.S. source and foreign source income.62

As explained in more detail below, the Economic Recovery Tax Act of 1981, the Deficit Reduction Act of 1984, and the Consolidated Omnibus Budget Reconciliation Act of 1985 suspended these rules as they relate to U.S.-based research activity through taxable years beginning on or before August 1, 1986; they provided that taxpayers were to allocate all research deductions for research conducted in the United States to U.S. source income during the suspension period.

1.861-14T(a)). Section 1.861-8T(e)(3) of the temporary regulation is expected to cover research expenses (Treas. Reg. sec. 1.861-14T(e)(2)). To date, however, substantive research allocation rules under 1.861-8T(e)(3) have not been issued or proposed. When those rules are issued, they generally are to be applied (except with respect to research expenses allocated under the statutory rules, described below, of DEFRA) as if all members of the affiliated group are a single taxpayer (Treas. Reg. sec. 1.861-14T(eX2)).

59 38 Fed. Reg. 15,840 (1973).

60 T.D. 6258, 1957-2 C.B. 368.

61 An earlier proposed revision of the Regulations, published in 1966, 31 Fed. Reg. 10,405 (1966), was withdrawn at the time the 1973 proposed revision was published.

62 The research Regulation also prescribes rules for the allocation and apportionment of deductions between pairs of gross income groupings other than U.S. source and foreign source income.