those expenses represent of the entire amount of research expense properly taken into account for that taxable year.

On June 24, 1992, it was announced that the Treasury Department and the IRS had undertaken a review of the research expense allocation regulation, and that in light of this review, the IRS temporarily would not require that taxpayers apply the regulation (Rev. Proc. 92-56, 1992-2 C.B. 409, amplified by Rev. Proc. 92–69, 1992-2 C.B. 435). According to these Revenue Procedures, taxpayers would not be required to apply the regulation with respect to research expenses incurred during what would ordinarily be an 18-month transition period-that is, the last six months of the taxpayer's first taxable year beginning after August 1, 1991 and the immediately succeeding taxable year-provided that such expenses were allocated and apportioned in accordance with a method based on the section 864(f) allocation rules.

The Omnibus Budget Reconciliation Act of 1993 (“1993 Act") generally extended section 864(f), with modifications, to cover the taxable year that immediately followed the period to which Revenue Procedure 92-56 applied.74 Under the 1993 Act, the portion of research expense automatically allocated and apportioned to income sourced in the place of performance of the research is 50 percent, rather than 64 percent. Thus, for research expense other than amounts incurred to meet certain legal requirements, and thus allocable to one geographical source, 50 percent of U.S.-incurred research expense is allocated and apportioned to U.S. source income, and 50 percent of foreign-incurred research expense is allocated and apportioned to foreign source income. The remaining research expense is allocated and apportioned either on the basis of sales or gross income, but subject to the condition that if income-based apportionment is used, the amount apportioned to foreign source income can be no less than 30 percent of the amount that would have been apportioned to foreign source income had the sales method been used. The 1993 Act also authorized the Treasury Department to prescribe regulations with respect to the implementation of certain adjustments regarding section 936 companies, the determination of whether research activities are conducted inside or outside the United States, and adjustments that may be appropriate in the case of cost sharing arrangements and contract research. For most taxpayers, the allocation rules of section 864(f) as amended by the 1993 Act apply to the taxable year that begins after August 1, 1993, and on or before August 1, 1994.

Foreign Law 75

Foreign countries' source rules for deductions

It appears that few countries have developed detailed rules governing the allocation of expenses between foreign and domestic in

74 Specifically, the 1993 Act applied the modified rules of section 864(f) to the first taxable year (beginning on or before August 1, 1994) that commenced immediately following the taxpayer's last taxable year to which Revenue Procedure 92-56 applies, or would have applied had the taxpayer been in existence and elected the benefits of that Revenue Procedure.

75 This section is based chiefly on the collection of studies of the source, allocation, apportionment, and related rules of 24 countries published by the International Fiscal Association (IFA): Rules for determining income and expenses as domestic or foreign, LXVb Cahiers de droit fiscal international (1980). While the discussion in this pamphlet also incorporates the fruits of subsequent research on selected topics, conducted by the staff of the Law Library, Library of Con

come (or taxable and nontaxable income). Thus, specific allocation rules for research expense, resembling those of Treasury Regulation sec. 1.861-8, are absent in most countries. The most common approach to allocations appears to be a facts and circumstances test or a reasonableness test. Many countries, however, have recognized the general principle that expenses, to be deductible against income from a particular source, should be related to that income. Some countries apparently have had specific rules for research expense. Under Finnish law, for example, research expenses generally have in the past been deductible from the category or categories of income to which they relate. In New Zealand, it has been the law that research expenditures must be demonstrated to yield some benefit to the New Zealand economy to be deductible against New Zealand income. In Japan, however, it has been the law that research expenses will not be allocated to offset foreign source income. In addition, Canada apparently has required no allocation of research expense to foreign source income.

Deductions in foreign countries for U.S.-performed research

U.S. income tax treaties generally require our treaty partners to allow appropriate deductions for expenses incurred in the United States. Generally, however, under the treaties, these countries are required to allow deductions only for research expenses directly related to local income. Some research conducted in the United States within a product category that includes products sold in a foreign country may not bear a direct relation to local income. A foreign country's disallowance of deductions for such research when those amounts are allocated to foreign income under the research Regulation may, therefore, comport with its treaty obligations.

Even absent a treaty, a deduction for overseas research has been within the scope of many countries' general rules governing deductions for overseas expenditures. However, foreign countries that recognize the right of taxpayers to deduct overseas expenses may not allow deductions in sufficient amounts to offset the impact of the research Regulation. Additionally, such countries may impose gross withholding taxes on royalty payments to U.S. companies for that research, potentially offsetting any tax benefits derived from favorable deduction rules.

While some foreign countries may prohibit direct deductions for U.S.-performed research, the foreign subsidiary of a U.S. company may be able to take a related deduction in some cases by paying the U.S. parent an increased price for technology and components to reflect research costs. Transfer prices paid by foreign subsidiaries for technology and components often are deductible under foreign tax laws. On the other hand, if deductions from foreign taxable income can be taken for the value of technology developed in the United States and then transferred abroad or incorporated into products sent abroad, such deductions would generally be of less benefit than a deduction for research expenses when incurred; research tends to generate costs well before it generates transferable benefits.

gress, this pamphlet does not purport to be based on a comprehensive update of IFA's 1980 survey.

Comparison of Allocation Methods

This section compares six methods of deducting research expenses by a taxpayer with $10,000 of U.S. sales and $10,000 of foreign sales (through a foreign branch). The taxpayer has $1,000 of U.S. source taxable income and $1,000 of foreign source taxable income before deduction of research expense. The taxpayer incurs $400 of research expense, all in the United States.

Table 6 shows the calculation of U.S. and foreign income under six methods. The first method, based on the proposed 1973 regulation, allocates research expense solely on the basis of sales (gross receipts). The second method is one of those available in the 1977 Regulation. Under the 1977 Regulation, the taxpayer described above is first permitted to apportion 30 percent ($120) of research expense to U.S. source income (place-of-performance apportionment). The remaining $280 ($400-$120) of research expense is split equally between U.S. and foreign source income on the basis of gross receipts, which results in $140 of foreign source and $260 of U.S. source research expense (sales method apportionment).76

76 In these examples, the optional gross income methods do not yield a smaller foreign-source apportionment of research expense than the sales method. Operation in subsidiary form instead could reduce the foreign source gross income to zero if the taxpayer did not repatriate income from the foreign subsidiary. In that case, an optional gross income method could be used to reduce the foreign-source apportionment of research expense by 50 percent under the unmodified Regulation, from $140 to $70, or by 100 percent under the temporary 1986 Act modification. Either of these allocations would be more favorable to the taxpayer than the allocations resulting from full repatriation of the foreign subsidiary's earnings.

Table 6.-Example of Apportionment of Domestic Research Expense Under 1.861-8 Regulation and Statutory Rules

1 Apportionment of research expense described in text.

2 Income after research equals income before research reduced by the research expense apportionment.

3U.S. tax on worldwide income (before the foreign tax credit) equals income after research times the present U.S. corporate tax rate (35 percent).

The third method of apportionment, provided under the ERTA/ DEFRA/1985 Act moratorium, allocates the full $400 of research expense to U.S. source income (place-of-performance apportionment). The fourth method, pursuant to the 1986 Act modifications to the 1977 Regulation, first apportions $200 of research expense to U.S. source income based on place of performance, then splits the remaining $200 evenly between U.S. and foreign source income, resulting in a $100 apportionment of research expense to foreign source income. The fifth method, pursuant to Code section 864(f) as first enacted in the 1989 Act, first apportions $256 of research expense to U.S. source income based on place of performance, then splits the remaining $144 evenly between U.S. and foreign source income, resulting in a $72 apportionment of research expense to foreign source income. The sixth method, pursuant to Code section 864(f) as amended in the 1993 Act, first apportions $200 of research expense to U.S. source income based on place of performance, then splits the remaining $200 evenly between U.S. and foreign source income, resulting in a $100 apportionment of research expense to foreign source income.

Table 7 illustrates the case where the taxpayer operates in a lowtax country and does not have excess foreign tax credits. The foreign country imposes tax at a 25-percent rate with no deduction for U.S.-performed research expense. The foreign taxable income is $1,000 (not reduced by research expense), and the foreign tax is $250. In this situation, the taxpayer would pay $310 of U.S. tax (after credit) under all six methods of apportionment. The total tax liability of $560 ($250 plus $310) is identical to the tax which would be owed if the taxpayer moved his foreign operations to the United States. Thus, the U.S. research apportionment rules are a matter of indifference for taxpayers who have no excess credits.