RECOMMENDATION: No change should be made in the 50%-40%-30% exclusive apportionment schedule of the Proposed Regulation. Approve LOSSES A few taxpayers have argued that the rule in the Proposed Regulation which allocates losses on the sale of property to the class of income which such property ordinarily gave rise should be changed to conform to the present rule for determining the source of gains on the sale of property. In other words, the loss would be sourced where title to the property passes. Both Treasury and IRS agree that the present source rule for gains is inappropriate, but that it can be changed only by amending the statute. Nothing in the statute, however, precludes a more appropriate rule for the allocation of losses. Treasury and the IRS believe that the loss rule in the Proposed Regulation better reflects economic realities and is less subject to taxpayer manipulation than the gain rule. A loss rule which follows the gain rule would permit taxpayers, at their discretion, to determine the source of a loss, on the sale of property regardless of where that property may have produced gross income. RECOMMENDATION: Retain the rule in the Proposed Regulation. Approve GENERAL AND ADMINISTRATIVE EXPENSE The Proposed Regulation apportions a part of G&A expense to foreign source income. Taxpayers with selfsufficient international departments have expressed concern that the IRS may still attempt to apportion other G&A expenses to foreign source income. The regulation can be revised to make it clear that no further apportionment would be required in such situations. RECOMMENDATION: Revise the Proposed Regulation to clarify the apportionment of G&A expense. Approve Disapprove_ STATE INCOME TAXES Under the Proposed Regulation, the deduction for state income taxes is apportioned to foreign income, to the extent those taxes are imposed on foreign income as defined under Federal law. Many taxpayers have urged that no apportionment should be made where the state, in its own statute, declares that it uses an income apportionment formula only for the purpose of reaching in-state income. However, such states may in practice tax foreign income as defined under Federal law. The Proposed Regulation makes clear that if state taxes are imposed in part on foreign source income, they should be apportioned in part to foreign source income. RECOMMENDATION: There should be no change in the principle that the deduction for state income taxes imposed on foreign income, as defined by Federal law, should be apportioned to foreign income. Approve TIMETABLE If a final regulation is to be issued during this Administration, a target date of January 3, 1977 should be set for publication. After that date, key senior personnel will be leaving the Treasury and the IRS, and key staff members will be abroad on treaty negotiations and away on annual leave. In order to meet the January 3, 1977 target, final decisions should be made before Christmas. You may wish to advise the EPB of your decision and give its members a chance to comment. RECOMMENDATION: Eleven years is long enough to consider a single regulation. Taxpayers can and should litigate their objections in court. I strongly urge that you approve the publication of this regulation in final form on January 3, 1977. Approve Disapprove Chairman RANGEL. Let me beg to interrupt here. I had hoped that staff would have advised the witnesses that in order to achieve our goal here and to cover the entire witness list by 1:30 that the witnesses should be advised that the entire statements will be placed in the record, but we are asking for a 5minute summary so that we can cover the entire scope of the testimony this morning. So with that in mind, I hope that you will be able to summarize. I had hoped that staff would have advised the witnesses that we need your cooperation. Mr. HUFBAUER. That concludes my statement, Mr. Chairman. STATEMENT OF LAWRENCE LOKKEN, PROFESSOR OF LAW, NEW YORK UNIVERSITY SCHOOL OF LAW Mr. LOKKEN. I am Lawrence Lokken, I am a professor of law at the New York University School of Law. I am not representing the University or any other organization. I am appearing just on my own. I come to talk to you about what Congressman Shannon called earlier this morning "pure tax policy" because that is about the only thing I know that you might be interested in. I think that the arguments on pure tax policy grounds have been pretty much agreed upon by the witnesses that have come before me. Let me summarize very briefly. What we are talking about here is the foreign tax credit of course. The foreign tax credit is a mechanism allowed by the United States to alleviate double taxation. Foreign countries tax only foreign source income when the taxpayer is a U.S. person and hence the credit is limited to the U.S. tax which is allocable to foreign source income. The tax generally is the tax on net income and hence foreign source income is defined also as a net concept, very basically foreign source income being gross income from foreign sources reduced by the cost of earning that foreign source gross income. The maximum credit, therefore, is the U.S. rate multiplied by that net foreign source figure. It seems agreed at least in concept that some portion of research and development costs ought to be allocated to foreign source income if a company used its R&D product in foreign production activities, and that is precisely what the regulations have provided. That is precisely what the 1981 moratorium has forbidden. So the issue it seems to me is whether R&D expense should be treated like any other expense in this regard. That is, whether a part of R&D expense should be allocated to foreign income to reflect the fact that R&D is used abroad or whether there should be something special about R&D, namely, whether we should allow R&D expense to be allocated only to U.S. income notwithstanding it is used in part to earn foreign income. My conclusion on the basis of pure tax policy is that the latter course is wrong, that this moratorium should be allowed to lapse and nothing should be substituted in its place. The regulations have, I think, been described already. I would like to point out, perhaps just to emphasize what has been said to you before, that the regulations are not in this context imposing some draconian penalty. The regulations have taken a very soft stand about research and development expenditures. Mr. Hufbauer says he was afraid when the regulations were put out that the Treasury would be accused of making some huge giveaway to multinational companies. As I point out in my statement, if a company uses its R&D for production in the United States and in foreign countries more or less equally in the two countries, it would seem in the abstract that the R&D expense should be split down the middle and allocated to each. The 1977 regulations on the other hand would allow in that case an allocation of just 17.5 percent to reflect the use of R&D half in foreign countries. So the regulations are designed to take into account the very concerns that are pressed by industry in favor of this moratorium and I really believe that that is sufficient. Departing from the realm of pure tax policy, I have some commentary at the end of my statement about some of the economic consequences of the moratorium. Most of this is drawn from the Treasury report. Let me just emphasize one or two points. One is that the number of tax dollars involved here-at least in relationship to total research and development expenditures-is very small. Therefore, it seems to me that the effect upon our R&D activity from this regulation must be very small. On the other hand, we are talking about a sum of $100 million in tax revenues. We have in this country a very large deficit these days. My observation in looking at the tax law for many years is that much of that deficit is attributable to the fact that the tax code is very leaky. Congressman Shannon referred to the fact that the code is full of special tax breaks. It seems to me that that is the problem. That is not the solution. This is an instance in which we ought to let one special concession lapse. Thank you. [The prepared statement of Mr. Lokken follows:] STATEMENT OF LAWRENCE LOKKEN, PROFESSOR OF LAW, NEW YORK UNIVERSITY SCHOOL OF LAW My name is Lawrence Lokken. I am a Professor of Law at the New York University School of Law, 40 Washington Square South, New York, New York 10012. I am also a Research Associate of the International Tax Program of Harvard Law School. In the latter capacity, I have been engaged since 1976 in a study of the source of income rules of the federal income tax law, a study which will culminate in a book to be entitled, "The Sources of Income: A Study of the Role of Source Concepts in the United States Taxation of International Business and Investment Income." In my appearance today. I do not represent New York University, the International Tax Program, or the Harvard Law School. I appear only as an interested citizen. THE ISSUE The Internal Revenue Code allows a credit against U.S. income taxes for income taxes paid to foreign countries. The credit is allowed to alleviate double taxation. It is generally allowed only to citizens and residents of the United States and domestic corporations. The theory underlying the credit is that when a United States person earns income abroad, primary jurisdiction to tax the income should lie with the foreign country that is the source of the income, and the United States should tax the income only to the extent that the foreign tax is less than the tax the United States would normally impose. Because the credit is allowed to eliminate double taxation, the credit is allowed only against the U.S. tax on foreign income. Since foreign countries tax United States persons only on income originating in these countries, no reduction of U.S. taxes on domestic source income is needed to eliminate double taxation. The maximum allowable credit for foreign income taxes is thus the U.S. tax, before credit, on foreign source income. Generally, for a large company, the maximum credit is 46 percent of foreign source income, and the net U.S. tax on foreign source income is 46 percent of the income less the taxes on the income imposed by foreign countries. Foreign source income is measured for this purpose by source rules found in our law, not the laws of the foreign countries that impose the taxes for which credit is claimed. The federal income tax is a tax on net income, that is, a tax on the excess of gross income over allowable deductions. Generally, this means that taxable income is gross receipts, reduced by the costs incurred in earning them. The U.S. tax on foreign source income thus can be determined accurately only if foreign source income is also defined as a net figure. The law has so provided for six decades. More particularly, the maximum credit is the U.S. rate multiplied by the taxpayer's "taxable income from sources without the United States," and the quoted words are defined as the excess of gross income from sources outside the United States over the deductions "properly apportioned or allocated thereto." Foreign source income thus is generally gross receipts from sources outside the United States, less the costs incurred in earning these foreign receipts. The issue before this committee today is whether research and development costs should be among the costs governed by these general rules or should be subject to a special regime. Research and development costs are usually deducted as incurred, even though the costs are typically expected to yield benefit far into the future. If a company's patents and know how are used in producing goods both in the United States and foreign countries, research and development costs are incurred in order to earn income from foreign as well as domestic sources. In this case, the general rule described above-that foreign source income is gross receipts from foreign sources less the costs incurred in earning these receipts-requires that the deduction for research and development costs must be allocated partly to foreign source income. This allocation would reduce taxable income from sources without the United States and thus would cause the maximum credit for foreign income taxes to be smaller than it would be if research and development costs were ignored in determining the credit. The Congress decided in 1981 that there should be a special rule for research and development costs, at least temporarily. It provided in § 223(a) of the Economic Recovery Tax Act of 1981 that for two years all deductions for the costs of research and development done in the United States should be allocated to domestic income. During this two year period, the treatment of research and development costs is unique. The general rules continue to apply to all other business costs. That is, taxpayers still must subtract from foreign source income at least a portion of all costs other than research and development costs that are incurred, in whole or in part, to generate foreign income. A research and development cost is the only cost that may be ignored in determining foreign source income even if it is incurred to earn foreign as well as domestic income. This unique treatment for research and development costs conflicts with the policy that the foreign tax credit should serve only to eliminate double taxation. When foreign source income is determined without subtraction for all deductible costs incurred in earning gross income from foreign sources, the foreign source income figure is artificially inflated, and the maximum credit is thereby enlarged. The maximum credit is thus larger than the precredit tax fairly allocable to foreign source income. The credit is thereby allowed to offset not only foreign source income but a portion of domestic source income as well. The allowance of a foreign tax credit against U.S. tax on income from domestic sources is not justified by the policy to eliminate double taxation. It is simply a subsidy for the specially treated item, research and development costs. The issue before this committee today is whether this special treatment for research and development costs should be continued. I urge that it not be. THE REGULATIONS The Treasury promulgated regulations in 1977 which apply the general rules described above to research and development costs. For companies that do most of |