eign subsidiaries-unlike research by the U.S. parent-will not as a practical matter enjoy the tax benefits accorded by Puerto Rico. That is a possible deterrent to going abroad. The other thing to consider is that people will say I can get tax savings because the foreign country allows a deduction. But, you don't get a deduction without having income. The foreign subsidiaries income will soon be increased because by doing the research, it will soon have a parent or know-how that it will license to the U.S. parent.

The subsidiary's income will thus be increased by the fact that instead of paying a royalty to the U.S. parent, it will be receiving a royalty from the U.S. parent. Pretty soon the combination of royalties not paid to and royalty received from other affiliates may well equal the research expenses in the foreign country. In that case you are not talking about saving tax in the country of research; you are talking about saving tax in the United States, because the United States will not discriminate and will therefore allow a bigger royalty to be paid to the country of research than a foreign country would if the United States were the country of research. To a large extent, then, research might be relocated abroad in, say, Germany, not for the deductions but because the deductions in Germany ultimately come from third countries like the United States in the form of royalties to the country that does the research.

Accordingly, say that a company will move abroad because a foreign country allows the deduction without talking about the 861 policies of that foreign country, or to say that the deduction will save tax in that country without speaking of the corresponding royalties that must be charged is to speak in terms that obscure what is happening here. A company might move abroad in order finally to pay royalties from the United States and to save U.S. tax. When the U.S. parent pays royalties, the royalties are just for the U.S. rights to technology, and there is no allocation of the deduction to foreign income.

Now, to conclude I would like to summarize where we are today. The companies have a rather sympathetic case, but in many instances, not for the reasons they may state. The companies excess foreign tax credit predicament occurs for a number of reasons. First, the United States has an overall foreign tax credit which allows the very high tax rates on developing countries to be averaged with the somewhat lower rates of developed countries. Next, we have congressional policies that prevent obtaining treaties which lower developing country tax rates.

The most relevant reason, however, may be that many industrialized countries discriminate against U.S.-owned companies. They discriminate not only in the tax base, but they have a higher tax rate on U.S.-owned companies than they have on their own companies.

To that degree, if the U.S. Treasury cannot protect its companies from overtaxation abroad, then the companies have a good case to go to the Treasury or the Congress and say, well, then protect us from that at home.

However, you understand that the consequences of that is that because other countries are discriminatorily overtaxing foreign income, the United States is going to exempt domestic income from

tax. This enables other countries to continue overtaxing at the expense of our Treasury, because ultimately the game is not between the companies in the United States, it is between the governments. They are really taking U.S. tax revenues. To the extent this moratorium is continued, it will remove the incentive of companies to complain about or try to alleviate discriminatory tax abroad. Therefore, a situation in which they have gotten into through no fault of their own will probably continue, other countries will overtax their foreign income, we will undertax their domestic income, and nobody will complain about it.

I think you should view what people say about the moratorium with the idea that relocation turns very often on extremely technical issues that nobody talks about, what 861 allocations will be in the foreign country, can you move research facilities abroad without tax, what policy will the country have that gives you the deduction about requiring royalties to be paid from the United States? I think these issues are very important. I think the most important issue is overtaxation abroad-and it is such overtaxation rather than particular incentives that this moratorium is about. Foreign countries may hope that the U.S. companies will relocate the facilities, but in any event they want to overtax Americanowned companies because it increases their tax revenue at the expense of a foreigner.

So the ultimate question is whether discriminatory taxation will continue and, if so, will anybody here complain about it. They will not if we take care of them by exempting domestic income from tax.

Thank you.

[The prepared statement of Mr. Kingson follows:]

STATEMENT OF CHARLES I. KINGSON, WILKIE, FARR & GALLAGHER, NEW YORK, N.Y.

CONTEXT AND BACKGROUND OF THE SECTION 861 REGULATIONS

What the section 861 regulations do

Foreign source taxable income is calculated by first classifying the items of gross income that are from foreign sources and then subtracting from foreign gross income the deductions attributable to those items. Section 861 of the Code classifies gross income as from either United States or foreign sources. Treasury Regulations section 1.861-8, commonly referred to as the section 861 regulations, allocates deductions between gross income from the United States and that from foreign

sources.

Both the statute and regulations thus serve the same purpose-determining foreign source taxable income. To the extent the section 861 regulations allocate deductions (such as research expenditures and interest payments) to gross income from foreign sources, they reduce foreign source taxable income.

Relevance of the section 861 regulations to the foreign tax credit

American companies generally want the highest possible percentage of their taxable income to be classified as foreign. This is because section 904(a) of the Code limits the amount of foreign tax that an American company can credit against United States tax to the following product: Foreign source taxable income divided by total taxable income multiplied by U.S. taxes.

Assume, for example, a United States corporate tax rate of 50 percent. Assume further that an American company had the following ordinary income and paid the following taxes:

The limitation fraction would be as follows: (Foreign income) 100 divided by (Total income) 200 multiplied by (U.S. taxes before credit) 100 equals 50.

The corporation would therefore owe $100 of U.S. taxes, against which it could offset $50 of foreign tax credit. It would therefore owe the same $50 of United States tax-no more and no less-than if it had not had any foreign source income.1

A simpler way of viewing the limitation, consistent with its objective, is that the credit is limited to the United States on foreign source income.2 Assuming for convenience a United States corporate tax rate of 50 percent, the foreign tax credit limitation becomes 50 percent of foreign source taxable income.3

Equivalence of excess credit to exempt income

When foreign taxes paid equal or exceed 50 percent of a United States company's foreign source taxable income, such income becomes effectively exempt from United States tax: that is, United States tax will not be payable on foreign source income.* The section 861 regulations, therefore, perform the same function as does section 265 of the Code, which disallows deductions attributable to income that is literally exempt from United States tax. To illustrate the similarity to a disallowance, assume that a United States company has the following income and taxes, before allocation of a $20 deduction for research expenses:

The foreign tax of $50 is equal to the U.S. tax imposed on that income. Accordingly, no U.S. tax is imposed on that income, and the foreign tax credit limitation (50 percent of $100 foreign source income) has been reached. The foreign income is therefore effectively exempt from U.S. tax.

If the $20 of research expense deduction is allocated to United States income, the result will be:

If it had had only the $100 of United States source income, its United States tax would have been $50.

2 The objective of such limitation, as set forth in a Joint Committee Staff pamphlet, is to prevent foreign tax credits from being used "to offset U.S. tax on domestic income".

3 This can be shown by rearranging the statutory formula in four steps.

(a) Foreign income multiplied by U.S. taxes divided by total income.

(b) Foreign income multiplied by U.S. taxes divided by total income.

(c) U.S. tax divided by total income equals effective U.S. tax rate.

(For a large corporation-assuming a 50 percent statutory rate-the effective tax rate is about 50 percent of taxable income. The reason is that, for this purpose, United States tax is calculated before reduction for such items as the investment tax credit and the foreign tax credit itself.) (d) Foreign income times 50 percent, or 50 percent of foreign income.

The equivalence can be shown by recent amendments affecting United States companies operating in Puerto Rico. Prior to 1977, their income was literally exempt from United States tax; since 1977, their income obtains a foreign tax credit equal to the United States tax on such income-i.e. 50 percent times Puerto Rico taxable income. The effect is the same.

Allocation of the deduction to foreign income therefore just reduces the amount of income that is exempt from tax anyway, and the deduction does not benefit the company.5

Until the foreign income becomes exempt from United States tax, however, deductions allocated to foreign income benefit a company just as much as deductions allocated to United States income. To illustrate, assume the following situation:

Assume next that $20 of deductions for research expense are allocated to foreign income. The situation becomes:

Foreign income..

Foreign tax

U.S. tax.

$100

50

0

The allocation of $20 research expense to foreign income has not hurt the taxpayer. It has saved him United States tax of $10, because before the allocation the foreign income was not exempt from United States tax.6

The moratorium as exempting income from tax

To the extent that American companies with potential excess foreign tax credit can get income classified as foreign rather than domestic, they can exempt it from United States tax. Congress has previously cut back on the ability of companies to obtain such exemption by using section 861 of the Code to classify gross income as foreign."

The section 861 regulations are equally as important as the rules classifying gross income as United States or foreign, because—as previously stated—together they determine how much foreign source taxable income a company has. They therefore ultimately present the same issue: whether income which is economically attributable to the United States is to be exempt from tax.

Assume also that the company invests enough in banks to produce $20 of interest. If invested in United States banks, the $20 would be U.S. source income on which $10 United States tax would have to be paid. If invested in foreign banks, it is foreign source gross income. Since this would raise the foreign tax credit limitation to $60 (50 percent of $120), investing in foreign banks would produce tax-exempt income. The illogic of this result, as well as its unfairness to domestic banks, caused Congress to change it in 1962.

Much the same result occurred if the company had a $20 gain on, say, 100 shares of General Motors stock. If the stock were sold in the United States, the gain would be subject to United States tax; if sold abroad, it would be foreign source gross income and therefore exempt from tax. Congress changed this in 1976, so that the $20 gain does not increase the foreign tax credit limitation.

5 Although the Code provides for carryovers of the $10 foreign tax paid in excess of the $40 limitation (50 percent times $80), the carryover does no good if-as is frequently the caseexcess credit is a chronic condition.

6 After allocation of the $20 expense, the foreign income has become exempt from United States tax; and a further allocation of, say, $10 of research expenses to foreign income-although reducing the foreign income to $90-cannot reduce the United States tax on such income below zero.

7 Assume: Foreign business profits, $100; Foreign tax paid, $60.

Assume further that a $20 deduction for research expenditures, although incurred in the United States, is on a proper cost accounting basis attributable to foreign sales. To attribute that deduction to the United States reduces United States income to $80. In other words, it exempts from tax $20 of United States source income.

A less complex way of viewing what this moratorium is about is to consider the case of an American living abroad who earns $100 in fees and incurs $20 of business expense in doing so. His other income consists of $20 of dividends from General Motors. The Code exempts from tax his earnings, but not his dividends. Under section 265 of the Code, he is considered to have $80 of exempt earnings ($100 minus his business expense) and $20 of taxable dividends. What the moratorium would do-if applicable to him—is reallocate the $20 business expense from his nontaxable fees to his taxable dividends. As a consequence, because of an expense applicable to his fees, both the fees and the dividends would be exempt from United States tax. History of the 861 regulations

Until 1973 the section 861 regulations were minimal, saying only that you attributed deductions to the proper income. In that year regulations were proposed which would have allocated research expenditures in accordance with the percentage of sales-including expected sales-here and abroad. To illustrate, if there were research expenditures of $100, and it was expected that ultimately 50 units of the product would be sold abroad and 50 in the United States, one-half-$50-of the deduction would be allocated to foreign income.

Companies objected to the proposed regulations, for several reasons. Among them were the following:

1. To use expected sales abroad was unfair, since this did not give an appropriate discount to the fact that profits from sales abroad would be earned later than profits from sales in the United States;

2. Economically, companies did research primarily for the United States market; so that the bulk of that expenditure should be traced to United States income rather than apportioned as if the two markets were fungible;

3. It would be unfair to allocate to foreign income more research deductions than the income obtainable from licensing such research; and

4. Apportioning the deductions in such a way that they were as a practical matter disallowed would encourage companies to relocate research facilities abroad, where foreign countries would allow a tax deduction to reduce tax.

The first two arguments are economic ones, which I do not intend to discuss. From a technical point of view, however, they appear to assume that income from the research activities attributable to United States sales will be taxed by the United States, whereas in fact much of it goes untaxed because the patent is transferred to a corporation with operations in Puerto Rico.

The third argument, which is extremely persuasive, can be illustrated by an example. Assume $100 of research expense, and that sales of the product will be onehalf in the United States, where United States parent P manufactures and distributes it; and one-half abroad, where P's foreign subsidiary F makes and distributes it. Assume further that the foreign tax rate on F's income is 50 percent.

Each company has $150 of profit before deduction of royalties or research expense, and F declares all its after-tax profits as a dividend. The foreign country where F manufactures, however, only allows a $30 deduction for royalties to P. Income of F...

Less royalty to P

Total.

Foreign tax.

After-tax profit (remitted as a dividend to P).

$150

30

120

60

60

This includes the $60 cash and the $60 of foreign tax deemed paid by P for foreign tax credit purposes.