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We know what the question is that we are wrestling with. With unanimous consent of the committee, your full prepared statements will be entered into the record.

It would be helpful if you could use the 5 minutes that we have allocated to you to try to answer some of the questions that have been raised by those people that oppose the extension of the moratorium.

Let's hear from the Chamber of Commerce, Mr. Schick.

STATEMENT OF C. WILLIAM SCHICK, ASSISTANT CONTROLLER, UNITED TECHNOLOGIES CORP., ON BEHALF OF THE CHAMBER OF COMMERCE OF THE UNITED STATES, ACCOMPANIED BY DAVID E. FRANASIAK, MANAGER OF TAX POLICY

Mr. SCHICK. Thank you very much, Mr. Chairman. I will briefly summarize what we think is the correct answer.

The technical and economic aspects have been well covered today. I have several key points.

First, we believe that the 1977 regulations are incorrect. We don't think that a cost allocation system that allocates U.S. R&D costs to foreign source income under circumstances where double taxation can arise must be corrected and must be approached carefully.

It is wrong to require allocation of R&D on bulldozers to income earned for lawn mowers, as the regulations do, just because these two products happen to be in the same S.I.C. classification.

Second, no matter how carefully the cost allocations are made, there is the potential, as has been discussed this morning, that costs will rise for R&D in this country and will have the potential of decreasing the R&D in this country.

It seems that Treasury supports this view. However, they have apparently not addressed the question of whether the allocations in the regulations are correct.

Finally, we think that although there may be other solutions, the simplest solution to this 861 question is to provide that all R&D costs incurred in the United States be allocated to U.S. source income.

It comes closest to what we believe is the correct solution and it removes increased tax costs that may arise from performing of R&D in the United States.

We urge that the provision be made permanent and that an additional 2 year moratorium is not appropriate.

Chairman RANGEL. Thank you, Mr. Schick.

[The prepared statement of Mr. Schick follows:]

STATEMENT OF C. WILLIAM SCHICK, ON BEHALF OF THE Chamber of CommERCE OF

THE UNITED STATES

I am William Schick, Assistant Controller of United Technologies Corporation. Our company is a member of the Chamber of Commerce of the United States, which is the organization I represent today. Accompanying me is Mr. David E. Franasiak, the Chamber's Manager of Tax Policy. We appreciate having this opportunity to address important research and development tax policy questions.

United Technologies Corporation designs, develops and manufactures products with high technology content. Our products include Pratt & Whitney Aircraft gas turbine engines, Sikorsky helicopters, Otis elevators, and Carrier air conditioners. We are headquartered in Hartford, Connecticut. Our annual sales volume is 14 bil

lion dollars. We invest 800 million dollars each year in research and development. We carry out our work with 180,000 employees.

SUMMARY

The U.S. Chamber supports making permanent the two-year rule in Section 223 of the Economic Recovery Tax Act of 1981, which provides that Research and Development (R&D) costs paid and incurred in the United States are to be allocated to U.S. source income. This provision suspended for 1982 and 1983 the R&D portion of Section 1.861-8 of the Income Tax Regulations, issued by Treasury in 1977. The matter now urgently requires attention.

The Internal Revenue Code has provided for a long time that foreign source income must be reduced by an allocation of indirect expenses incurred in the U.S. The 1977 regulations required that certain amounts of R&D costs incurred in the United States be charged against foreign source income. This, in turn, in many cases reduces the foreign tax credit while usually increasing the U.S. tax by an equal amount.

The effect is that substantial amounts of R&D costs incurred in the United States are denied as Federal income tax deductions. The methods of computing the R&D allocations under the regulations are highly arbitrary. Because of that, the expenses are not generally deductible in foreign countries. In these instances, the costs are not deductible anywhere. Another way of saying it is that the same business is, or can be, subjected to double taxation-foreign and U.S.

The 1977 regulations require U.S. R&D incurred to design and develop a domestic product to be allocated to foreign source income derived from sales of the products that have nothing to do with the U.S. products.

Such results are in conflict with sound tax policy. It is wrong to have regulations which result in double taxation. Such results are also in conflict with sound trade policy. One way a company could avoid the 1.861-8 penalty is to transfer R&D operations to countries that would allow a tax deduction.

The Treasury itself, in its study, recognized that the regulations could reduce R&D expenditures in the U.S. and adversely affect our competitive position. On that basis, Treasury recommended a further two-year suspension. We think that Treasury's conclusions justify a permanent solution now.

We understand the Committee wishes to consider the relationship of the Section 861 R&D matter to the "Tax free" transfer of technology abroad for use in manufacturing operations. We think there is a limited relationship between these two matters. The Section 861 matter is largely concerned with tax policy. The question in this matter is whether the allocations of R&D required in the 1977 regulations are correct and whether it is proper to have a provision which results, or can result, in double taxation.

The transfer of technology abroad is largely a trade issue, the tax policy questions having been already dealt with through Section 367(a), which requires taxpayers to obtain rulings from the IRS as to whether tax avoidance is the nature for transfers. The Chamber opposes deterrents to trade, such as taxes on transfers of economic resources between the United States and its trading partners.

Tax policy aspects

OUR VIEWS IN MORE DETAIL

Sections 861, 862, and 863 of the Internal Revenue Code were created to define the source of income. They require that indirect expenses be apportioned to the source of income. Presumably, if this defining process is properly carried out, that which is U.S. source income will be taxed in the U.S., and that which is foreign source income will be taxed in the foreign nation. It is entirely correct to deal with the apportionment of expenses to source in this context.

Since the overall foreign tax credit is limited to 46% of a company's_foreign source income, there is a need to define source of income for that purpose. Sections 861, 862, and 863 are used for this purpose. These sections require an apportionment of deductions to the source of income.

The allocation of indirect expenses to the foreign source income, without a corresponding foreign deduction, has the inherent effect of taxing the same earnings twice; that is to say, the allocations cause double taxation. This result, of course, defeats the very purpose of the foreign tax credit, which is to prevent double taxation.

Double taxation results, or can result depending on the particular circumstances, because the U.S. expenses that are allocated under the Section 1.861-8 regulations

to the foreign source income generally are not deductible or may not be deductible in the foreign jurisdiction. This result occurs because the world taxing system is not set up to provide that indirect expenses to be allocated under the Section 1.861-8 concept are deductible in the foreign jurisdiction. Thus, a U.S. taxpayer-in effectreceives no deduction for the expenses either in the U.S. or in the foreign country from which the foreign source income is derived.

Moreover, a U.S. taxpayer can avoid or minimize the penalty imposed by the Section 1.861-8 regulations by moving all or some of its R&D operations to other nations, where a deduction might be realized. In writing the Section 1.861-8 regulations, the Internal Revenue Service misinterpreted, we believe, the intent of Sections 861, 862, and 863 as they relate to the foreign tax credit.

A theoretical example of this process is shown in the Appendix. The example assumes that a U.S. company maintains an operation in foreign Country X, through a foreign subsidiary. The operation in Country X is an exact duplicate of the operation in the U.S. Country X's tax laws are exactly the same as the tax laws of the U.S., except that Country X allows a full deduction for all R&D incurred in Country X. In the example, it is assumed that the U.S. requires a 35 percent allocation of R&D costs, if incurred in the U.S., to foreign source income. Further, the example assumes 100 percent of the income earned in Country X is repatriated.

Using the figures in the example, if the R&D expenses are incurred in the U.S., the effective combined foreign and U.S. tax rate is 54.9 percent even though the tax rate in each country is 46 percent.

If the R&D effort is carried out in Country X instead of in the U.S., the combined rate is 46 percent, exactly equal to the rates imposed in each country.

This example demonstrates how 1.861-8 results in double taxation. It also demonstrates how the regulations result in a denial of an R&D deduction and that this anomaly could be overcome by moving the R&D operations.

The main problem is that the 1977 regulations require the allocation of U.S. R&D to foreign source income almost without regard to any particular facts or circumstances. In the regulation, there is a presumption that U.S.-incurred R&D that is even remotely related to products the taxpayer manufactures abroad must be allocated to income earned abroad.

The overreaching regulatory approach is exemplified in a particular provision in the regulations which requires that R&D spent in the United States to develop bulldozers must be allocated to foreign source income derived by an affiliated manufacturer from sales of lawn mower engines abroad. The regulations require this conclusion on the basis that bulldozers and lawn mower engines are in the same two-digit Standard Industrial Classification (SIC) Code; hence, there is a presumption that bulldozer R&D benefits lawn mower engines.

Whether there is a casual or beneficial relationship between bulldozer R&D and lawn mower engine R&D, we do not know. We suspect there is not much of a relationship. Even if it were correct to allocate any U.S.-incurred R&D expenses to foreign source income for purposes of computing the foreign tax credit, it is wrong to do so in an arbitrary and inflexible manner such as is mandated in the 1977 regulations.

We know of an actual instance where the regulations may require R&D expenses incurred to design and develop a product in the U.S. to be allocated to income derived from a different product developed in a foreign country merely because the two products are in the same SIC. The Department of Commerce has confirmed that the two products are in the same SIC only because separate classifications would cause the public disclosure of competitive information.

The U.S. Department of Commerce publishes product/service classifications for the purpose of compiling industrial statistics. Thus, the classifications may or may not reflect the extent to which a particular R&D project benefits another project. SIC's should not be used for cost allocation purposes.

The regulations also presume that all R&D is conducted in the United States, and completely ignore the fact that many products manufactured and sold abroad were designed and developed abroad. It makes no sense to require allocations of U.S. R&D expenses to income derived from sale of products abroad that were, in fact, designed abroad.

The arbitrariness of those regulations caused the current controversy. This controversy now requires that Congress enact a correct solution.

In those cases where the facts and circumstances do indicate that R&D expenses incurred in the United States are conducted on behalf of a foreign operation, the Commissioner may invoke Section 482. This section gives the Commissioner the power to distribute, allocate, or apportion any deduction to any commonly owned organization or trade or business to which the deduction pertains. If that process is

correctly carried out, each entity, U.S. and foreign, will bear its proper deductions and report its proper income to the relevant taxing authorities, and the current controversy will be resolved.

Relationship to "tax-free” transfers to technology

We do not think there is a significant relationship between the Section 1.861-8 matter and the so-called "tax-free" transfer of technology abroad. The Section 1.861-8 regulations are wrong from a tax-policy viewpoint based on the analysis we have presented above.

The proposed cure to the 1.861-8 problem does have some trade policy aspects since the cure is to provide that all R&D expenses incurred in the United States are to be allocated to U.S. source income. This is also a practical solution, since it is unlikely that detailed, formula-type regulations can be written which will result in a correct allocation. This is because correct allocations depend on the particular facts and circumstances pertaining to the various taxpayers.

On the other hand, the question of transfer of technology abroad is largely a trade issue. At one time, it was a tax policy issue because the possibility existed of transferring technology abroad in order to avoid income taxes. This matter has been dealt with already through Section 367 which mandates that the taxpayer request a ruling, in which proceeding the taxpayer must prove that his purpose is not to avoid U.S. income taxes. Also, Section 1491 deals harshly with tax avoidance, imposing a 35 percent excise tax on transfers made for the purpose of avoiding income tax.

Therefore, the matter is one of trade policy. Is it in the interests of the United States to permit tax-free transfers of resources abroad? Such resources include capital and people, as well as technology. Except in cases where such transfers can endanger the Nation's security, it has been the policy of the United States to not impose barriers on these transfers. The U.S. Chamber continues to support this policy.

Treasury report

Finally, the Treasury Report on the Section 1.861-8 regulations concludes that the regulations do cause a reduction in U.S. R&D activity, and that this, in turn, can cause a loss in our nation's competitiveness. There is a consensus that the American business establishment is falling behind its foreign competitors in productivity. There is little doubt that this trend, in whole or in part, comes about from a decline in the level of U.S. R&D expenditures relative to those of some other countries. We must not allow this trend to continue.

On the other hand, the Treasury study does not fully address the question as to the correctness of the 1977 regulations. The report states, "The objective (of the regulations) is to avoid allocating R&D expense related to one product to foreign source income earned from sales of a wholly different product category." We question whether this is a properly stated objective. Even if it is, the regulations do not achieve the objective because they require allocations of R&D costs to foreign source income earned from wholly different product categories through the use of SIC Codes that were not designed for tax purposes.

We think the regulations are wrong, and unlike the Treasury Department, we recommend not an additional two-year suspension of the R&D portion of the regulations, but a permanent solution. Temporary resolutions do not permit companies to plan how resources are to be deployed. Over the past few years, there has been enough on-again-off-again tax policy. The right solution is to require that U.S. incurred R&D expenditures be charged to U.S. source income.

THEORETICAL MODEL-HOW S1.861-8 REGULATIONS CAN RESULT IN DOUBLE TAXATION Assumed Facts:

1. Company operates in two countries, through subsidiaries, U.S.A. and Country X.

2. Factory, sales and support operations in the two countries are exact duplicates. There are no exports.

3. Country X's Internal Revenue Code is exactly the same as U.S. Internal Revenue Code, except that all R&D expenses incurred in Country X are allocable to Country X source income.

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Combined tax rate of two countries: 46 percent times $450 equals combined tax of $207-model 2; 54.9 percent times $450 equals combined tax of $161-model 1.

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Chairman RANGEL. The National Association of Manufacturers, Mr. Ragland.

STATEMENT OF ROBERT A. RAGLAND, DIRECTOR OF TAXATION, NATIONAL ASSOCIATION OF MANUFACTURERS

Mr. RAGLAND. Thank you very much. I will summarize my statement briefly for the record.

The position of NAM is that the current moratorium on the allocations of R&D costs under IRC section 861 should be made permanent. Continued reliance on ERTA's moratorium enacted on an emergency basis promotes uncertainly in our R&D tax policy and will require us to revisit this question again in future years.

There are two reasons for our position. The first is that the 1981 moratorium in our judgment is working. Notwithstanding the generally unfavorable climate of the past 2 years, industrial R&D increased 10.2 percent since 1981. Before that, spending on research and development generally was declining. In fact, it had fallen

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