The first panel will be Richard Kaplan, a professor from Boston College of Law, speaking for himself and also speaking for Professor Ault; Jon Bischel, professor of law, Syracuse University; and Stephen D. Desmond, a partner of Price Waterhouse.

Thank you very much. We have written statements from all of the witnesses. They will be entered into the record without objection, and you can proceed to highlight those statements.

STATEMENT OF PROF. RICHARD L. KAPLAN, UNIVERSITY OF ILLINOIS, AND ON BEHALF OF PROF. HUGH J. AULT, BOSTON COLLEGE LAW SCHOOL

Mr. KAPLAN. Thank you, Mr. Chairman. I will be brief, both because you already have our statement and because many of the concerns that I was going to express have already been articulated very well by Congressman Pease.

The idea of allocating research and development expenses to U.S. income exclusively should not be seen as an R&D incentive at all. It is exclusively restricted to those companies that are operating in high tax countries and which have excess tax credits. In other words, this is no incentive to R&D, but rather to bigness, as in fact the Treasury Department's report-that is the Treasury Department of the Reagan administration-shows that 85 percent of the benefits under this regulation go to 24 companies in of the Fortune 100.

This allocation rule has no benefit to any small company operating in some garage in Silicon Valley, coming up with new ideas. It has no benefit to middle-size companies doing R&D here but selling their products overseas, because those companies do not incur foreign income taxes. The only benefit that this allocation rule under ERTA can have is for those big companies that have not only foreign sales but also foreign operations and manufacturing. And even within this category of mature companies with foreign operations, only those companies that are operating in high tax countries, higher than U.S. taxes, would generate the excess tax credits that are affected by this rule.

So first and foremost, we must understand that this is not an incentive for R&D. In fact, this mechanism actually reduces the U.S. tax burden of those 24 major companies on their U.S. income. They are not saving foreign taxes. They are saving U.S. taxes. So that their U.S. income does not bear the same proportion of tax that some small entrepreneur in Massachusetts or California must bear. If anything, the ERTA rule creates a competitive disadvantage for the small corporation vis-a-vis the large multinational.

Furthermore, I would refer you to a recent report of the National Science Foundation entitled "An Assessment of Three R&D Tax Incentives Provided by the Economic Recovery Tax Act of 1981." In this 47-page report analyzing the effectiveness or ineffectiveness of the R&D tax incentives in ERTA, not one word is mentioned about this particular rule, because the National Science Foundation understands that this is not an R&D incentive at all. It is not merely inefficient, it is not an R&D incentive that even merits discussion. Rather, this is simply a mechanism to reduce U.S. taxes on U.S. income. Every accounting treatise acknowledges that the proper

way to handle these expenses is to use the same principles that multinationals apply internally, for their own reports, not just to R&D but also to interest expenses, home office expenses, and other overhead costs-namely, allocate those expenses to the income affected, including foreign source income. When these companies have done so, then perhaps they will get a deduction against their foreign source income from to foreign countries.

I mention that point not because it has any particular relevance to what the United States should do. That is, we are not supposed to underwrite the rest of the world's tax systems, but there is a great deal of smoke being blown about to the effect that these countries will not allow R&D deductions for the beleaguered multinationals of the Fortune 100.

In point of fact, virtually every country that these companies would have operations in has a tax treaty with the United States. These treaties have two interesting provisions relevant here. One, a nondiscrimination clause that requires our treaty partner not to discriminate against U.S. companies vis-a-vis their local companies. That applies to all principles of treating taxable income and expense. More specific is a second provision that I have listed in exhibit A to our prepared statement. Under these provisions, our treaty partners acknowledge that general and administrative overhead-type expenses shall be allocated and allowed as deductions against foreign taxes. That is not to say that the companies have a blank check. No, each provision limits the allowable deductions to the amounts that are reasonably attributable.

So all the bellyaching that we are hearing is really an audit issue: that is, whether research and development expenses properly allocable to foreign source income are going to be allowed as deductions by the foreign countries. They have said in their treaties that if the expenses are reasonably attributable, they will be allowed. Of course, there may be questions about whether a particular R&D expense is reasonably attributable. But that is neither a treaty issue nor a tax policy issue. That is simply an administrative matter.

After all, our own Internal Revenue Service doesn't allow every deduction that one claims, unfortunately. The R&D issue is the same issue that applies, say to entertainment expenses of corporate lobbyists. Those expenses may be deductible, but their deductibility must be proven to the satisfaction of the taxing authorities. The same principle applies here to R&D.

The foreign taxing authorities may certainly question the specific amounts allocated to foreign source income. But the fundamental idea that some U.S. based R&D or other overhead expenses may be allocated to foreign source income is part of every U.S. tax treaty.

I will conclude with one final point, because there is so much. wrangle, if you will pardon the pun, about jobs, and that this is really a jobs bill. Not being a Congressman, I can only imagine how tiring it must be for every single corporate tax deduction to be masqueraded as a jobs bill. Aren't you just a bit tired of hearing about still another jobs bill, after ERTA-perhaps more appropriately entitled the "Employment Reduction Tax Act of 1981"-with its accelerated cost recovery system that was supposed to be the panacea for corporate America?

An interesting side effect is that ERTA reduced U.S. effective corporate tax rates so that most of our trading partners now have higher tax rates than we do, often substantially so. As a consequence, multinationals are generating these excess foreign tax credits that they are now asking you to help them with. If we continue the unprincipled rule that ERTA created for R&D, we will not see more R&D, nor any new jobs. About the only jobs affected by this rule are those of the corporate lobbyists you have already heard from.

Thank you.

Mr. RANGEL. Thank you for your eloquent and searching remarks.

[The prepared statement follows:]

STATEMENT OF PROF. RICHARD L. KAPLAN, UNIVERSITY OF Illinois, anD PROF. HUGH J. AULT, BOSTON COLLEGE LAW SCHOOL

Mr. Chairman, we are law professors who teach in the area of taxation with particular emphasis on the U.S. taxation of international transactions. Accordingly, we have followed the developments affecting Treasury Regulation § 1.861-8 for some time, especially the attention devoted recently to the question of allocating research and development (R&D) expenses between U.S. and foreign source income. It is our view that the moratorium on the application of the Regulation should not be extended. The suspension of the existing Regulation as it applies to R&D expenses was ill-advised and is impossible to justify. R&D expenses should be treated on the same principle as any other type of income-producing expense.

INTRODUCTION

In essence, the Regulation requires that R&D expenses be allocated between U.S. (domestic) and foreign source income on the basis of various factors, which ultimately try to match revenues earned with the expenses incurred in earning those revenues. Some of the details of the allocation formulae in the present regulation could certainly be questioned-indeed, in many situations they seem too generous to usbut the basic principle that these costs should be allocated is beyond dispute. The concept that expenses should be allocated to the various categories of revenue that those expenses helped produce is at the heart of financial accounting principles and, despite occasional departures, is embodied as a central feature in our federal tax system. That is the clear import of Internal Revenue Code section 861 and its implementing Regulations. If this principle is abandoned, income derived in part from certain expenditures would not be matched with those expenditures, resulting in inappropriate distortions.

That is why the section 861 Regulations apply to a wide variety of expenses, not just research and development costs. Interest expenses, home office management costs, legal and accounting fees, income taxes, and other expenditures are equally subject to the allocation regime currently under attack. The proper treatment of all of these costs is to allocate them between foreign and U.S. source income. That is the principle adopted for any expense that cannot be specifically associated with a particular source of income but which benefits the entire enterprise, or at least several parts of that enterprise. The Regulation, in other words, subjects R&D expenses to the same allocation rule that applies to other overhead-type costs, and any proposed departure from this principle should satisfy a rather heavy burden of proof.

R&D SUBSIDY

Since the proposal to allocate all R&D expenses to U.S. source income cannot be justified on the basis of general tax concepts and principles, proponents have sought to cast it as an R&D incentive. But this proposal would have little impact on research undertaken in this country. Its principal impact is not on R&D at all, but on the calculation of the foreign tax credit. For U.S. taxpayers, the allocation of expenses between foreign and domestic source income is part of the effort to limit the tax credit allowed by U.S. law for taxes paid to foreign governments on foreign source profits. Without this limitation, which has been part of the foreign tax credit mechanism from its beginnings, the United States would be allowing a credit against U.S. taxes owed on U.S. source income. This result comes about as follows. If

expenses are not allocated to foreign source income, then the limitation on the credit for foreign taxes is increased, since the limitation is then expressed in terms of gross income rather than net income-necessarily a larger number. In effect, the foreign taxes are being credited against the U.S. tax owed on U.S. source income. That has never been the policy of the U.S. taxing statutes, and there is no serious effort to change this long-standing policy-even now.

TAXPAYERS AFFECTED

The R&D allocation issue, for all of the rhetoric about encouraging R&D, has its impact only on the foreign tax credit limitation of companies that are operating in countries with effective tax rates higher than that of the United States. Only those corporations have "excess credits"-foreign taxes actually paid-that they presently cannot use because of the restriction that these credits be applied exclusively against U.S. taxes on foreign source income. These companies, accordingly, are the claimants now petitioning for relief from this fundamental limitation. In effect, they want to repeal the section 904 foreign tax credit limitation, at least as it applies to them. This proposal, in other words, is simply special interest legislation for a limited class of beneficiaries.

And who are these beneficiaries? According to the June 1983 Report on this subject prepared by the Reagan Treasury Department, 85 percent of the tax benefit from the proposed change would go to 24 companies on Fortune magazine's list of the 100 largest U.S. industrial corporations. (p. 32) It is this rather small group that has the wide-reaching foreign operations, including operations in relatively high-tax countries, that produce the "excess credits" situation that Code section 861 tries to monitor. Thus, the repeal of the R&D regulations presently sought would primarily benefit large, mature corporations, not the start-up, innovation-oriented, high technology concerns that have high R&D expenses, but little or no foreign source income. Quite to the contrary, the proposed change in allocation rules has virtually no significance to even midsize firms selling their products overesas, because foreign sales are not generally subject to the foreign taxes that the 861 Regulations affect. This change, in other words, is no subsidy to R&D, but rather is a subsidy to big companies-the biggest, in fact, of the big multinationals.

FOREIGN LAW ISSUES

A related issue is the contention that these multinational corporations need special treatment, because foreign governments will not allow them to deduct U.S.based R&D costs against their foreign source earnings. If they could, of course, the whole issue would largely disappear since the high-rate foreign taxes presently producing the "excess credits" would be reduced pro tanto. Quite apart from the unstated premise that the United States should act as ultimate underwriter for the rest of the world's tax systems, the assertion that foreign deductions are being systematically disallowed is highly overstated, if not entirely fallacious. Regardless of whether the question arises between a U.S. head office and a foreign branch or between a U.S. parent and its foreign subsidiaries, some R&D expenses are properly allowable against foreign earnings, be the context one of licensing royalties, costsharing arrangements, or intercompany transfer prices. The foreign country, to be sure, may try to reduce the amount of such allowances, just as the U.S. Commissioner of Internal Revenue monitors claimed deductions and disallows those he finds questionable. Negotiations between the U.S. company and the foreign government on these issues may then take place-so-called "horse trading"-but that is fundamentally an audit issue, a question of verifiable costs and their proper treatment. The central idea that some related R&D expenses may be deducted against foreign earnings is widely recognized. Indeed, it is clarified in every income tax treaty that the United States presently has in force, as set forth in Exhibit A to this Statement. Thus, the specter of asymmetrical treatment of R&D costs by foreign nations is really not a serious argument. In principle, such deductions are allowed by our treaty partners, though of course there may be some dispute in individual cases about the amount of the deduction, as there is in intercompany transactions generally-whether domestic or foreign.

OTHER EFFECTS AND CONCLUSION

Finally, and this is by no means the least significant issue, repealing the R&D rules would seriously jeopardize the delicate compromise represented by the section 861-8 Regulations. These Regulations went through a particularly vexatious gestation period of some eleven years, during which time two earlier drafts were released

and extensively criticized. Only after extensive consultations with the affected industry groups was the final version of these rules released in 1977. The Regulations embody numerous compromises made by both sides to achieve a proper balance between fairness for taxpayers, on the one hand, and protection of the fisc, on the other. The general approach of these Regulations is really rather generous, but the point remains that these Regulations cover a wide range of affected transactions. The present controversy involves only one issue-R&D expenses. But make no mistake. If this handful of multinationals wins repeal of the R&D rules, other taxpayers will step forward and seek repeal of those aspects of the section 861 Regulations that pinch their activities. Overriding the Treasury Department's delicate compromise in the R&D area, in other words, will not put the issue of allocating expenses to rest. Very much to the contrary, it will encourage other groups to challenge other parts of this multi-faceted Regulation and to seek from Congress the sort of special interest legislation being sought here. The correct approach is to return to the principled treatment of the allocation of R&D expenses worked out in the 1977 Regulations.

EXHIBIT A

United States tax treaties with the following countries have provisions permitting allocation of U.S.-based costs to foreign source earnings (applicable provision shown):

Chairman RANGEL. May we hear now from Professor Bischel. STATEMENT OF JON BISCHEL, PROFESSOR OF LAW, SYRACUSE UNIVERSITY COLLEGE OF LAW

Mr. BISCHEL. Thank you, Mr. Chairman.

My name is Jon Bischel, and as indicated in my written statement I hold an appointment at the Syracuse University College of Law. I have also taught at three other law schools, including two graduate tax programs in Boston and Florida. Most importantly, however, I spent 15 years writing in the area of technology taxation, including three books and approximately 20 articles. For that same 15-year period I have also maintained an extensive private practice, and I specialize in working with small high technology companies.

As indicated, in 1977, the U.S. Treasury finalized the expense allocation and apportionment regulations pursuant to section 861 of the code. In my opinion they constitute a major disincentive, not incentive, to research and development activities carried on in the United States. The thrust of the regulations is to arbitrarily allo