When you are talking about $100 of research expense, the proposed regulations said if half your sales were abroad, you allocated $50 to foreign source income. The present regulations, if half your sales are abroad, allows only $17.50 to foreign source income, and if only a quarter of your sales are foreign, as little as $8.75 out of $100 of research expenses must be allocated to foreign source income. For a company with one-fourth of its sales abroad, we may be talking about-if its foreign gross income is lower, this moratorium is affecting $8.75 of $100, which the 861 regulations would now allocate to foreign income. Mr. DORGAN. Do you generally concur with Mr. Shannon's recommendations to the committee? Mr. KINGSON. I think that that recommendation is based on economics, which is not the subject of my testimony. I think the issue is a question of weighing exempting U.S. income from tax and removing the incentive to stop discrimination, versus jobs and relocating facilities abroad. But I think it is very important that you be aware-be conscious of what decision you are making and that relocating abroad is a very complex tax decision, the consequences of which may be quite unknowable at this time. Mr. DORGAN. Is that a lengthy euphemism for "it is bad tax policy" in your opinion? I understand what you are saying about the economic issues and I am mindful of them and concerned about them, but I get the feeling in your answers to Mr. Anthony and your answer now that you think this is probably bad tax policy. Mr. KINGSON. I would prefer not to take a direct stand on that. Mr. DORGAN. All right. Well, I appreciate your concern and we appreciate your very thorough presentation that sets out some very important issues for us. I think all of us are concerned about trying to encourage and continue research and development activities in this country. I have not made a decision on this issue. I expect many people have not either. We are trying to sift our way through to find out not only good tax policy, but what makes good sense for the country. Mr. Thomas. Mr. THOMAS. I understand your concern and the reason you appear today. Perhaps you don't want to reveal it publicly, but I just, frankly, think you owe me a yes or no on that last question if we meet later someplace else. I will push you a little harder maybe then. Many of us don't have the experience and knowledge, and we cannot weigh it as you weigh it. We appreciate your going through it and the problem is ultimately we have to make a decision. Mr. KINGSON. I understand, but in a sense you have to make a decision based on factors beyond my expertise. Although I can see the tax issues, I have no idea whether, in fact, companies have an intention of relocating abroad, whether it will discourage jobs in the United States, whether it will do all the things that Mr. Shannon fears it will do if you don't renew the moratorium. Mr. DORGAN. If I might interpose for a second, Mr. Thomas. Mr. Kingson was an invited witness for the committee for the purpose of giving background information and I expect he has a number of considerations that would lead him not to want to make known a permanent position of his. I would encourage you to meet him afterwards and have a cup of coffee and- Mr. THOMAS. I made him that offer. He has not said yes or no. Do you know someone who can make that kind of decision and weigh the choices which you indicated are necessary in terms of reallocation? Mr. KINGSON. I think that the question about the jobs, I think it is an unknowable factor. The question is, how much money and how much are you willing to give up on that possibility? I think that you should weigh with some skepticism the idea that I am going to relocate abroad and get the deduction without getting the income and without knowing their 861 policy. Mr. THOMAS. If I might pursue that, even including people engaged in the business who tell us, based on their financial statements, they have made that decision. Mr. KINGSON. I would be very curious. I have been to many seminars given by accounting firms with their foreign partners and one of the things I asked them, the foreign partners, is what is the 861 policy of your country? They have difficulty in articulating it. I think that because our foreign investment has exceeded that of other countries, we have focused on the section 861 issue before the other countries have. I think that if you were to-if you were to divide the companies up, they are not monolithic. They may come in advocating a moratorium because it helps everybody, but the ones who do not have substantial withholding taxes-for example, the ones who get their dividends form Germany and Netherlands or the United Kingdom where by treaty there are no withholding taxes as opposed to getting them from France, Canada, or the developing countries-they probably have very little incentive to relocate abroad, when, as my example indicates, they save $50 worth of tax for every $100 of research expense. Companies that do not get $50 worth of tax benefits because of withholding tax on employees, may decide to relocate abroad. But that decision probably depends upon the IRS leting them do so without constituting a taxable sale upon the 861 policies of the foreign country to which they locate, and upon how much royalties the foreign country will require them to charge for the research. That, in turn, depends on how good the technology will be, what the foreign country's policy will be, and what our policy will be. I think it is a very complex decision. To say that if you don't give us a moratorium, we will relocate because we get a deduction if the foreign country just begins the analysis. The companies that appear here will be in very different positions, depending on the amount of withholding, where they have to relocate and where or how much know-how they have to transfer abroad. I am sorry I cannot give a yes or no. Mr. THOMAS. Thank you, Mr. Chairman. Mr. DORGAN. We have other witnesses who will talk about tax policy and give us judgments of theirs about whether or not this is good tax policy. We didn't mean to put you on the spot, you volunteered to come forward and give us the technical background and you demonstrated those skills under these latest questions that would probably give you the capability of running for office successfully. Mr. KINGSON. Mr. Dorgan, I don't know about that. Mr. Chapoton, Assistant Secretary of the Treasury. We welcome you, sir. STATEMENT OF HON. JOHN E. CHAPOTON, ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY Mr. CHAPOTON. Thank you, Mr. Chairman. I will be brief, because I think Mr. Kingson has made some of the points I would have had to cover. But I think this discussion we have just had has focused the question to the core point that the committee will have to consider and that we at Treasury and in the administration are going to have to consider. First, let me say that I am happy to be here to present the Department's views and the administration's views on this question of the allocation of the cost of R&E performed in the United States to domestic source income. The allocation of domestic source R&E to domestic source income solely as required by the moratorium produces a tension between two policy objectives, as Mr. Kingson's testimony and the questions following made clear. On the one side, it is promotion of domestic R&E to strengthen the competitive position of the U.S. economy in world markets. The other side is the objective of U.S. tax policy to preserve the tax base by limiting the credit for foreign income taxes to the amount of U.S. tax which would be paid on the foreign income, thereby preventing foreign taxes from reducing U.S. tax on U.S. income. As I think Mr. Kingson pointed out very well, the code even before the present 861 regulations has clearly required taxpayers to allocate and apportion R&E expenses and other expenses between the income from domestic and foreign sources related to that expense. The moratorium which came in in 1981, of course, required 100 percent allocation of R&E to domestic source income and told the Treasury to produce a study on the effect of the allocation, which was done and released in June of this year. Let me say at the outset that the administration is firmly committed to encouragement of productivity enhancing private sector R&E and for this reason we have supported a further 2-year extension of the ERTA suspension of the allocation of R&E abroad so that the results may be considered further and that we may identify the alternatives to be included in a coherent national program. That is what this committee needs to do and that is what we need to do. I will forego the part of my statement, Mr. Chairman, in the interest of time, that covers the points covered by Mr. Kingson that basically show clearly that the allocation of this expense, like the allocation of any expense, is required from a tax policy ground or from a correct measurement of income ground. We can argue about whether the specifics of the allocation are correct or sound as a matter of accounting, but I think that we ought to brush that question aside for the time being at least and get to the more significant questions. We think the R&E regulations are an objective attempt to satisfy the statutory requirement. I heard Mr. Shannon say he thought the regulations were unsound in some respects—that is not a generally held view. We have heard very little complaint about the technical aspects of the regulations, that is that they require the allocation of too much abroad if you decide that some allocation abroad is required. The point that Mr. Kingson didn't get into in as much detail, that I want to make here, is that the companies that are benefited by the moratorium are those that are in excess credit position. I think he said that, but that bears emphasis because you have to see whether this incentive device works correctly. It does not benefit companies that have a low foreign tax rate on their foreign income. It, instead, benefits those with high effective foreign tax rates either because of the statutory rate or, as Mr. Kingson points out, because of the disallowance of deductions which we would allow on income earned abroad. The effect is the same; there is a high foreign tax rate on the foreign income. The companies that build up excess foreign tax credits are the companies that are affected by the allocation of R&E abroad. U.S. corporations can rightfully claim they are disadvantaged by the refusal of foreign governments to recognize R&E deductions or cost sharing payments performed outside of their country even though related to income produced and taxed in their country. I think Mr. Kingson made the point clearly that that is a valid complaint, and the question is whether you satisfy that complaint and that discrimination by making a change in U.S. tax liability. When we analyze it, as this committee is now doing, we come to the conclusion that the suspension of allocation of R&E abroad should not be analyzed as an attempt to correctly measure source of income, but it should be analyzed as a tax incentive to encourage domestic R&E so the question we must decide and you must decide is, is it an effective incentive to encourage domestic R&E or is it not an effective incentive? That was part of the purpose of our report. We found in the report that, had the regulation been in effect in calendar 1982 instead of being suspended by ERTA, U.S. tax liabilities of U.S. firms would have been $100 million to $240 million higher than they were as a result of the suspension. New data that we have since that report was released in June— that is data on the excess credit positions of the companies involved-indicates that the lower end of the range is our best estimate of the cost of the suspension. That is, around $100 million is the revenue cost from the moratorium in calendar 1982. As we project that forward, we find that a 2-year extension would cost approximately $120 million and $133 million in 1984 and 1985, respectively. An appraisal of the ERTA suspension as an R&E incentive depends in no small part on how it affects different taxpayers and, as I mentioned, it does not affect taxpayers uniformly. It only reduces the tax liability of those firms that are in excess credit positions so it depends on that factor, on the firm's foreign operations, and not on the level of its R&E effort. The information that we have developed also shows that the regulation has its most significant effect on large multinational companies as opposed to the relatively small high tech companies. There are a number of reasons for this in our statement, and they are pretty obvious when some thought is given to them. The $100 million to $240 million higher tax liabilities in 1982 that would have occurred absent the moratorium would have increased the cost of privately financed R&E activity we estimate by less than one percent. If we use the $100 million tax figure for increased 1982 liabilities absent the moratorium which now, as I stated, is our best estimate, we calculated a reduction in R&E in 1982 of from $40 million to $110 million. The higher costs reduce R&E to some extent and our estimate is that the reduction would have been $40 million to $110 million. We think most of the reduction would have occurred because domestic R&E is somewhat more expensive rather than a transfer of R&E activities from domestic to foreign locations. Any reduction in R&E will affect employment in the industries but it is impossible to determine how much employment would be affected. Offsetting adjustments take place in the U.S. economy as a result of any policy change so it is difficult and often impossible to determine the macroeconomic consequences of policies which have a highly concentrated effect on a relatively narrow range of firms and industries. Thus the problem of R&E allocation is not primarily of finding out how best to increase aggregate employment in the short run but how to design an appropriate incentive to increase productivity and expand employment opportunities in the long run. We recognize that any reduction in R&E may adversely affect the competitive position of the United States and because of the importance of the R&E and the competitive position of the U.S. economy, it is essential that the Federal policy be designed so that the resources available to finance Federal incentives encourage the maximum in R&E and innovative activity. For these reasons we support a 2-year extension of the suspension of the allocation of R&E expenses abroad. We want to consider the question that you have been discussing and want to work with you to address that question. We suggest we give ourselves 2 years to look at it. Thank you, Mr. Chairman. [The prepared statement and a report prepared by the Department of the Treasury on regulation 1.861-8 follow:] |