temporary provision which has the effect of suspending the relevant portions of the Treasury regulation, 1.861-8.

Under the ERTA provision, all R&D expenses are allocable to U.S. source income for a taxpayer's 2 taxable years following enactment of ERTA. Inasmuch as ERTA was enacted on August 13, 1981, the temporary provision will be expiring, or has already expired, for many taxpayers.

The subcommittee's hearing will focus on three major issues:

One, the findings and recommendations contained in the Department of Treasury's June 1983 report, entitled "The impact of the section 861-8 regulation on U.S. research and development" and other related analysis;

Two, the policy implications of not requiring expenses to be allocated between U.S. and foreign source income, including the incentive under present law to make tax free transfers of technology for use in manufacturing operations abroad; and three, the research activities and location response of taxpayers who are affected by changes in source allocation rules.

As I mentioned previously, the temporary ERTA allocation rule expires very soon. The purpose of the hearing today is to examine, in a comprehensive manner, the issues surrounding code sections. 861-3 and the implementing regulation. The hearing will provide the Committee on Ways and Means with a complete record of information on the subject, allow for the presentation of contrasting views, and will assist the committee in weighing the appropriateness of present law rules as implemented by the Treasury regulation, the temporary allocation rule as provided for in ERTA, or other legislative or administrative options.

Before the first witness, I want to announce a change in the subcommittee's hearing schedule. In addition to our hearing today which will end at 1:30 p.m., the subcommittee will also receive testimony on this matter on Thursday afternoon, November 3, from 2 p.m. to 4:30 p.m. The hearing on November 3 will also be held in the main committee hearing room, 1100 Longworth House Office Building.

We have a distinguished group of witnesses scheduled to appear today and on November 3. I welcome each of you and look forward to receiving your testimony.

If there are opening statements to be made by my colleagues, I would recognize them for that purpose.

If not, our first witness will be Congressman Jim Shannon from the sovereign State of Massachusetts. We welcome you and your testimony this morning.

STATEMENT OF HON. JAMES M. SHANNON, A REPRESENTATIVE
IN CONGRESS FROM THE STATE OF MASSACHUSETTS

Mr. SHANNON. Thank you, Mr. Chairman. And thank you, members of the subcommittee.

I appreciate the opportunity to appear before you today. I want you to know that I believe it is essential that Congress act on the section 861 problem before the end of this session. I also think that the best action we could take would be to do away altogether with Treasury regulation 1.861-8.

In 1981 the Ways and Means Committee, and Congress as a whole, made an important policy decision. By enacting a tax credit for companies that increase their R&D spending, we recognized the fact the R&D is going to be one of the most important elements in the ability of the United States to remain competitive with other industrialized nations. In a high technology era where constant innovation and product improvement are the key to success, we simply have to have a solid domestic R&D base. And the alarming fact was, we were beginning to lose that base.

Civilian R&D had been stagnating since 1968, staying at about 1.5 percent of GNP, while in Japan it had grown to 1.9 percent, and in West Germany 2.3 percent. There is evidence that the credit has helped provide an incentive to turn this around.

Companies have substantially increased their R&D spending in each of the past few years, despite a recession which led to cutbacks in capital spending.

The fact that we also imposed a moratorium on the implementation of Treasury regulation 1.861-1 that same year was a further recognition of the importance of building up our domestic R&D base. As I am sure succeeding witnesses will tell you, this regulation, which requires a company with foreign operations to allocate some of its domestic R&D expenditures to foreign source income, will be a disincentive to conducting R&D here in the United States. If our aim is to improve our domestic R&D capacity, such a regulation simply does not make sense.

This regulation discourages domestic R&D spending because even though the IRS may allocate domestic expenditures to foreign source income, those countries where the income is received may not. Allocating those expenses to foreign source income has the effect of reducing that income for U.S. tax purposes, and thus lowering the limit on the amount of foreign tax credit a company can take.

This may place the company in an "excess credit" position, restricting its ability to offset foreign against domestic tax liability. At the same time, the foreign country may tax the company on that income with no deduction for the expenses allocated to it by the United States. Thus, a company operating abroad may find that doing its R&D in the United States leads to increased tax liability and double taxation of some foreign earnings.

Few countries require this sort of allocation of R&D expenditures of domestic R&D expenditures. Furthermore, many of the other countries with whom we compete offer a variety of incentives to encourage companies to conduct R&D within their borders. Thus, this regulation places U.S. companies doing their R&D at home at a competitive disadvantage with companies operating in these countries and places the United States at a disadvantage in its attempts to increase the amount of R&D conducted in this country. At a time when we are fighting to maintain our position in the world economy, I see no sense in creating an incentive to send R&D jobs abroad.

I am aware that some of the analysts who will come before you today are going to say that as a matter of pure, clean tax policy, allocation should occur. In an ideal tax system, income is matched to expenses, and if some of a company's income is coming from

abroad, then some of its expenses should be allocated to that income. They will tell you that the current Treasury formula may not be the best one, but that some kind of allocation formula should be used.

Well, they are right on one point: the Treasury formula does not provide a good allocation. The allocation of R&D expenses on the basis of SIC product groups results in distortions, because much of the income within the group may be completely unrelated to the expenses involved. So, at the very least this formula should be changed.

However, I seriously doubt whether it is ever going to be possible to devise a system that will really produce an accurate matching. And I fear that whatever system you come up with will be just as complicated and just as burdensome for companies to deal with as the one in the current regulations.

But once you get beyond all the arguments as to which formula is best, there is one essential point that I think is inescapable: We have never let pure tax policy be our only consideration in matters like this.

The code is full of provisions that make no sense as a matter of pure tax policy but which Congress felt were justified by social or economic considerations that were just as important. I cannot emphasize strongly enough my belief that this is one of those cases: the importance of maintaining and improving our domestic R&D capacity, and the jobs associated with it, far outweighs any other consideration.

You will be told that only a couple of dozen big multinationals have sufficient foreign income and are close enough to exceeding their foreign tax credit limit to be affected. Even assuming this is true, how do we know that more companies won't be affected in the future? More to the point, I think that any provision that encourages the movement of jobs, from whatever source and in whatever numbers, out of the United States and into a foreign country is bad policy and should not be implemented.

It is true, of course, that this movement of R&D outside the country will occur only to the extent that the allocation rules are a determining factor in a company's location of its R&D operations. But I feel quite confident in stating that the rules will, indeed, be a determining factor. My confidence is based on conversations with corporate representatives who have said their decisions on where to base their R&D operations will depend on the resolution of the 861 question. It is also based on studies by respected analysts that say much the same thing.

The National Research and Development Survey issued last January by Arthur Andersen & Co. made this point very clearly. The survey of 85 corporations found that R&D investments by U.S. companies in foreign markets was increasing faster than in U.S. markets. Those surveyed said that Government incentives or disincentives played a significant role in their R&D decisions, and a number of them specifically mentioned regulation 1.861-1 as a detriment to domestic R&D operations.

Forty-four percent of the respondents stated that if the moratorium on this regulation was lifted they would be in an excess foreign tax credit situation, and most of those surveyed believed that lift

ing the moratorium would encourage an expansion of foreign R&D investments in the future.

The same conclusions were reached by a Tax Notes study published last June. The author of that study constructed an economic model to examine the probable corporate response to a reinstitution of the 1.861-1 rules. He found that implementation of these rules would exert pressure on corporations to reduce domestic R&D and would create problems for firms planning to enter export markets.

His conclusion was that:

To enhance the American international trade sector and provide comparability between the tax treatment of foreign and domestic income, the moratorium on section 1.861-1 of the regulations should be continued.

Finally, the Treasury Department undertook a study, which was also issued in June. That study found that if the section 861 regulations had been in effect in 1982, privately financed R&D domestic R&D spending would have been reduced by anywhere from $40 million to $260 million. Treasury concluded that since a reduction in R&D spending could adversely affect the competitive position of the United States, the 2-year moratorium should be extended.

But once you accept the premise that these regulations do, indeed, create a disincentive to domestic R&D, what is the sense of extending the moratorium? All that does is force the affected companies to live with uncertainty for another 2, 3, or however many years. Many high technology firms do their R&D planning on a longer cycle than that, typically 3-to-5 years. They want to plan their R&D operations now, and an extended moratorium just isn't going to be much help to them in doing that.

For that reason, I have joined my colleague Cec Heftel and a majority of the Ways and Means Committee in sponsoring H.R. 1887, which would settle the question once and for all by doing away with the 1.861-1 regulations and requiring that expenditures for R&D conducted within the United States be allocated to U.S. source income. I think that this bill represents the best solution to the section 861 problem, and I hope that we will see action on it soon. Our ability to compete in world markets and create jobs at home is too important to either sacrifice on the altar of tax policy or leave to the uncertainty of another moratorium.

Thank you, Mr. Chairman.

Chairman RANGEL. Thank you, Mr. Shannon.

I assume that what it boils down to is that we have a couple of dozen multinational corporations that believe that their tax liability as it relates to research and development would be increased if we don't make the changes that you are suggesting. It would be for these companies that have excess foreign credits that you fear this increased liability might cause them to shift their research and development overseas in an effort to reduce their tax liability; is that correct?

Mr. SHANNON. Well, I am afraid they will shift some of their research and development efforts overseas. Other countries offer great incentives for investment and I am afraid that there will be an incentive in future planning of R&D activities to move some of that overseas.

Chairman RANGEL. But it would be really the profit motivation. I guess they have shared with you and not with me really, that we would be losing jobs and a lot of research information if we don't give them some type of tax relief?

Mr. SHANNON. Well, ultimately that is the fear. I think that what we should be trying to do is, in as many ways as is possible, encourage more expenditures in R&D here at home.

Chairman RANGEL. I don't think anyone disagrees with that.

Mr. SHANNON. I think to a certain degree these 861 regulations encourage these companies-many of whom have large foreign markets-to take their R&D and bring it closer to their markets for tax reasons. I think that that is a loss to our economy and to our Nation and one we should try to avoid.

Chairman RANGEL. I don't think there is any part of our Tax Code that is left pure so I don't argue that we should just maintain good tax law because it is good tax law. However, it does seem to me that generally your position has been that where you can provide incentive, you provide it, and do what you want to do, and make it abundantly clear to people that you are doing this to reach a certain goal.

It appears to me that we really don't know what is happening but we stand a chance that some of the multinationals will shift their R&D overseas. Otherwise, we are just hoping they don't do this. It is only those that have excess foreign credits involved. So it seems we are getting all of this law just for a few corporations to reduce their tax liability hoping that they will stay with us.

Mr. SHANNON. Well, I think what we are saying is first of all there is no question that some of our largest corporations do a whole lot of the R&D work that is done in the American economy and to the degree they are doing that we should encourage them to do more.

The other point I would like to make, Mr. Chairman, is this: In 1981 we did some terrible things in that tax law and we did some good things. We did things that clearly didn't work and we did things that clearly have worked. Since 1981 capital investment has gone down in the country despite many of the provisions adopted in 1981 were geared toward encouraging capital investment.

Capital investment has gone down, investment in R&D has gone up. Why? Because we were putting provisions in, part of the reason is we put the provisions in to encourage R&D here at home. We put in a tax credit. We did the 861 provisions to keep it from going abroad. It is one aspect of our tax policy in 1981 that I think has worked despite what the critics said in 1981 and despite what some have said since 1981.

But even with those incentives put in in 1981, I think there is a consensus in the Congress and the country that the United States still faces a crisis in encouraging R&D in scientific innovation.

We have to establish some policies to encourage more of that over the period of the next couple of years. Some of that I hope will be increased Government support for agencies like the National Science Foundation. Some of it will be a real full-scale effort to train and educate technical people. Some will be more strengthening of the areas of tax incentives to encourage R&D.