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Section 223(b) of the Economic Recovery Tax Act of 1981 1/ (ERTA) requires the Secretary of the Treasury to study the impact of Treasury regulation section 1.861-8 2/ (the Regulation) "(A) on research and experimental activities conducted in the United States and (B) on the availability of the foreign tax credit." 3/ The required study is related to section 223(a) of ERTA, which provides that, for a two-year period, all research and experimental expenditures which are paid or incurred for research activities conducted in the United States shall be allocated or apportioned to income earned within the United States. Section 223(a) of ERTA, in effect, suspends the section of the Regulation dealing with the allocation and apportionment of research and experimental expenditures between income earned inside and outside the United States.

The suspension and study provisions contained in ERTA reflect the Congressional interest in the Regulation's potential effect on U.S.-based research activities. Under U.S. law, a U.S. corporation is taxable on its worldwide income, whether earned in the United States or in foreign countries. Since income earned outside the United States (foreign source income) typically is also taxed by the country where it is earned, the United States allows income taxes paid to a foreign country to be credited against a taxpayer's U.S. income tax liability, up to an amount equal to the U.S. tax on foreign source income.

The Regulation, issued January 3, 1977, specifies how a U.S. taxpayer's expenses, losses, and other deductions are to be divided between its income from domestic and foreign sources. Special rules are provided for certain kinds of expenses including research and development (R&D), interest, and legal and accounting fees. The suspension of the Regulation applies only to the special rules for R&D. The attribution of R&D expenses to foreign source gross income and consequent reduction in foreign source taxable income may reduce the foreign tax credit allowable under U.S. law. If the foreign government does not allow the apportioned expense as a deduction, income taxes actually paid to the foreign government will not be reduced and,

1/ P.L. 97-34.

2/ Unless otherwise indicated, all section and regulation references in this report are to the Internal Revenue Code of 1954, as amended, and regulations promulgated thereunder to the date of this report.

3/ P.L. 97-34, section 223(b).

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therefore, a U.S. taxpayer's total, domestic plus foreign, tax liability will increase, if its foreign taxes paid are in excess of the limitation allowed under U.S. law.

The possibility of increased total taxes and the accompanying effect on U.S.-based R&D activity motivated the enactment of section 223 of ERTA. U.S. multinational businesses contended that the Regulation caused U.S. business to transfer U.S.-based research activity abroad in order to obtain a tax deduction under foreign law and thereby reduce foreign tax liability. 4/ The legislative history of section 223 indicates that Congress believed that the transfer of U.S. research activities overseas is not in the best interests of the United States. This concern was the principal reason for the ERTA provisions suspending the Regulation by allowing expenses for U.S. R&D activities to be allocated or apportioned entirely to U.S. income for a two-year period and requiring the Secretary of the Treasury to study the impact of the Regulation on U.S. R&D. 5/

Chapter 2 discusses U.S. taxation of foreign source income, the role of the foreign tax credit and its limitation, the operation of the Regulation, and the potential effect of the Regulation's R&D rules. In the absence of the suspension of the Regulation's R&D rules, the law clearly requires a proper allocation of U.S. R&D to foreign source income. The Regulation's R&D rules reflect significant modifications of the 1973 proposed regulation in response to taxpayer comments. Compared to the 1973 proposed regulation, the Regulation's R&D rules, as modified, allow significantly less R&D expense to be allocated to foreign source income.

A U.S. corporate taxpayer is subject to U.S. tax at a 46 percent rate on income from both domestic and foreign sources. 6/ Foreign income taxes are creditable against U.S. tax on foreign source income. Section 904 of the Code effectively limits the foreign tax credit to 46 percent of foreign income. The objective of the limitation is to prevent foreign taxes from reducing U.S. tax on domestic income. The domestic and foreign portions of a taxpayer's worldwide taxable income are, for purposes of the

4/ Tax Incentive Act of 1981, H. Rept. No. 97-201, 97th Cong., 1st Sess., 1981, p. 131 and Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, 97th Cong., 1st Sess., p. 142 (hereinafter cited as "ERTA, General Explanation").

5/ H. Rept.

pp. 141-142.

No. 97-201 and ERTA General

Explanation,

6/ Lower rates apply to the first $100,000 of taxable income.

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limitation on the credit, determined under U.S. law. The Regulation is instrumental in the determination of foreign source taxable income. On the one hand, allocating R&D expense to foreign source income will increase a taxpayer's total, domestic plus foreign, tax liabilities, if it is in an excess foreign tax credit position. On the other hand, not requiring any allocation of R&D expense to foreign income probably overstates foreign source income and may permit foreign taxes to reduce U.S. taxes on domestic income.

Chapter 3 estimates and analyzes the effect of the Regulation's R&D rules on U.S. tax liabilities and U.S.-based R&D activities. If the R&D rules in the Regulation had been in effect in calendar year 1982, instead of the ERTA suspension or moratorium, U.S. tax liabilities of U.S. firms would have been $100 million to $240 million higher. Since privately-funded R&D performed in the United States was about $37 billion in 1982, this estimated increase in U.S. tax liabilities would have increased the cost of domestic R&D between .27 and .65 percent, or by less than 1.0 percent. This cost increase will have two effects: less R&D will be performed and some will be moved from the United States to abroad. Based on assumed responses of both the overall level and the geographical location of R&D to this range of cost increases, domestic R&D spending would have been reduced by about $40 million to $260 million in 1982. Most of the reduction is accounted for by the net reduction in the overall level of R&D rather than a transfer abroad.

Chapter 4 contains the report's conclusions and recommendation. All firms are not affected uniformly by the suspension of the Regulation. It only reduces the tax liabilities of firms in an excess foreign tax credit position. These firms earn from 16 percent to 22 percent of the worldwide income of U.S. manufacturing corporations. Whether or not a firm is in an excess credit position does not seem to be closely related to the level of its R&D effort. The suspension of the Regulation has its most significant impact on large, mature multinational firms, as opposed to small, emerging, high technology companies. It affects those R&D oriented taxpayers with relatively large amounts of foreign production and income, as opposed to those taxpayers exploiting their R&D primarily for domestic production. Nonetheless, the Treasury Department recognizes that the reduction in R&D may adversely affect the competitive position of the United States. Accordingly, the Treasury supports a two-year extension of the present moratorium. This will give Congress an opportunity to consider the findings of this report while Congress and the Administration work to develop a coherent national program of R&D incentives.

U.S.

Chapter 2

citizens,

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residents, and corporations are subject to U.S. tax on their income from all sources, both domestic and foreign. 1/ Since income derived from sources outside the United States (Foreign source income) is usually also taxed by the foreign country where it is earned, the United States allows a credit for foreign taxes imposed on foreign source income.

A. Foreign tax credit

The foreign tax credit provides U.S. taxpayers with a dollar for dollar reduction of, or offset against, their U.S. income tax liability. One hundred dollars of allowable credit, for example, reduces U.S. income tax liability by an equivalent amount. Under the foreign tax credit provisions of the Code, a U.S. taxpayer is permitted to credit "income, war profits, and excess profits taxes," or taxes in lieu thereof, paid to a foreign jurisdiction against its U.S. income tax liability. 2/ The credit is available for income taxes paid on foreign branch income, withholding taxes (on such items as dividends from a foreign corporation, interest and royalties) and, provided the U.S. taxpayer is a corporation which owns at least ten percent of the voting stock of the foreign corporation, the corporate tax on the underlying earnings or accumulated profits out of which any dividends are paid. 3/

B. Foreign tax credit limitation

By allowing a foreign tax credit, the United States cedes primary taxing jurisdiction to the source country, i.e., the foreign country in which the income is earned. If $40 in qualifying foreign taxes are paid on a given amount of foreign source income and if the pre-credit U.S. tax liability on that income is $50, the taxpayer will pay $40 to the foreign country and $10 to the United States. In this situation, the tax collected by the

1/ I.R.C. sections 1, 11, and 61; contrast U.S. source based taxation of nonresident aliens and foreign corporations under I.R.C. sections 871(b) and 882(a).

2/ I.R.C. sections 33, 901, and 903.

The foreign tax credit for income, excess profits, and war profits taxes paid was first enacted in 1918. Revenue Act of 1918, sections 222, 238, and 240(c). The credit was expanded to include taxes paid in lieu of income, excess profits and war profits taxes in 1942. Revenue Act of 1942, section 158(f).

3/ I.R.C. sections 33, 901, 902, and 960.

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