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

The foreign tax credit provides U.S. taxpayers with a dollar for dollar reduction of their U.S. income tax liability. Under U.S. law and long-standing U.S. international tax policy, the foreign tax credit is limited to the U.S. tax on the foreign source income. The purpose of the limitation is to prevent foreign taxes from reducing U.S. taxes on domestic source income. That is, taxes paid to a foreign country can be used to reduce U.S. tax on income earned in that country, but not on income earned in the United States.

The

Foreign source taxable income, for the purpose of calculating the limitation on the credit, is measured under U.S. tax rules. Regulation 1.861-8 provides rules for the allocation and apportionment of R&D and other expenses to gross income for determining taxable income from foreign and domestic sources. objective of the Regulation's R&D rules, which were suspended by section 223 of ERTA, is to match R&D expense with the foreign and domestic source income generated by or related to the expenditure.

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The Regulation's R&D rules reflect significant modifications the 1973 proposed regulations in response to taxpayer comments. For example, R&D aimed exclusively at meeting a U.S. government legal requirement can be allocated solely to U.S. income. Thirty percent of the remaining R&D expense can be "exclusively apportioned" to U.S. source income, provided that more than one-half the R&D is performed in the United States. The Regulation allocates R&D on a product line basis. The objective is to avoid allocating R&D expense related to one product to foreign source income earned from sales in a wholly different product category. The gross income option allows the apportionment to foreign source income to be reduced by up to one-half the amount apportioned on the basis of sales. Compared to the 1973 proposed regulation, these modifications allow less R&D expense to be allocated to foreign income and recognize that U.S. R&D may be most valuable in the domestic market. For example, the Regulation permits a taxpayer with equal amounts of domestic and foreign sales, and using the gross income option to reduce its sales-based apportionment by 50 percent, to allocate less than 20 percent of its R&D expense to foreign source income.

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Any allocation of R&D expense to foreign source income will reduce taxable income and the limitation on the credit. 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. Consequently, the allocation may increase a taxpayer's total, U.S. plus foreign, tax liability. Some allocation to foreign income, however, is appropriate on tax policy grounds when domestic R&D is exploited in a foreign market and generates foreign, as well as domestic income. If an allocation is not made, foreign source taxable income will be too high and the higher limitation may allow the credit for foreign tax to reduce U.S. taxes on domestic source income. Thus, requiring no allocation of domestic R&D expense to foreign source income attributable to the expense can best be viewed as an R&D incentive.

Compared to the Regulation, the section 223 ERTA moratorium reduces U.S. tax liabilities. If the R&D rules in the Regulation had been in effect in calendar 1982 instead of the ERTA provision, U.S. tax liabilities of U.S. firms would have been $100 million to $240 million higher.

All firms are not affected uniformly by the moratorium. It only reduces the tax liabilities of firms in an excess 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 moratorium has its most significant effect on large, mature multinationals, as opposed to small, relatively young, 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. of the Regulation's $100 million to $240 million estimated increase in additional U.S. tax liabilities, about 85 percent is estimated to be accounted for by 24 U.S. firms on the list of the 100 largest U.S. industrial corporations compiled by Fortune magazine.

This $100 million to $240 million increase in tax liabilities would have increased the cost of privately-financed U.S. R&D by between .27 and .65 percent, or by less than 1.0 percent. Based on assumed responses of both the overall level and geographical location of R&D to this range of cost increases, the $37 billion in privately-financed domestic R&D spending in 1982 would have been reduced by about $40 million to $260 million. Most of the reduction represents a net reduction in overall R&D undertaken by U.S. corporations and their foreign affiliates, because U.S. R&D has become somewhat more expensive, rather than a transfer of R&D abroad.

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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 provide Congress with 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.