Allocation and Apportionment of Research and Experimental Expenditures

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0023-95]

RIN 1545-AT49

Allocation and Apportionment of Research and Experimental

Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document provides guidance concerning the allocation and

apportionment of research and experimental expenditures for purposes of

determining taxable income from sources within and without the United

States. This document affects taxpayers that have income from United

States and foreign sources and that have made expenditures for research

and experimentation that the taxpayer deducts under section 174 of the

Internal Revenue Code of 1986. This document also provides notice of a

public hearing on these proposed regulations.

DATES: Written comments must be received by August 22, 1995. Outlines

of topics to be discussed at the public hearing scheduled for September

8, 1995, at 10 a.m. must be received by August 18, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0023-95), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. In the alternative, submissions may be hand

delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R

(INTL-0023-95), Courier's Desk, Internal Revenue Service, 1111

Constitution Avenue, NW, Washington, DC 20224. The public hearing will

be held in the Auditorium, Internal Revenue Building, 1111 Constitution

Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Carl

Cooper [[Page 27454]] at (202) 622-3840; concerning submissions,

Michael Slaughter, (202) 622-8543 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

This notice of proposed rulemaking does not contain collections of

information and, therefore, it has not been submitted to the Office of

Management and Budget for review under the Paperwork Reduction Act (44

U.S.C. 3504(h)).

Background and Explanation of Provisions

Section 1.861-8(e)(3) of the Income Tax Regulations provides rules

regarding the allocation and apportionment of research and experimental

expenditures for purposes of determining taxable income from sources

within and without the United States.

This notice of proposed rulemaking proposes three changes to the

existing regulations at Sec. 1.861-8(e)(3).

First, allocation of research and experimental expenditures to

three digit SIC code product categories of gross income would be

permitted. Existing regulations require taxpayers to allocate research

and experimental expenditures to two digit SIC code product categories.

Use of three digit SIC code product categories would enable taxpayers

to allocate research and experimental expenditures to narrower classes

of gross income than the classes of gross income permitted by the

existing regulations.

Second, the percentage of research and experimental expenditures

that may be exclusively apportioned to United States source income

under the sales method of apportionment under Sec. 1.861-8(e)(3)(ii)

would be increased from 30 percent to 50 percent. Thus, where an

apportionment based upon geographic sources of income of a deduction

for research and experimental expenses is necessary and the sales

method of apportionment is elected, an amount equal to 50 percent of

the deduction for research and experimental expenditures shall be

apportioned exclusively to the statutory or residual grouping of gross

income, as the case may be, arising from the geographic source where

the research and experimental activities which account for more than 50

percent of the amount of the deduction were performed.

Third, use of the optional gross income methods of apportionment

would constitute a binding election to use such methods in subsequent

years. The election would not be revocable without the prior consent of

the Commissioner.

These changes would apply to taxable years beginning after December

31, 1995. However, the taxpayer would have the option to apply the new

rules, in their entirety, to taxable years beginning after December 31,

1994.

Examples (3) through (8) of Sec. 1.861-8(g) are conformed to these

changes. Examples (9) through (16) and Example (23) are removed and

reserved.

The three changes are proposed in part on the basis of an economic

study performed by the Treasury Department pursuant to Rev. Proc. 92-

56, 1992-2 C.B. 409, which is being simultaneously published by

Treasury. The Treasury study evaluates the factual relationships

between taxpayer performed research and experimental expenses and

income from foreign sources. The study reviewed evidence of foreign

returns from research and experimental expenditures in the form of both

royalties and the retained earnings and profits of controlled foreign

corporations. Estimates of foreign returns attributable to research and

experimental expenditures were translated into appropriate allocations

and apportionments using two alternative methodologies. One methodology

was based on estimated comparable domestic returns for research and

experimental expenditures. The other methodology simulated the

relationship expected between the current returns from research and

experimental expenditures and the level of current research and

experimental expenditures for taxpayers with ongoing research programs.

The methodologies generated a range of allocations and apportionments

to foreign income that were not inconsistent with the available

evidence. The allocations and apportionments to foreign income which

would result from adoption of these proposed regulations are within

that range and are about 25 percent lower than the allocations and

apportionments to foreign income which result under the current

regulations.

In addition, the proposed regulations provide explicit rules for

allocating and apportioning research and experimental expenses incurred

by a partnership and for computing a partner's sales for purposes of

apportioning research and experimental expenses under the sales method.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to section 7805(f) of the Internal

Revenue Code, this notice of proposed rulemaking will be submitted to

the Chief Counsel for Advocacy of the Small Business Administration for

comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for September 8, 1995, at 10

a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution

Avenue NW, Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the building lobby more than 15 minutes

before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by August 22, 1995 and submit an outline of the

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by August 18, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Carl Cooper, Office of

the Associate Chief Counsel (International). However, other personnel

from IRS and Treasury participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

[[Page 27455]]

PART 1--INCOME TAXES

Paragraph 1. The authority citation continues to read as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.861-8 is amended by:

1. Revising paragraph (e)(3).

2. Revising paragraph (g), Examples (3) through (8).

3. Removing and reserving paragraph (g), Examples (9) through (16)

and (23).

The revisions read as follows:

Sec. 1.861-8 Computation of taxable income from sources within the

United States and from other sources and activities.

* * * * *

(e) * * *

* * * * *

(3) Research and experimental expenditures--(i) Allocation--(A) In

general. The methods of allocation and apportionment of research and

experimental expenditures set forth in this paragraph (e)(3) recognize

that research and experimentation is an inherently speculative

activity, that findings may contribute unexpected benefits, and that

the gross income derived from successful research and experimentation

must bear the cost of unsuccessful research and experimentation.

Expenditures for research and experimentation which a taxpayer deducts

under section 174 ordinarily shall be considered deductions which are

definitely related to all income reasonably connected with the relevant

broad product category (or categories) of the taxpayer and therefore

allocable to all items of gross income as a class (including income

from sales, royalties, and dividends) related to such product category

(or categories). For purposes of this allocation, the product category

(or categories) which a taxpayer may be considered to have shall be

determined in accordance with the provisions of paragraph (e)(3)(i)(B)

of this section.

(B) Determination of product categories. Ordinarily, a taxpayer's

research and experimental expenditures may be divided between the

relevant product categories. Where research and experimentation is

conducted with respect to more than one product category, the taxpayer

may aggregate the categories for purposes of allocation and

apportionment; however, the taxpayer may not subdivide the categories.

Where research and experimentation is not clearly identified with any

product category (or categories), it will be considered conducted with

respect to all the taxpayer's product categories. A taxpayer shall

determine the relevant product categories by reference to the three

digit classification of the Standard Industrial Classification Manual

(SIC code). A copy may be purchased from the Superintendent of

Documents, United States Government Printing Office, Washington, DC

20402. The individual products included within each category are

enumerated in Executive Office of the President, Office of Management

and Budget, Standard Industrial Classification Manual, 1987 (or later

edition, as available). Once a taxpayer selects a product category for

the first taxable year for which this paragraph (e)(3) is effective

with respect to the taxpayer, it must continue to use that product

category in following years, unless the taxpayer establishes to the

satisfaction of the Commissioner that, due to changes in the relevant

facts, a change in the product category is appropriate. For this

purpose, a change in the taxpayer's selection of a product category

shall include a change from a three digit SIC code category to a two

digit SIC code category, a change from a two digit SIC code category to

a three digit SIC code category, or any other aggregation,

disaggregation or change of a previously selected SIC code category.

The two digit SIC code category ``Wholesale trade'' is not applicable

with respect to sales by the taxpayer of goods and services from any

other of the taxpayer's product categories and is not applicable with

respect to a domestic international sales corporation (DISC) or foreign

sales corporation (FSC) for which the taxpayer is a related supplier of

goods and services from any of the taxpayer's product categories. The

two digit SIC code category ``Retail trade'' is not applicable with

respect to sales by the taxpayer of goods and services from any other

of the taxpayer's product categories, except Wholesale trade, and is

not applicable with respect to a DISC or FSC for which the taxpayer is

a related supplier of goods and services from any other of the

taxpayer's product categories, except Wholesale trade.

(C) Affiliated Group. (1) Except as provided in paragraph

(e)(3)(i)(C)(2) of this section, the allocation and apportionment

required by this paragraph (e)(3) shall be determined as if all members

of the affiliated group (as defined in Sec. 1.861-14T(d)) were a single

corporation. See Sec. 1.861-14T.

(2) For purposes of the allocation and apportionment required by

this paragraph (e)(3), sales and gross income from products produced in

whole or in part in a possession by an electing corporation (within the

meaning of section 936(h)(5)(E)), and dividends from an electing

corporation, shall not be taken into account, except that this

paragraph (e)(3)(i)(C)(2) shall not apply to sales of (and gross income

and dividends attributable to sales of) products with respect to which

an election under section 936(h)(5)(F) is not in effect.

(3) The research and experimental expenditures taken into account

for purposes of this paragraph (e)(3) shall be reduced by the amount of

such expenditures included in computing the cost-sharing amount

(determined under section 936(h)(5)(C)(i)(I)).

(D) Exception. Where research and experimentation is undertaken

solely to meet legal requirements imposed by a political entity with

respect to improvement or marketing of specific products or processes,

and the results cannot reasonably be expected to generate amounts of

gross income (beyond de minimis amounts) outside a single geographic

source, the deduction for such research and experimentation shall be

considered definitely related and therefore allocable only to the

grouping (or groupings) of gross income within that geographic source

as a class (and apportioned, if necessary, between such groupings as

set forth in paragraphs (e)(3)(ii)(B) and (iii) of this section). For

example, where a taxpayer performs tests on a product in response to a

requirement imposed by the U.S. Food and Drug Administration, and the

test results cannot reasonably be expected to generate amounts of gross

income (beyond de minimis amounts) outside the United States, the costs

of testing shall be allocated solely to gross income from sources

within the United States.

(ii) Apportionment of research and experimentation--sales method--

(A) Exclusive apportionment. Where an apportionment based upon

geographic sources of income of a deduction for research and

experimentation is necessary (after applying the exception in paragraph

(e)(3)(i)(D) of this section), an amount equal to fifty percent (50%)

of such deduction for research and experimentation shall be apportioned

exclusively to the statutory grouping of gross income or the residual

grouping of gross income, as the case may be, arising from the

geographic source where the research and experimental activities which

account for more than fifty percent (50%) of the amount of such

deduction were performed. If the fifty percent test of the preceding

sentence is not met, then no part of the deduction shall be apportioned

under this paragraph (e)(3)(ii)(A). This exclusive apportionment

reflects the view that research and experimentation is often most

valuable in the country where it is performed, for two reasons. First,

[[Page 27456]] research and experimentation often benefits a broad

product category, consisting of many individual products, all of which

may be sold in the nearest market but only some of which may be sold in

foreign markets. Second, research and experimentation often is utilized

in the nearest market before it is used in other markets, and in such

cases, has a lower value per unit of sales when used in foreign

markets. The taxpayer may establish to the satisfaction of the

Commissioner that, in its case, one or both of the conditions mentioned

in the preceding sentences warrant a significantly greater percent than

50 percent (50%) because the research and experimentation is reasonably

expected to have very limited or long delayed application outside the

geographic source where it was performed. For purposes of establishing

that only some products within the product category (or categories) are

sold in foreign markets, the taxpayer shall compare the commercial

production of individual products in domestic and foreign markets made

by itself, by uncontrolled parties (as defined under paragraph

(e)(3)(ii)(C) of this section) of products involving intangible

property which was licensed or sold by the taxpayer, and by those

controlled corporations (as defined under paragraph (e)(3)(ii)(D) of

this section) which can reasonably be expected to benefit directly or

indirectly from any of the taxpayer's research expense connected with

the product category (or categories). The individual products compared

for this purpose shall be limited, for nonmanufactured categories,

solely to those enumerated in Executive Office of the President, Office

of Management and Budget Standard Industrial Classification Manual,

1987 (or later edition, as available), and, for manufactured

categories, solely to those enumerated at a 7-digit level in the U.S.

Bureau of the Census, Census of Manufacturers: 1992, Numerical List of

Manufactured Products, 1993 (or later edition, as available). Copies of

both of these documents may be purchased from the Superintendent of

Documents, United States Government Printing Office, Washington, DC

20402. For purposes of establishing the delayed application of research

findings abroad, the taxpayer shall compare the commercial introduction

of its own particular products and processes (not limited by those

listed in the Standard Industrial Classification Manual or the

Numerical List of Manufactured Products) in the United States and

foreign markets, made by itself, by uncontrolled parties (as defined

under paragraph (e)(3)(ii)(C) of this section) of products involving

intangible property which was licensed or sold by the taxpayer, and by

those controlled corporations (as defined under paragraph (e)(3)(ii)(D)

of this section) which can reasonably be expected to benefit, directly

or indirectly, from the taxpayer's research expense. For purposes of

evaluating the delay in the application of research findings in foreign

markets, the taxpayer shall use a safe haven discount rate of 10

percent per year of delay unless he is able to establish to the

satisfaction of the Commissioner, by reference to the cost of money and

the number of years during which economic benefit can be directly

attributable to the results of the taxpayer's research, that another

discount rate is more appropriate.

(B) Remaining apportionment. The amount equal to the remaining

portion of such deduction for research and experimentation, not

apportioned under paragraph (e)(3)(ii)(A) of this section, shall be

apportioned between the statutory grouping (or among the statutory

groupings) within the class of gross income and the residual grouping

within such class in the same proportions that the amount of sales from

the product category (or categories) which resulted in such gross

income within the statutory grouping (or statutory groupings) and in

the residual grouping bear, respectively, to the total amount of sales

from the product category (or categories). For purposes of this

paragraph (e)(3), amounts received from the lease of equipment during a

taxable year shall be regarded as sales receipts for such taxable year.

Amounts apportioned under this paragraph (e)(3) may exceed the amount

of gross income related to the product category within the statutory

grouping. In such case, the excess shall be applied against other gross

income within the statutory grouping. See paragraph (d)(1) of this

section for instances where the apportionment leads to an excess of

deductions over gross income within the statutory grouping.

(C) Sales of uncontrolled parties. For purposes of the

apportionment under paragraph (e)(3)(ii)(B) of this section, the sales

from the product category (or categories) by each party uncontrolled by

the taxpayer, of particular products involving intangible property

which was licensed or sold by the taxpayer to such uncontrolled party

shall be taken fully into account both for determining the taxpayer's

apportionment and for determining the apportionment of any other member

of a controlled group of corporations to which the taxpayer belongs if

the uncontrolled party can reasonably be expected to benefit directly

or indirectly (through any member of the controlled group of

corporations to which the taxpayer belongs) from the research expense

connected with the product category (or categories) of such other

member. In the case of licensed products, if the amount of sales of

such products is unknown (for example, where the licensed product is a

component of a large machine), a reasonable estimate should be made. In

the case of sales of intangible property, and in cases where a

reasonable estimate of sales of licensed products cannot be made, the

sales taken into account shall be an amount which is ten times the

amount received or accrued for the intangible during the taxpayer's

taxable year. For purposes of this paragraph (e)(3)(ii)(C), the term

uncontrolled party means a party which is not a person with a

relationship to the taxpayer (specified in section 267(b)), or is not a

member of a controlled group of corporations to which the taxpayer

belongs (within the meaning of section 993(a)(3) or section 927(d)(4)).

An uncontrolled party can reasonably be expected to benefit from the

research expense of a member of a controlled group of corporations to

which the taxpayer belongs if such member can reasonably be expected to

license, sell, or transfer intangible property to that uncontrolled

party or transfer secret processes to that uncontrolled party, directly

or indirectly, through a member of the controlled group of corporations

to which the taxpayer belongs.

(D) Sales of controlled parties. For purposes of the apportionment

under paragraph (e)(3)(ii)(B) of this section, the sales from the

product category (or categories) of the taxpayer shall be taken fully

into account and the sales from the product category (or categories) of

a corporation controlled by the taxpayer shall be taken into account to

the extent provided in this paragraph (e)(3)(ii)(D) for determining the

taxpayer's apportionment, if such corporation can reasonably be

expected to benefit directly or indirectly (through another member of

the controlled group of corporations to which the taxpayer belongs)

from the taxpayer's research expense connected with the product

category (or categories). However, sales from the product category (or

categories) between or among such controlled corporations or the

taxpayer shall not be taken into account more than once; in such a

situation, the amount sold by the selling corporation to the buying

corporation shall be subtracted from the sales of the buying

corporation. For [[Page 27457]] purposes of this paragraph

(e)(3)(ii)(D), the term a corporation controlled by the taxpayer means

any corporation other than an uncontrolled party as defined in

paragraph (e)(3)(ii)(C) of this section. A corporation controlled by

the taxpayer can reasonably be expected to benefit from the taxpayer's

research expense if the taxpayer can be expected to license, sell, or

transfer intangible property to that corporation or transfer secret

processes to that corporation, either directly or indirectly through a

member of the controlled group of corporations to which the taxpayer

belongs. Past experience with research and experimentation shall be

considered in determining reasonable expectations. However, if the

corporation controlled by the taxpayer has entered into a bona fide

cost-sharing arrangement, in accordance with the provisions of

Sec. 1.482-7, with the taxpayer for the purpose of developing

intangible property, then that corporation shall not reasonably be

expected to benefit from the taxpayer's share of the research expense.

The sales from the product category (or categories) of a corporation

controlled by the taxpayer taken into account shall be equal to the

amount of sales that bear the same proportion to total sales of the

controlled corporation as the taxpayer's direct or indirect ownership,

as defined in section 1563, of the total combined voting power of all

classes of stock entitled to vote of such corporation bears to the

total outstanding combined voting power of all such classes of stock of

such corporation.

(iii) Apportionment of research and experimentation--gross income

methods. In lieu of apportioning the deduction for research and

experimental expense under paragraph (e)(3)(ii) of this section, a

taxpayer may make a binding election pursuant to paragraph

(e)(3)(iii)(C) of this section to apportion such deduction, as

prescribed in paragraph (e)(3)(iii)(A) or (B) of this section, between

the statutory grouping (or among the statutory groupings) of gross

income and the residual grouping of gross income. These optional

methods must be applied to the taxpayer's entire deduction for research

and experimental expense remaining after applying the exception in

paragraph (e)(3)(i)(D) of this section, and may not be applied on a

product category basis. Thus, after the allocation of the taxpayer's

entire deduction for research and experimental expense under paragraph

(e)(3)(i) of this section (by attribution to SIC code categories), the

taxpayer must then apportion as necessary the entire deduction as

allocated by separate amounts to various product categories, using only

the sales method under paragraph (e)(3)(ii) of this section or only the

optional gross income methods under this paragraph (e)(3)(iii). The

taxpayer may not use the sales method for a portion of the deduction

and optional gross income methods for the remainder of the deduction

separately allocated.

(A) Option one. The taxpayer may apportion its research and

experimental expenditures ratably on the basis of gross income between

the statutory grouping (or among the statutory groupings) of gross

income and the residual grouping of gross income in the same

proportions that the amount of gross income in the statutory grouping

(or groupings) and the amount of gross income in the residual grouping

bear, respectively, to the total amount of gross income, if both of the

following two conditions are met.

(1) The amount of research and experimental expense ratably

apportioned to the statutory grouping (or groupings in the aggregate)

is not less than fifty percent (50%) of the amount which would have

been so apportioned if the taxpayer had used the method described in

paragraph (e)(3)(ii) of this section; and

(2) The amount of research and experimental expense ratably

apportioned to the residual grouping is not less than fifty percent

(50%) of the amount which would have been so apportioned if the

taxpayer had used the method described in paragraph (e)(3)(ii) of this

section.

(B) Option two. If, when the amount of research and experimental

expense is apportioned ratably on the basis of gross income, either of

the conditions described in paragraph (e)(3)(iii)(A) (1) or (2) of this

section is not met, the taxpayer may either--

(1) Where the condition of paragraph (e)(3)(iii)(A)(1) of this

section is not met, apportion fifty percent (50%) of the amount of

research and experimental expense which would have been apportioned to

the statutory grouping (or groupings in the aggregate) under paragraph

(e)(3)(ii) of this section to such statutory grouping (or to such

statutory groupings in the aggregate and then among such groupings on

the basis of gross income within each grouping), and apportion the

balance of the amount of research and experimental expenses to the

residual grouping; or

(2) Where the condition of paragraph (e)(3)(iii)(A)(2) of this

section is not met, apportion fifty percent (50%) of the amount of

research and experimental expense which would have been apportioned to

the residual grouping under paragraph (e)(3)(ii) of this section to

such residual grouping, and apportion the balance of the amount of

research and experimental expenses to the statutory grouping (or to the

statutory groupings in the aggregate and then among such groupings

ratably on the basis of gross income within each grouping).

(C) Binding election to use optional gross income methods. A

taxpayer may use either the sales method under paragraph (e)(3)(ii) of

this section or the optional gross income methods under this paragraph

(e)(3)(iii) for its return filed for its first taxable year to which

this paragraph (e)(3) applies. The taxpayer's use of the optional gross

income methods for its return filed for its first taxable year to which

this paragraph (e)(3) applies or for any subsequent taxable year shall

constitute a binding election to use the optional gross income methods

for all taxable years thereafter. The taxpayer's election to use the

optional gross income methods may not be revoked without the prior

consent of the Commissioner.

(iv) Special rules for partnerships. For purposes of applying this

paragraph (e)(3), if research and experimental expenditures are

incurred by a partnership in which the taxpayer is a partner, the

taxpayer's research and experimental expenditures shall include the

taxpayer's distributive share of the partnership's research and

experimental expenditures. In applying the exception for expenditures

undertaken to meet legal requirements under paragraph (e)(3)(i)(D) of

this section and the exclusive apportionment for the sales method under

paragraph (e)(3)(ii)(A) of this section, a partner's distributive share

of research and experimental expenditures incurred by a partnership

shall be treated as incurred by the partner for the same purpose and in

the same location as incurred by the partnership. In applying the

remaining apportionment for the sales method under paragraph

(e)(3)(ii)(B) of this section, a taxpayer's sales from a product

category shall include the taxpayer's share of any sales from the

product category of any partnership in which the taxpayer is a partner.

For purposes of the preceding sentence, a taxpayer's share of sales

shall be proportionate to the taxpayer's distributive share of the

partnership's gross income in the product category, but the sales of

the partnership taken into account by the taxpayer shall in no event be

less than ten times the amount received or accrued for any intangible

from the partnership during the taxpayer's taxable year.

[[Page 27458]]

(v) Examples. Examples (3) through (8) of paragraph (g) of this

section illustrate the allocation and apportionment of research and

experimental deductions.

(vi) Effective date. This paragraph (e)(3) applies to taxable years

beginning after December 31, 1995. However, the taxpayer may at its

option, apply this paragraph (e)(3) in its entirety to taxable years

beginning after December 31, 1994.

* * * * *

(g) * * *

* * * * *

Example 3--Research and Experimentation--(i) Facts. X, a

domestic corporation, is a manufacturer and distributor of small

gasoline engines for lawn mowers. Gasoline engines are a product

within the category, Engines and Turbines (SIC Industry Group 351).

Y, a wholly owned foreign subsidiary of X, also manufactures and

sells these engines abroad. During 1996, X incurred expenditures of

$60,000 on research and experimentation, which it deducts as a

current expense, to invent and patent a new and improved gasoline

engine. All of the research and experimentation was performed in the

United States. In 1996, the domestic sales by X of the new engine

total $500,000 and foreign sales by Y total $300,000. X provides

technology for the manufacture of engines to Y via a license that

requires the payment of an arm's length royalty. In 1996, X's income

is $150,000, of which $140,000 is from domestic sales and $10,000 is

royalties from Y.

(ii) Allocation. The research and experimental expenditures were

incurred in connection with small gasoline engines and they are

definitely related to the items of gross income to which the

research gives rise, namely gross income from the sale of small

gasoline engines in the United States and royalties received from

subsidiary Y, a foreign manufacturer of gasoline engines.

Accordingly, the expenses are allocable to this class of gross

income.

(iii) Apportionment. (A) For purposes of applying the foreign

tax credit limitation, the statutory grouping is general limitation

gross income from sources without the United States and the residual

grouping is general limitation gross income from sources within the

United States. Since the related class of gross income derived from

the use of engine technology consists of both gross income from

sources without the United States (royalties from Y) and gross

income from sources within the United States (gross income from

engine sales), X's deduction of $60,000 for its research and

experimental expenditure must be apportioned between the statutory

and residual grouping before the foreign tax credit limitation may

be determined. Because more than 50 percent of X's research and

experimental activity was performed in the United States, 50 percent

of that deduction can be apportioned exclusively to the residual

grouping of gross income, gross income from sources within the

United States. The remaining 50 percent of the deduction can then be

apportioned between the residual and statutory groupings on the

basis of sales by X and Y. Alternatively, X's deduction for research

and experimentation can be apportioned under the optional gross

income method. The apportionment for 1996 is as follows:

(1) Tentative Apportionment on the Basis of Sales.

(i) Research and experimental expense to be apportioned between

residual and statutory groupings of gross income: $60,000.

(ii) Less: Exclusive apportionment of research and experimental

expense to the residual grouping of gross income ($60,000 x 50

percent): $30,000.

(iii) Research and experimental expense to be apportioned

between residual and statutory groupings of gross income on the

basis of sales: $30,000.

(iv) Apportionment of research and experimental expense to the

residual grouping of gross income ($30,000 x $500,000/

($500,000+$300,000)): $18,750.

(v) Apportionment of research and experimental expense to the

statutory grouping of gross income ($30,000 x $300,000/

($500,000+$300,000)): $11,250.

(vi) Total apportioned deduction for research and

experimentation: $60,000.

(vii) Amount apportioned to the residual grouping

($30,000+$18,750): $48,750.

(viii) Amount apportioned to the statutory grouping: $11,250.

(2) Tentative Apportionment on the Basis of Gross Income.

(i) Research and experimental expense apportioned to sources

within the United States (residual grouping) ($60,000 x $140,000/

($140,000+$10,000)): $56,000.

(ii) Research and experimental expense apportioned to sources

within country Y (statutory grouping) ($60,000 x $10,000/

($140,000+$10,000)): $4,000.

(iii) Amount apportioned to the residual grouping: $56,000.

(iv) Amount apportioned to the statutory grouping: $4,000.

(B) The total research and experimental expense apportioned to

the statutory grouping ($4,000) under the gross income method is

approximately 36 percent of the amount apportioned to the statutory

grouping under the sales method. Thus, X may use option two of the

gross income method (paragraph (e)(3)(iii)(B) of this section) and

apportion to the statutory grouping fifty percent (50%) of the

$11,250 apportioned to that grouping under the sales method. Thus, X

apportions $5,625 of research and experimental expense to the

statutory grouping. X's use of the optional gross income method will

constitute a binding election to use the optional gross income

method for all taxable years thereafter.

Example 4--Research and Experimentation--(i) Facts. Assume the

same facts as in Example 3 except that X also spends $30,000 in 1996

for research on steam turbines, all of which is performed in the

United States, and X has steam turbine sales in the United States of

$400,000. X's foreign subsidiary Y neither manufactures nor sells

steam turbines. The steam turbine research is in addition to the

$60,000 in research which X does on gasoline engines for lawnmowers.

X thus has a deduction of $90,000 for its research activity. X's

gross income is $200,000, of which $140,000 is from sales of

gasoline engines, $50,000 is from sales of steam turbines, and

$10,000 is royalties from Y.

(ii) Allocation. X's research expenses generate income from

sales of small gasoline engines and steam turbines. Both of these

products are in the same three digit SIC code category, Engines and

Turbines (SIC Industry Group 351). Therefore, the deduction is

definitely related to this product category and allocable to all

items of income attributable to it. These items of X's income are

gross income from the sale of small gasoline engines and steam

turbines in the United States and royalties from foreign subsidiary

Y, a foreign manufacturer and seller of small gasoline engines.

(iii) Apportionment. (A) For purposes of applying the foreign

tax credit limitation, the statutory grouping is general limitation

gross income from sources outside the United States and the residual

grouping is general limitation gross income from sources within the

United States. X's deduction of $90,000 must be apportioned between

the statutory and residual groupings. Because more than 50 percent

of X's research and experimental activity was performed in the

United States, 50 percent of that deduction can be apportioned

exclusively to the residual grouping, general limitation gross

income from sources within the United States. The remaining 50

percent of the deduction can then be apportioned between the

residual and statutory groupings on the basis of total sales by X

and Y. Alternatively, X's deduction for research and experimentation

can be apportioned under the optional gross income methods. The

apportionment for 1996 is as follows:

(1) Tentative Apportionment on the Basis of Sales.

(i) Research and experimental expense to be apportioned between

residual and statutory groupings of gross income: $90,000.

(ii) Less: Exclusive apportionment of the research and

experimental expense to the residual grouping of gross income

($90,000 x 50 percent): $45,000.

(iv) Research and experimental expense to be apportioned between

the residual and statutory groupings of gross income on the basis of

sales: $45,000.

(iv) Apportionment of research and experimental expense to the

residual grouping of gross income ($45,000 x ($500,000+400,000)/

($500,000+$400,000+$300,000)): $33,750.

(v) Apportionment of research and experimental expense to the

statutory grouping of gross income ($45,000 x $300,000/

($500,000+$400,000+$300,000)): $11,250.

(vi) Total apportioned deduction for research and

experimentation: $90,000.

(vii) Amount apportioned to the residual grouping

($45,000+$33,750): $78,750.

(viii) Amount apportioned to the statutory grouping: $11,250.

(2) Tentative Apportionment on the Basis of Gross Income.

(i) Research and experimental expense apportioned to sources

within the United States (residual grouping)

[[Page 27459]] ($90,000 x $190,000/($140,000+$50,000+10,000)):

$85,500.

(ii) Research and experimental expense apportioned to sources

within country Y (statutory grouping) ($90,000 x $10,000/

($140,000+$50,000+$10,000)): $4,500.

(iii) Amount apportioned to the residual grouping: $85,500.

(iv) Amount apportioned to the statutory grouping: $4,500.

(B) The total research and experimental expense apportioned to

the statutory grouping ($4,500) under the gross income method is 40

percent of the amount apportioned to the statutory grouping under

the sales method. Thus, X, may use option two of the gross income

method (paragraph (e)(3)(iii)(B) of this section) and apportion to

the statutory grouping fifty percent (50%) of the $11,250

apportioned to that grouping under the sales method. Thus, X

apportions $5,625 of research and experimental expense to the

statutory grouping. X's use of the optional gross income method will

constitute a binding election to use the optional gross income

method for all taxable years thereafter.

Example 5--Research and Experimentation--(i) Facts. Assume the

same facts as in Example 3 except that in 1997 X continues its sales

of the new engines, with sales of $600,000 in the United States and

$400,000 by subsidiary Y. X also acquires a 60 percent ownership

interest in foreign corporation Z and a 100 percent ownership

interest in foreign corporation C. X transfers its engine technology

to Z for a royalty equal to 5 percent of sales, and X enters into an

arm's length cost-sharing arrangement with C to share the funding of

all of X's research activity. In 1997, corporation Z has sales in

country Z equal to $1,000,000. X incurs expense of $80,000 on

research and experimentation in 1997, and in addition, X performs

$15,000 of research on gasoline engines which was funded by the

cost-sharing arrangement with C. All of Z's sales are from the

product category, Engines and Turbines (SIC Industry Group 351). X

performs all of its research in the United States and $20,000 of its

expenditure of $80,000 is made solely to meet pollution standards

mandated by law. X establishes, to the satisfaction of the

Commissioner, that the expenditure in response to pollution

standards is not expected to generate gross income (beyond de

minimis amounts) outside the United States.

(ii) Allocation. The $20,000 of research expense which X

incurred in connection with pollution standards is definitely

related and thus allocable to the residual grouping, general

limitation gross income from sources within the United States. The

remaining $60,000 in research and experimental expenditure incurred

by X is definitely related to all gasoline engines and is therefore

allocable to the class of gross income to which the engines give

rise, gross income from sales in the United States, royalties from

country Y, and royalties from country Z. No part of the $60,000

research expense is allocable to dividends from country C, because

corporation C has already paid, through its cost-sharing

arrangement, for research activity performed by X which may benefit

C.

(iii) Apportionment. For purposes of applying the foreign tax

credit limitation, the statutory grouping is general limitation

gross income from sources without the United States, and the

residual grouping is general limitation gross income from sources

within the United States. X's deduction of $60,000 for its research

and experimental expenditure must be apportioned between these

groupings. Because more than 50 percent of the research and

experimentation was performed in the United States, 50 percent of

the $60,000 deduction can be apportioned exclusively to the residual

grouping. The remaining 50 percent of the deduction can then be

apportioned between the residual and the statutory grouping on the

basis of sales by X, Y, and Z. (If X utilized the optional gross

income methods in 1996, then its use of such methods constituted a

binding election to use the optional gross income methods for all

taxable years thereafter. The optional gross income methods are not

illustrated in this Example 5 (see instead Examples 3 and 4).) Since

X has only a 60 percent ownership interest in corporation Z, only 60

percent of Z's sales (60% of $1,000,000, or $600,000) are included

for purposes of apportionment. The allocation and apportionment for

1997 is as follows:

(A) X's total research expense: $80,000.

(B) Less: Legally mandated research directly allocated to the

residual grouping of gross income: $20,000.

(C) Tentative apportionment on the basis of sales.

(1) Research and experimental expense to be apportioned between

residual and statutory groupings of gross income: $60,000.

(2) Less: Exclusive apportionment of research and experimental

expense to the residual grouping of gross income ($60,000 x 50

percent): $30,000.

(3) Research and experimental expense to be apportioned between

the residual and the statutory grouping on the basis of sales:

$30,000.

(4) Apportionment of research and experimental expense to

general limitation gross income from sources within the United

States (residual grouping) ($30,000 x $600,000/

($600,000+$400,000+$600,000)): $11,250.

(5) Apportionment of research and experimental expense to

general limitation gross income from countries Y and Z (statutory

grouping) ($30,000 x $400,000+$600,000/

($600,000+$400,000+$600,000)): $18,750.

(6) Total apportioned deduction for research and experimentation

($30,000+$30,000): 60,000.

(7) Amount apportioned to the residual grouping

($30,000+$11,250): $41,250.

(8) Amount apportioned to the statutory grouping of sources

within countries Y and Z: $18,750.

Example 6--Research and Experimentation--(i) Facts. X, a

domestic corporation, manufacturers and sells forklift trucks and

other types of materials handling equipment in the United States.

The manufacture and sale of forklift trucks and other materials

handling equipment belongs to the product category, Construction,

Mining, and Materials Handling Machinery and Equipment (SIC Industry

Group 353). X also sells its forklift trucks to a wholesaling

subsidiary located in foreign country Y (but title passes in the

United States), and X manufactures forklift trucks in foreign

country Z. The wholesaling of forklift trucks to country Y also

belongs to X's product category Transportation equipment and,

therefore, may not belong to the product category, Wholesale trade

(SIC Major Group 50 and 51). In 1997, X sold $7,000,000 of forklift

trucks to purchasers in the United States, $3,000,000 of forklift

trucks to the wholesaling subsidiary in Y, and transferred forklift

truck components with an FOB export value of $2,000,000 to its

branch in Z. The branch's sales of finished forklift trucks were

$5,000,000. In response to legally mndated emission control

requirements, X's United States research department has been engaged

in a research project to improve the performance and quality of

engine exhaust systems used on its products in the United States. It

incurs expenses of $100,000 for this purpose in 1997. In the past, X

has customarily adapted the product improvements developed

originally for the domestic market to its forklift trucks

manufactured abroad. During the taxable year 1997, development of an

improved engine exhaust system is completed and X begins installing

the new system during the latter part of the taxable year in

products manufactured and sold in the United States. X continues to

manufacture and sell forklift trucks in foreign countries without

the improved engine exhaust systems.

(ii) Allocation. X's deduction for its research expense is

definitely related to the income to which it gives rise, namely

income from the manufacture and sale of forklift trucks within the

United States and in country Z. Although the research is undertaken

in response to a legal mandate, it can reasonably be expected to

generate gross income from the manufacture and sale of trucks by the

branch in Z. Therefore, the deduction is not allocable solely to

income from X's domestic sales of forklift trucks. It is allocable

to income from such sales and income from the sales of X's branch in

Z.

(iii) Apportionment. For the method of apportionment on the

basis of either sales or gross income, see example 3. However, in

determining the amount of research apportioned to income from

foreign and domestic sources, the net sales of the branch in Z are

$3,000,000 ($5,000,000 less $2,000,000) and the sales within the

United States are $12,000,000 ($7,000,000 plus $3,000,000 plus

$2,000,000).

Example 7--Research and Experimentation--(i) Facts. X, a

domestic corporation, is a drug company which manufactures a wide

variety of pharmaceutical products for sale in the United States.

Pharmaceutical products belong to the product category, Drugs (SIC

Industry Group 283). X exports its pharmaceutical products through a

foreign sales corporation (FSC). X's wholly owned foreign subsidiary

Y also manufactures pharmaceutical products. In 1997, X has domestic

sales of $10,000,000, the FSC has sales of $3,000,000, and Y has

sales of $5,000,000. In that same year, 1997, X incurs

[[Page 27460]] expense of $200,000 on research to test a product in

response to requirements imposed by the United States Food and Drug

Administration (FDA). X is able to show that, even though country Y

imposes certain testing requirements on pharmaceutical products, the

research performed in the United States is not accepted by country Y

for purposes of its own licensing requirements, and the research has

minimal use abroad. X is further able to show that its FSC sells

goods to countries which do not accept or do not require research

performed in the United States for purposes of their own licensing

standards.

(ii) Allocation. Since X's research expense of $200,000 is

undertaken to meet the requirements of the United States Food and

Drug Administration, and since it is reasonable to expect that the

expenditure will not generate gross income (beyond de minimis

amounts) outside the United States, the deduction is definitely

related and thus allocable to the residual grouping.

(iii) Apportionment. No apportionment is necessary since the

entire expense is allocated to the residual grouping, general

limitation gross income from sales within the United States.

Example 8--Research and Experimentation--(i) Facts. X, a

domestic corporation, is engaged in continuous research and

experimentation to improve the quality of the products that it

manufactures and sells, which are floodlights, flashlights, fuse

boxes, and solderless connectors. X incurs and deducts $100,000 of

expenditure for research and experimentation in 1997 which was

performed exclusively in the United States. As a result of this

research activity, X acquires patents which it uses in its own

manufacturing activity. X licenses its floodlight patent to Y and Z,

uncontrolled foreign corporations, for use in their own territories,

countries Y and Z, respectively. Corporation Y pays X an arm's

length royalty of $3,000 plus $0.20 for each floodlight sold. Sales

of floodlights by Y for the taxable year are $135,000 (at $4.50 per

unit) or 30,000 units, and the royalty is $9,000

($3,000+$0.20 x 30,000). Y has sales of other products of $500,000.

Z pays X an arm's length royalty of $3,000 plus $0.30 for each unit

sold. Z manufactures 30,000 floodlights in the taxable year, and the

royalty is $12,000 ($3,000+$0.30 x 30,000). The dollar value of Z's

floodlight sales is not known and cannot be reasonably estimated

because, in this case, the floodlights are not sold separately by Z

but are instead used as a component in Z's manufacture of lighting

equipment for theaters. The sales of all Z's products, including the

lighting equipment for theaters, are $1,000,000. Y and Z each sell

the floodlights exclusively within their respective countries. X's

sales of floodlights for the taxable year are $500,000 and its sales

of its other products, flashlights, fuse boxes, and solderless

connectors, are $400,000. X has gross income of $500,000, consisting

of gross income from domestic sources of $479,000, and royalty

income of $9,000 and $12,000 from foreign corporations Y and Z

respectively.

(ii) Allocation. X's research and experimental expenses are

definitely related to all of the products that it produces, which

are floodlights, flashlights, fuse boxes, and solderless connectors.

All of these products are in the same three digit SIC Code category,

Electric Lighting and Wiring Equipment (SIC Industry Group 364).

Thus, X's research and experimental expenses are allocable to all

items of income attributable to this product category, domestic

sales income and royalty income from the foreign countries in which

corporations Y and Z operate.

(iii) Apportionment. (A) The statutory grouping of gross income

is general limitation income from sources without the United States.

The residual grouping is general limitation gross income from

sources within the United States. X's deduction of $100,000 for its

research expenditures must be apportioned between the groupings. For

apportionment on the basis of sales in accordance with paragraph

(e)(3)(ii) of this section, X is entitled to an exclusive

apportionment of 50 percent of its research and experimental expense

to the residual grouping, general limitation gross income from

sources within the United States, since more than 50 percent of the

research activity was performed in the United States. The remaining

50 percent of the deduction can then be apportioned between the

residual and statutory groupings on the basis of sales. Since Y and

Z are unrelated licensees of X, only their sales of the licensed

product, floodlights, are included for purposes of apportionment.

Floodlight sales of Z are unknown, but are estimated at ten times

royalties from Z, or $120,000. All of X's sales from the entire

product category are included for purposes of apportionment on the

basis of sales. Alternatively, X may apportion its deduction on the

basis of gross income, in accordance with paragraph (e)(3)(iii) of

this section. The apportionment is as follows:

(1) Tentative Apportionment on the basis of sales.

(i) Research and experimental expense to be apportioned between

statutory and residual groupings of gross income: $100,000.

(ii) Less: Exclusive apportionment of research and experimental

expense to the residual groupings of gross income ($100,000 x 50

percent): $50,000.

(iii) Research and experimental expense to be apportioned

between the statutory and residual groupings of gross income on the

basis of sales: $50,000.

(iv) Apportionment of research and experimental expense to the

residual groupings of gross income ($50,000 x $900,000/

($900,000+$135,000+$120,000)): $38,961.

(v) Apportionment of research and experimental expense to the

statutory grouping, royalty income from countries Y and Z

($50,000 x $135,000+$120,000/($900,000+$135,000+$120,000)): $11,039.

(vi) Total apportioned deduction for research and

experimentation: $100,000.

(vii) Amount apportioned to the residual grouping

($50,000+$38,961): $88,961.

(viii) Apportioned to the statutory grouping of sources within

countries Y and Z: $11,039.

(2) Tentative apportionment on gross income basis.

(i) Apportionment of research and experimental expense to the

residual grouping of gross income ($100,000 x $479,000/$500,000):

$95,800.

(ii) Apportionment of research and experimental expense to the

statutory grouping of gross income ($100,000 x $9,000+$12,000/

$500,000): $4,200.

(iii) Amount apportioned to the residual grouping: $95,800.

(iv) Amount apportioned to the statutory grouping of general

limitation income from sources without the United States: $4,200.

(B) Since X's apportionment on the basis of gross income to the

statutory grouping, $4,200, is less than 50 percent of its

apportionment on the basis of sales to the statutory grouping,

$11,039 it may use Option two of paragraph (e)(3)(iii)(B) of this

section and apportion $5,520 (50 percent of $11,039) to the

statutory grouping.

Examples (9) through (16)--[Reserved]

* * * * *

Example (23)--[Reserved]

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-12621 Filed 5-19-95; 9:25 am]

BILLING CODE 4830-01-U