Allocation and Apportionment of Research and Experimental Expenditures

DEPARTMENT OF THE TREASURY

26 CFR Part 1

[TD 8646]

RIN 1545-AT49

Allocation and Apportionment of Research and Experimental

Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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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.

EFFECTIVE DATE: January 1, 1996.

FOR FURTHER INFORMATION CONTACT: Carl Cooper at (202) 622-3840 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

On May 24, 1995, the IRS published a notice of proposed rulemaking

and notice of public hearing in the Federal Register (60 FR 27453)

proposing amendments to the Income Tax Regulations (26 CFR part 1)

under section 861 of the Internal Revenue Code of 1986. 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 inside and

outside the United States.

The notice of proposed rulemaking proposed three principal changes

to the existing regulations. First, allocation of research and

experimental expenditures to three-digit SIC code product categories of

gross income would be permitted. 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. 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. The three changes were 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), ``The

Relationship Between U.S. Research and Development and Foreign

Income,'' which was published by the Treasury Department simultaneously

with the proposed regulations.

Written comments responding to the notice were received, and a

public hearing was held on September 8, 1995.

Regarding the determination of product categories under Sec. 1.861-

8(e)(3)(i)(B) of the proposed regulations, commenters suggested that

the rule requiring a taxpayer to determine relevant product categories

by reference to the three-digit classification of the Standard

Industrial Classification Manual should be modified to allow

determinations by reference to the five-digit classifications of the

Manual. This suggestion was not adopted, because such a rule would too

narrowly restrict the necessarily broad scope of the deduction. The IRS

continues to believe that research and experimentation is an inherently

speculative activity, that findings may contribute unexpected benefits,

and that gross income derived from successful research and

experimentation must bear the cost of unsuccessful research and

experimentation.

Commenters suggested that the regulations permit taxpayers to

determine product categories by reference to two- or three-digit

categories at the annual election of the taxpayer. This suggestion was

not adopted. The regulations provide that a taxpayer may determine

product categories by reference to two- or three-digit categories. A

taxpayer may aggregate, disaggregate or change a previously selected

SIC code category if the taxpayer establishes to the satisfaction of

the Commissioner that, due to changes in the relevant facts, a change

in product category is appropriate. This rule provides a simple and

workable format for balancing the need for consistency with the desire

for flexibility.

Referring to current Sec. 1.861-8(g) Example 6 (which has been

redesignated Sec. 1.861-17(h) Example 4), commenters suggested that the

regulations allow the use of the Wholesale Trade SIC code category with

respect to sales from any other category. The current Sec. 1.861-8(g)

Example 6 was not correct on this point and does not override the rule

stated parenthetically in the list of two digit SIC code categories in

present Sec. 1.861-8(e)(3)(i)(A) that wholesale trade may not be

combined with other product categories. The final regulations include

this rule along with Example 6 corrected to conform to the rule.

Regarding the exclusive place of performance apportionment rule

under Sec. 1.861-8(e)(3)(ii)(A) of the proposed regulations, commenters

suggested adding a rule providing that if the ratio of foreign research

and experimental expenditures in a three digit SIC code category of all

foreign affiliates of a United States consolidated group over foreign

affiliate sales in that SIC code category exceed fifty percent of the

ratio of United States consolidated group research and experimental

expenditures in that SIC code category over United States consolidated

group sales in that SIC code category, then the United States

consolidated group research and experimental expenditures should be

exclusively apportioned to United States source gross income. This

suggestion has not been adopted. Although a foreign affiliate may incur

substantial research and experimental expenditures in a given product

category, the foreign affiliate may still benefit from the research and

experimental expenditures of the United States consolidated group. See

Perkin-Elmer Corporation v. Commissioner, 103 T.C. 464 (1994).

Regarding the optional gross income methods of apportionment under

Sec. 1.861-8(e)(3)(iii) of the proposed regulations, commenters

suggested that

[[Page 66503]]

the final regulations include a fifty percent exclusive place of

performance apportionment under the optional gross income methods to be

parallel with Sec. 1.861-8(e)(3)(ii)(A). This suggestion has been

adopted in part. Section (b)(1)(ii) of the final regulations includes a

twenty-five percent exclusive place of performance apportionment under

the optional gross income methods. This twenty-five percent exclusive

apportionment ensures that taxpayers electing to use one of the

optional gross income methods also obtain results comparable to those

obtained by taxpayers electing to use the sales method, i.e., an

overall allocation that is twenty-five percent lower on average than

the allocation to foreign source income resulting from the current

regulations. The Treasury Department study does not support a greater

exclusive apportionment.

Commenters suggested that the proposed regulations should be

modified to reduce the floor on the amount of research and experimental

expenditures that must be apportioned to foreign source income under

the optional gross income methods from fifty percent to thirty percent

of the amount that would have been apportioned under the sales method.

This suggestion has not been adopted. The adoption of this suggested

rule in addition to the twenty-five percent exclusive apportionment

rule is not supported by the Treasury Department study.

Commenters suggested the elimination of the binding election to use

the optional gross income methods under Sec. 1.861-8(e)(3)(iii)(C) of

the proposed regulations. Commenters also suggested that the binding

election rule should be modified to provide for a change of method

without the prior consent of the Commissioner after five years' use of

one method. This suggestion, which recognizes the need for consistency

while reducing the administrative burden on taxpayers, has been

adopted.

Commenters suggested that the effective date election under

Sec. 1.861-8(e)(3)(vi) of the proposed regulations permit election by

fiscal year taxpayers whose taxable years begin after August 1, 1994,

but before January 1, 1995. This suggestion has been adopted.

Finally, these provisions, which were previously published as

Sec. 1.861-8(e)(3), have been renumbered and will now be published as

Sec. 1.861-17. This change has been made solely for the purpose of

achieving greater clarity in formatting and is not intended to result

in any additional substantive changes.

Special Analyses

It has been determined that these final regulations are 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,

the notice of proposed rulemaking preceding these final regulations has

been submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

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.

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

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) to read as set forth below.

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

23.

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. For rules regarding the

allocation and apportionment of research and experimental expenditures,

see Sec. 1.861-17.

* * * * *

Par. 3. Section 1.861-17 is added to read as follows:

Sec. 1.861-17 Allocation and apportionment of research and

experimental expenditures.

(a) Allocation--(1) In general. The methods of allocation and

apportionment of research and experimental expenditures set forth in

this section 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 that a taxpayer deducts under section 174 ordinarily

shall be considered deductions that 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) that

a taxpayer may be considered to have shall be determined in accordance

with the provisions of paragraph (a)(2) of this section.

(2) Product categories--(i) Allocation based on 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.

(ii) Use of three digit standard industrial classification codes. 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).

(iii) Consistency. Once a taxpayer selects a product category for

the first taxable year for which this section 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

[[Page 66504]]

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.

(iv) Wholesale trade 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.

(v) Retail trade category. 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.

(3) Affiliated Groups--(i) In general. Except as provided in

paragraph (a)(3)(ii) of this section, the allocation and apportionment

required by this section 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.

(ii) Possessions corporations. (A) For purposes of the allocation

and apportionment required by this section, 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 (a)(3)(ii) 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.

(B) The research and experimental expenditures taken into account

for purposes of this section shall be reduced by the amount of such

expenditures included in computing the cost-sharing amount (determined

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

(4) Legally mandated research and experimentation. 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 (c) and

(d) 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.

(b) Exclusive apportionment--(1) In general. An exclusive

apportionment shall be made under this paragraph (b), where an

apportionment based upon geographic sources of income of a deduction

for research and experimentation is necessary (after applying the

exception in paragraph (a)(4) of this section).

(i) Exclusive apportionment under the sales method. If the taxpayer

apportions on the sales method under paragraph (c) of this section, an

amount equal to fifty percent 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

of the amount of such deduction were performed.

(ii) Exclusive apportionment under the optional gross income

methods. If the taxpayer apportions on the optional gross income

methods under paragraph (d) of this section, an amount equal to twenty-

five percent of such deduction for research and experimentation shall

be apportioned exclusively to the statutory grouping 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 of the amount of such deduction

were performed.

(iii) Exception. If the applicable fifty percent geographic source

test of the preceding paragraph (b)(1)(i) or (ii) is not met, then no

part of the deduction shall be apportioned under this paragraph (b)(1).

(2) Facts and circumstances supporting an increased exclusive

apportionment--(i) In general. The exclusive apportionment provided for

in paragraph (b)(1) of this section reflects the view that research and

experimentation is often most valuable in the country where it is

performed, for two reasons. First, 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 exclusive allocation percentage than allowed by paragraph

(b)(1) of this section because the research and experimentation is

reasonably expected to have very limited or long delayed application

outside the geographic source where it was performed. Past experience

with research and experimentation may be considered in determining

reasonable expectations.

(ii) Not all products sold in foreign markets. 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 (c)(2)(i) 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 (c)(3)(ii) of this

section) that 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,

[[Page 66505]]

United States Government Printing Office, Washington, DC 20402.

(iii) Delayed application of research findings abroad. 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

(c)(2)(i) of this section) of products involving intangible property

that was licensed or sold by the taxpayer, and by those controlled

corporations (as defined under paragraph (c)(3)(i) of this section)

that 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.

(c) Sales method--(1) In general. The amount equal to the remaining

portion of such deduction for research and experimentation, not

apportioned under paragraph (a)(4) or (b)(1)(i) 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) that 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).

(i) Apportionment in excess of gross income. Amounts apportioned

under this section 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 Sec. 1.861-8(d)(1) for instances where the apportionment

leads to an excess of deductions over gross income within the statutory

grouping.

(ii) Leased property. For purposes of this paragraph (c), amounts

received from the lease of equipment during a taxable year shall be

regarded as sales receipts for such taxable year.

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

apportionment under paragraph (c)(1) of this section, the sales from

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

taxpayer, of particular products involving intangible property that 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. 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. Past

experience with research and experimentation shall be considered in

determining reasonable expectations.

(i) Definition of uncontrolled party. For purposes of this

paragraph (c)(2) the term uncontrolled party means a party that 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

927(d)(4)).

(ii) Licensed products. 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 based on the principles of section 482 should be made.

(iii) Sales of intangible property. In the case of sales of

intangible property, regardless of whether the consideration received

in exchange for the intangible is a fixed amount or is contingent on

the productivity, use, or disposition of the intangible, if the amount

of sales of products utilizing the intangible property is unknown, a

reasonable estimate of sales shall be made annually. If necessary,

appropriate economic analyses shall be used to estimate sales.

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

under paragraph (c)(1) 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 (c)(3) 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). 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.

(i) Definition of a corporation controlled by the taxpayer. For

purposes of this paragraph (c)(3), the term a corporation controlled by

the taxpayer means any corporation that has a relationship to the

taxpayer specified in section 267(b) or is a member of a controlled

group of corporations to which the taxpayer belongs (within the meaning

of section 993(a)(3) or 927(d)(4).

(ii) Sales to be taken into account. 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 the total sales of the controlled corporation as the

total value of all classes of the stock of such corporation owned

directly or indirectly by the taxpayer, within the meaning of section

1563, bears to the total value of all classes of stock of such

corporation.

(iii) Sales not to be taken into account more than once. 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.

(iv) Effect of cost-sharing arrangements. If the corporation

controlled by the taxpayer has entered

[[Page 66506]]

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.

(d) Gross income methods--(1)(i) In general. In lieu of applying

the sales method of paragraph (c) of this section, the remaining amount

of the deduction for research and experimentation, not apportioned

under paragraph (a)(4) or (b)(1)(ii) of this section, shall be

apportioned as prescribed in paragraphs (d)(2) and (3) of this section,

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

gross income and the residual grouping of gross income.

(ii) Optional methods to be applied to all research and

experimental expenditures. These optional methods must be applied to

the taxpayer's entire deduction for research and experimental expense

remaining after applying the exception in paragraph (a)(4) 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 (a)(2) 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

(c) of this section or only the optional gross income methods under

this paragraph (d). 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.

(2) 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 the

conditions described in paragraph (d)(2)(i) and (ii) of this section

are both met.

(i) The amount of research and experimental expense ratably

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

is not less than fifty percent of the amount that would have been so

apportioned if the taxpayer had used the method described in paragraph

(c) of this section; and

(ii) The amount of research and experimental expense ratably

apportioned to the residual grouping is not less than fifty percent of

the amount that would have been so apportioned if the taxpayer had used

the method described in paragraph (c) of this section.

(3) 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 (d)(2)(i) or (ii) of this section

is not met, the taxpayer may either--

(i) Where the condition of paragraph (d)(2)(i) of this section is

not met, apportion fifty percent of the amount of research and

experimental expense that would have been apportioned to the statutory

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

(ii) Where the condition of paragraph (d)(2)(ii) of this section is

not met, apportion fifty percent of the amount of research and

experimental expense that would have been apportioned to the residual

grouping under paragraph (c) 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).

(e) Binding election--(1) In general. A taxpayer may choose to use

either the sales method under paragraph (c) of this section or the

optional gross income methods under paragraph (d) of this section for

its original return for its first taxable year to which this section

applies. The taxpayer's use of either the sales method or the optional

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

which this section applies shall constitute a binding election to use

the method chosen for that year and for four taxable years thereafter.

(2) Change of method. The taxpayer's election of a method may not

be revoked during the period referred to in paragraph (e)(1) of this

section without the prior consent of the Commissioner. After the

expiration of that period, the taxpayer may change methods without the

prior consent of the Commissioner. However, the taxpayer's use of the

new method shall constitute a binding election to use the new method

for its return filed for the first year for which the taxpayer uses the

new method and for four taxable years thereafter. The taxpayer's

election of the new method may not be revoked during that period

without the prior consent of the Commissioner.

(i) Short taxable years. For purposes of this paragraph (e), the

term taxable year includes a taxable year of less than twelve months.

(ii) Affiliated groups. In the case of an affiliated group, the

period referred to in paragraph (e)(1) of this section shall commence

as of the latest taxable year in which any member of the group has

changed methods.

(f) Special rules for partnerships--(1) Research and experimental

expenditures. For purposes of applying this section, 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.

(2) Purpose and location of expenditures. In applying the exception

for expenditures undertaken to meet legal requirements under paragraph

(a)(4) of this section and the exclusive apportionment for the sales

method and the optional gross income methods under paragraph (b) 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.

(3) Apportionment under the sales method. In applying the remaining

apportionment for the sales method under paragraph (c) 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.

(g) Effective date. This section applies to taxable years beginning

after December 31, 1995. However, a taxpayer may at his or her option,

apply this section in its entirety to all taxable years beginning after

August 1, 1994.

(h) Examples. The following examples illustrate the application of

this section:

Example 1--(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

[[Page 66507]]

(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 gross income is $160,000, of which

$140,000 is U.S. source income from domestic sales of gasoline

engines and $10,000 is foreign source royalties from Y, and $10,000

is U.S. source interest income.

(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. The U.S. source interest income is not within this class of

gross income and, therefore, is not taken into account.

(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 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 of small

gasoline engines 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) Exclusive apportionment of research and experimental

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

25 percent):................................................ $15,000

(ii) Research and experimental expense apportioned to sources

within the United States (residual grouping) ($45,000 x

$140,000/($140,000+$10,000)):............................... $42,000

(iii) Research and experimental expense apportioned to

sources within country Y (statutory grouping) ($45,000 x

$10,000/($140,000+$10,000)):................................ $3,000

(iv) Amount apportioned to the residual grouping:............ $57,000

(v) Amount apportioned to the statutory grouping:............ $3,000

(B) The total research and experimental expense apportioned to

the statutory grouping ($3,000) under the gross income method is

approximately 26 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 (d)(3) 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 methods

will constitute a binding election to use the optional gross income

methods for 1996 and four taxable years thereafter.

Example 2--(i) Facts. Assume the same facts as in Example 1

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 U.S. source income from domestic

sales of gasoline engines, $50,000 is U.S. source income from

domestic sales of steam turbines, and $10,000 is foreign source

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 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, 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 of small gasoline engines and steam turbines 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

(iii) 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

[[Page 66508]]

(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) Exclusive apportionment of research and experimental

expense to the residual grouping of gross income ($90,000 x

25 percent):................................................ $22,500

(ii) Research and experimental expense apportioned to sources

within the United States (residual grouping) ($67,500 x

$190,000/($140,000+$50,000+$10,000)):....................... $64,125

(iii) Research and experimental expense apportioned to

sources within country Y (statutory grouping) ($67,500 x

$10,000/($140,000+$50,000+$10,000)):........................ $3,375

(iv) Amount apportioned to the residual grouping:............ $86,625

(v) Amount apportioned to the statutory grouping:............ $3,375

(B) The total research and experimental expense apportioned to

the statutory grouping ($3,375) under the gross income method is 30

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 (d)(3) 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 methods will constitute a binding

election to use the optional gross income methods for 1996 and four

taxable years thereafter.

Example 3--(i) Facts. Assume the same facts as in Example 1

except that in 1997 X continues its sales of the new engines, with

sales of $600,000 in the United States and $400,000 abroad by

subsidiary Y. X also acquires a 60 percent (by value) 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, 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 of gasoline engines 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 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 of gasoline engines 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 in 1996 and for four taxable years thereafter. If X utilized

the sales method in 1996, then its use of such method constituted a

binding election to use the sales method in 1996 and for four

taxable years thereafter.) The optional gross income methods are not

illustrated in this Example 3 (see instead Examples 1 and 2). 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 groupings on the

basis of sales:............................................. $30,000

(4) Apportionment of research and experimental expense to

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 gross

income from sources within countries Y and Z:............... $18,750

Example 4--Research and Experimentation--(i) Facts. X, a

domestic corporation, manufactures 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

[[Page 66509]]

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 mandated

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). See Sec. 1.861-17(c)(3)(iii).

Example 5--(i) Facts. X, a domestic corporation, is a drug

company that 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

pharmaceutical products of $10,000,000, the FSC has sales of

pharmaceutical products of $3,000,000, and Y has sales of

pharmaceutical products of $5,000,000. In that same year, 1997, X

incurs 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 FSC sells goods

to countries that 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, gross income

from sales within the United States.

Example 6--(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 that was performed exclusively in the United States. As a

result of this research activity, X acquires patents that 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

from sales of floodlights, flashlights, fuse boxes, and solderless

connectors of $479,000, and royalty income of $9,000 and $12,000

from foreign corporations Y and Z respectively. X utilized the

optional gross income methods of apportionment for its return filed

for its first taxable year to which this section applies.

(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 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 (c) of this section, X is

entitled to an exclusive apportionment of 50 percent of its research

and experimental expense to the residual grouping, 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 (d) 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

[[Page 66510]]

(vi) Total apportioned deduction for research and

experimentation:............................................ $100,000

(vii) Amount apportioned to the residual grouping

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

(viii) Amount apportioned to the statutory grouping of

sources within countries Y and Z:........................... $11,039

(2) Tentative Apportionment on Gross Income Basis

(i) Exclusive apportionment of research and experimental

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

25 percent):................................................ $25,000

(ii) Apportionment of research and experimental expense to

the residual grouping of gross income ($75,000 x $479,000/

$500,000):.................................................. $71,850

(iii) Apportionment of research and experimental expense to

the statutory grouping of gross income ($75,000 x

$9,000+$12,000/$500,000):................................... $3,150

(iv) Amount apportioned to the residual grouping:............ $96,850

(v) Amount apportioned to the statutory grouping of general

limitation income from sources without the United States:... $3,150

(B) Since X has elected to use the optional gross income methods

of apportionment and its apportionment on the basis of gross income

to the statutory grouping, $3,150, is less than 50 percent of its

apportionment on the basis of sales to the statutory grouping,

$11,039, it must use Option two of paragraph (d)(3) of this section

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

grouping.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: December 13, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-30901 Filed 12-21-95; 8:45 am]

BILLING CODE 4830-01-U