IRS issues proposed regulations on allocation and apportionment of research and experimental expenditures.

• Author: Goodman, Mark E.

On Dec. 21, 1995, the Treasury Department issued new proposed regulations that provide further guidance on the correct method of allocating research and experimental expenses between U.S.-source and foreign-source income. The new proposed regulations make three changes to the previously issued 1977 regulations with regards to the allocation of these expenses. The new rules should be more favorable to taxpayers in an excess foreign tax credit (FTC) position.

The excess FTC limitation usually occurs because of a higher foreign tax rate compared to the US. tax rate. The allowable FTC is limited to the U.S. tax on the net foreign-source income. The most obvious tax strategy for clients in an excess FTC position is to either increase foreign-source income or allocate as little expense to the foreign-source income, as possible. If a taxpayer is successful in shifting as little expense as possible overseas, its net US. tax may decrease by increasing the allowable FTC.

Regs. Sec. 1.861-8 sets forth detailed rules for allocating and apportioning expenses, including research and development (R&D) expenses. Under the 1977 regulations, expenditures for R&D are related to all income reasonably connected with a taxpayers specific broad product categories. Taxpayers had to allocate income into specified product categories that are based on a two-digit Standard Industrial Classification System (SIC), and then match the related research expenses with that income. The product categories were found in Regs. Sec. 1.861-8(e)(3)(i)(A).

An exception to the aforementioned product category allocation rule under Regs. Sec. 1.861-8(e)(3)(i)(B) related to government-mandated R&D expenditures. Under this exception, any research expenses incurred because of government requirements would be allocated directly to gross income arising in that particular geographical area. Any research expenses remaining after the mandated allocation had to be apportioned between foreign and US. sources within the applicable product category. Two available methods were provided to achieve this goal: the sales method or die gross income method.

The sales method contained an exclusive apportionment rule, under which 30% of research costs were automatically allocated to the place where the research was undertaken (under the theory that the research activities are most beneficial to the geographical area in which they are performed). After allocating research expenses under the exclusive...