Proposed Section 861 regulations.

• Position: Allocation and apportionment of research and experimental expenses in determining taxable income

On October 19, 1995, Tax Executives Institute filed the following comments with the Internal Revenue Service on proposed regulations under section 861 of the Internal Revenue Code, relating to the allocation and apportionment of research and experimentation expenses for purposes of determining taxable income from U.S. and foreign sources. TEI's comments were prepared under the aegis of its International Tax Committee, whose chair is Philip J Bergquist of Apple Computer, Inc. Materially contributing to the preparation of these comments were Lester D. Ezrati of Hewlett-Packard Co., David D. Gillman of Medtronic, Inc., Raymond G. Rossi of Intel Corp., and Richard L. Sartor of the Boeing Company.

On May 19, 1995, the Internal Revenue Service issued proposed regulations under section 861 of the Internal Revenue Code, relating to the allocation and apportionment of research and experimental expenses for purposes of determining taxable income from U.S. and foreign sources. The proposed regulations would amend regulations issued in 1977 and were published in the May 24, 1995, issue of the Federal Register (60 F.R. 27453) and the June 12, 1995, issue of the Internal Revenue Bulletin (1995-24 I.R.B. 6).(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the Internal Revenue Code relating to the operation of multinational business enterprises, including those in incurring significant research and experimental expenses. We believe that the diversity and professional training of our members enable us to bring an

important, balanced, and practical perspective to the issues relating to Prop. Reg. [sections] 1.861-8.

Introduction

In 1977, the Treasury Department issued regulations under section 861 relating to the allocation and apportionment of U.S. research and experimental (R&E) expenses against foreign income. The 1977 regulations provided two allocation and apportionment methods for research expenses -- the sales method and the optional gross income method. Under the sales method, a 30-percent exclusive apportionment, or "set aside," was accorded to the place of performance of the R&D activities.(2)

The issuance of the 1977 regulations produced a firestorm of protest since they effectively increased the allocation of expenses to foreign-source income and thereby limited the foreign tax credits available to a multinational corporation to offset its U.S. income tax. The controversy prompted Congress in 1981 to enact a temporary moratorium on the application of the Treasury regulations. Since that time, the moratorium has been extended and modified nine times by legislative and administrative actions.(3) The most recent legislation (enacted as part of the Omnibus Budget Reconciliation Act of 1993) allocated 50 percent of foreign-incurred R&E expenses to foreign-source income and 50 percent of U.S.-incurred R&E expenses to domestic-source income; the extension, however, expired for calendar-year taxpayers on December 31, 1994.(4)

The 1977 regulations, which have been in force for fewer than 5 of the 18 years since their promulgation, adversely affected the competitiveness of U.S. multinationals and actually encouraged the offshore migration of R&D activities. The IRS and Treasury have now issued proposed regulations that would bring some...