. THE TAX TREATMENT OF 
 RESEARCH AND DEVELOPMENT (R&D) EXPENDITURES 
 

BY MULTINATIONAL CORPORATIONS: 
 THE IMPACT OF REGULATIONS 1.861-8 
 

Anita M. Benvignati
 

U.S. Treasury Department 
 

OTA Paper 43 December 1980 

OTA papers are circulated so that the preliminary findings

of tax research conducted by Staff members and others associated-with the .Office of Tax Analysis may reach a wider 

audience. The views expressed are those of the author and 

do not reflect Treasury policy. Comments are invited, but 

OTA papers should not be quoted without permission from the 
 author. 
 

Off ice of Tax Analysis

U.S. Treasury Department

Washington, D.C. 20220 

Issued: December 1980 
 
TABLE OF CONTENTS 
 

I. Introduction 
 

11. Regulations Section 1.861-8 and R&D Expenses 
 

111. What Does the Economic Literature Tell Us? 
 

IV. Some Alternatives 
 

V. Conclusion 
 

Paqe 
 

1 
 

2 

4 

8 

12 
 
THE TAX TREATMENT OF RESEARCH AND DEVELOPMENT (R&D)
 EXPENDITURES BY MULTINATIONAL CORPORATIONS: 
 THE IMPACT OF REGULATIONS 1.861-8 
 

Anita M. Benvignati* 
 U.S. Treasury Department 
 

I. INTRODUCTION 
 

Sections 861 and 862 of the Internal Revenue Code 
 require corporations to allocate or apportion expenses,
 losses, and other deductions between domestic and foreign 
 source income. Where deductions, such as R&D expenses,
 interest expenses, and stewardship expenses, cannot be 
 definitely allocated to either source, an appropriate
 portion must be apportioned to each source of income. This 
 apportionment of expenses can substantially reduce a U.S. 
 corporation's foreign tax credit limitation, the amount of 
 income attributable to its DISC, or otherwise result in a 
 higher U.S. tax liability. 
 

Early in 1977, Regulations section 1.861-8 was issued 
 after considerable controversy and debate. The regulations
 detail methods to be used in assigning "not definitely
 allocable" expenses to foreign source income. The most 
 controversial part of the regulations has been that dealing
 with R&D expenses. By denying U.S. corporations a full 
 deduction for domestic R&D expenses against domestic income 
 and by assigning some portion to foreign source income,
 where it often is not allowed as a deduction by foreign tax 
 authorities, the apportionment can effectively deny any tax 
 deduction for a part of R&D expenses. Corporations engaging
 extensively in international business or in the production
 of technology-intensive products may, in some cases, be 
 subject to a significantly higher over-all tax on their 
 worldwide income. For these reasons, large and expanding
 U.S.-based multinationals have opposed the new regulations. 
 

* 	 Brookings Economic Policy Fellow assigned to the Office 

of Tax Analysis. The author wishes to thank Thomas Horst 

and Emil Sunley for their many valuable suggestions.

Views and opinions expressed herein should not be construed as the official position of the U.S. Department of 

the Treasury. 
-2-

Two specific issues have arisen in connection with the 
 apportionment of R&D expenses under Regulations section 
 1.861-8. First, from the point of view of sound economic 

policy, the question has been raised as to whether, despite.

potential foreign benefits derived from such expenditures, 

any allo6ation of R&D expenses should be made to foreign 

source income. And secondly, if such apportionments are to 
 be made, what is the proper way to match R&D expenses against
 income? While the former impinges on such important matters 
 

as domestic productivity and the international competitive­
 ness of U.S. corporations, it is the latter, more narrow 
 topic, we seek to discuss here. Do Treasury's 1977 regulations meet the statutory requirement of properly matching R&D 

expenses to sources of income? Or could they be improved 
 upon significantly? 
 

This paper begins by outlining the methods available to 

corporations under Regulations section 1.861-8 for apportioning R&D expenses between domestic and foreign source 

income. It then reviews the economic literature on the production and dissemination of technology for the light it 

sheds on the proper matching of R&D expenses to sources of 

income. This paper concludes by examining the implications

of the literature for ways in which the 1.861-8 rules could 

be restructured to achieve a more precise matching of 

expenses to income sources. 

11. REGULATIONS SECTION 1.861-8 AND R&D EXPENSES 

Under the existing regulations, corporations are per­
 mitted to allocate totally to their domestic income those R&D 
 expenses incurred either solely to meet U.S. government
 mandates (for example, to meet an OSHA or EPA regulation) or 
 those made jointly with a foreign entity where a bona fide 
 

cost-sharing agreement exists (which presumably already
 assigns R&D expenses to the domestic and foreign sources). 
 

Corporations may then select one of two methods for appor­
 tioning all remaining R&D expenses between domestic and 
 foreign source income--the Sales Method or the Gross-to-Gross 
 Method. 
 

Under the Sales Method, corporations first assign an 
 "exclusive apportionment" percentage of R&D expenses solely 
 to their domestic income. For taxable years beginning in 
 1975, 50 percent of R&D expenses can be allocated exclusively 

to domestic source income and the remainder apportioned

between domestic and foreign sources. The allowable percentage drops to 40 percent in 1978, and 30 percent for taxable 

years beginning in 1979 and thereafter. 1/ 
-3-
 

c 

How did the Treasury Department justify this special
 

allowance? Generally speaking, it reasoned that the rate of 
 return to domestically conducted R&D is considerably higher
 in the domestic market than in foreign markets. This sug­
 

gested that some kind of mechanism should be provided to 
 adjust for the difference. The two specific reasons offered' 
 in the regulations are that (1) categories of products mar­
 keted abroad are frequently narrower in breadth than those 
 marketed at home, so that domestic R&D typically has greater

applicability and hence returns in the domestic market than 

in foreign markets, and (2) new products and processes of 
 production are often introduced in foreign markets later than 
 in the domestic market, which reduces the discounted value of 
 

foreign returns relative to domestic returns even when 
 streams of additional income are otherwise identical in each 
 location. Recognizing that the fixed "exclusive apportion­
 ment" percentage provided in the regulations may not fully
 compensate certain firms having either unusually narrow 
 ranges of foreign product applications and/or unusually large
 foreign introduction lags, Treasury permits corporations to 
 apply to the Commissioner of the IRS for a higher exclusive 
 apportionment on the basis of "facts and circumstances" 
 relevant to these two specific criteria. 
 

After making an "exclusive apportionment" to domestic 
 

source income, a corporation must apportion its remaining R&D 
 expenses between domestic and foreign source income on the 
 basis of its domestic and foreign sales in 2-digit SIC pro-
 duct categories (or broader product groupings). Permitting
 the taxpayer to break R&D down into 2-digit SIC industries is 

an effort to fine-tune the regulations so that only closely

related sales enter the apportionment formula. Other rules 
 adopted for this same purpose are (1) the exclusion (i.e.,
 the netting out) of intracorporate transfers of inputs from 
 the parent operation to subsidiaries (or branches) for calcu­
 lating sales of those foreign affiliates, (2) the exclusion 
 of all sales of purely wholesale or'retail foreign affiliates 
 (since they fall into a different 2-digit SIC category from 
 the manufacturing activity which R&D activity typically
 supports), and (3) the restriction of sales to no specific
 

product grouping for apportioning basic research expenses, on 
 the assumption that such expenditures are not directly
 related to any specific products or process. 
 

As an alternative to the Sales Method, a corporation may 
 use the Gross-to-Gross Method. R&D expenses (other than 
 those allocated to domestic income as government-mandated or 
 cost-sharing research) are apportioned between domestic and 
 foreign income on the basis of gross income derived from each 
 source. No "exclusive apportionment" or product category 
 
-4-

breakdowns are permitted. 'IGross income" for this purpose
 includes gross profits from a trade or business (gross
 receipts or sales less cost of goods sold), dividends, rents, 
 royalties, and other income received. The amount apportioned 
 to foreign source income using the Gross-to-Gross Method may
 not fall below half of what would have been apportioned under 
 the Sales Method. Thus, the amount which would be appor­
 

tioned to domestic source income under the Sales Method 
 limits the amount which may be apportioned under the Gross-
 to-Gross Method. 
 

The Gross-to-Gross Method often results in a smaller 
 allocation of R&D expenses to foreign source income than the 
 Sales Method when foreign operations are conducted through a 
 foreign subsidiary rather than a branch. This result tends 
 to occur even when "net profits" per dollar of sales are 
 identical for the foreign subsidiary and its U.S. parent.
 Why? Gross income from a foreign subsidiary includes only

dividends distributed to the U.S. parent and not earnings retained for foreign reinvestment. Although such dividends are 
 "grossed-up" to include any income taxes "deemed paid" by the 
 parent, such income is net of the subsidiary's depreciation,
 

interest expenses, advertising costs, and other such deduc­
 tions. By contrast, the gross income of the U.S. parent in­
 cludes all profits, whether reinvested or not, and is gross
 of all expenses except the cost of goods sold. This 
 asymmetry in the way gross income is calculated may be 
 responsible for the Treasury Department's limiting the use of 
 the Gross-to-Gross rule to those instances where the foreign
 apportionment of R&D expenses is at least 50 percent of that 
 under the Sales.Method. 2/ 

111. WHAT DOES THE ECONOMIC LITERATURE TELL US? 

In general, the economic literature on the innovation 
 process examines the intent of a given R&D undertaking or 
 project, since this intention provides useful information 
 about its applicability in different markets. One appro,ach
 taken in the literature is to distinguish between basic 
 research projects and applied or development research pro­
 

jects. Basic research projects are related either to no 
 product group or only to a general group of products. For 
 example, projects may be expected to benefit the development

of chemical products or processes although specific chemical 

applications are not foreseen. By contrast, R&D projects

classified as applied or developmental usually seek to 

develop specific new (or improved) products or specific new 

(or improved) processes of production. 2/ 
-5-

The distinction between basic and applied research, while 
 drawn in the current regulations, is not handled as well as 

it might be. A more flexible treatment of basic research 

would seem appropriate since not all such projects are so 

general as to be related to all the corporation's endeavors. 

For example, a basic chemical research project is not likely 
 to help with its overseas hotel business. This principle
 should be reflected in the regulations. 
 

A second approach taken in the literature distinguishes

between development projects undertaken solely in response to 

needs or demands of a single geographical market and those 

undertaken with more general geographical applications in 

mind. Because development projects are often efforts to 

improve existing products or processes rather than to develop

kntirely -new ones (as in the case of applied research), they 
 are typically market-specific. Furthermore, within the cate­
 gory, there is re.ason to believe from previous studies [e.g.,
 Mansfield, 19711 that development projects seeking to make 
 relatively minor improvements are likely to be more locally
 oriented than other types of development projects. Short-
 term projects have tended to coincide with this distinction. 
 Where such short-term, market-specific development projects 
 can be isolated from other domestic R&D undertakings, they

could be exclusively assigned to U.S. (or, if appropriate,

foreign) income, and not lumped together with remaining

projects . 

A final distinction made in the literature is between 

product and process technology. Evidence tends to suggest

that domestically developed process technology earns significantly lower rates of return in foreign markets than in the 

domestic market. This is attributable to the greater difficulty which U.S. multinationals experience abroad in protecting process technology from imitation by competitors. 4/

This same discrepancy apparently does not exist for producf

technology, provided the technology is legally patented.

Imitators are more visibly exposed and thwarted when copying 

new products since they openly present them on the market. 

By contrast, when they copy a new method of production, the 

adoption of new equipment or methods takes place within the 

confines of their own factory facility. Mansfield, Romeo,

and Wagner [19791 discovered that for this reason corporations try to hold their process technology close to headquarters where proprietory secrets can be more effectively

protected. Hence, they tend to exploit these technologies in 

foreign markets by exporting domestically produced goods and 

avoiding foreign direct investment or foreign licensing.

Regulations effectively apportioning domestic R&D expenses on 

the basis of relative returns should reflect the difference 

between product and process R&D by apportioning less process

R&D to foreign source income. 
-6-

A distinction is also be made in the literature with 

regard to the type of corporation performing R&D. Firms 

whose international commercial activities are limited in 

-scope or duration earn on domestic R&D distinctly lower 

foreign returns per dollar of forei,gn sales than domestic 
 returns per dollar of domestic sales. Why? An answer is 
 given in the economic literature on multinational corporation
 (MNC's)--institutions whose structural and organizational
 features, particularly at maturity, help them to obtain 
 higher returns on domestic R&D in foreign markets. In its 
 textbook version, a "mature multinational," compared to other 
 firms, tends to (1) treat foreign markets as an integral part
 of its operations, (2) be more experienced in interpreting 

and understanding foreign needs, (3) be less hampered by

foreign market information imperfections, (4) have a better 

established reputation and presence in foreign markets, 

(5) have more experience in transferring technology to 

foreign recipients (who often are long-established subsidiaries), (6) utilize even the simpler marketing channels, such 

as exporting and foreign licensing, more effectively, and 

(7) wield qreater market power in foreign markets. As a 

result of these advantages, the mature multinational is able 
 to generate more foreign income from new technology than 
 other corporations participating in foreign markets. More 
 specific reasons for this contention bear enumerating. 
 

First, the experienced multinational can often introduce 
 its new technologies in foreign markets shortly after, if not 
 at the same time, as it introduces them domestically. This 
 reduces income losses due to time-lags in the receipt of what 
 otherwise would be identical.income streams. Early
 technology-based theories of trade and investment have argued
 that many obstacles stand in the way of introducing new pro-
 ducts and processes of production in foreign markets. These 
 obstacles include the need for headquarters to be close to 
 the market location for effective interpretation and speedy
 feedback of customer needs, the additional time involved to 
 adapt new technologies to suit foreign needs, the exporting
 delays that may occur due to trade barriers, the time delays
 in gathering information and making necessary contacts to 
 consummate a favorable foreign licensing contract, and the 
 reluctance to set-up overseas production because of extra 
 start-up costs often associated with such efforts or govern­
 ment restrictions sometimes imposed on incoming foreign
 direct investments. 
 

Evidence suggests that mature multinationals can overcome 

most, if not all, these obstacles. 5/ Their accumulated 

knowledge and experience in dealing-with different foreign

market needs tend to minimize any difficulties they may 
 
encounter in conducting the early stages of new commercial 
 undertakings at a "distance" from targeted markets. Suppor­
 tive overseas R&D units -- a not uncommon feature of such 

enterprises -- often further enhance the MNC's communications 

at that functional level, as well as increase the efficiency

with which they can adapt new products or processes to suit 

local market preferences. 6/ Their long-established, local 

production record means their reputation is probably well 

known to local customers. And their start-up costs associated with foreign production are lessened, if not eliminated, 
 by the existence of an on-going network of foreign subsidi­
 aries which already operate at least as efficiently as local 
 enterprises. Finally, where foreign governments restrict 
 ownership participation in direct investment, mature MNC's 

are in a better position to negotiate favorable contract 

alternatives. These may be in the traditional form of a 
 licensing agreement or joint-venture or in a more innovative 
 form, such as a co-production contract, turn-key plant, or 
 possibly even a compensatory trade agreement (as now explored
 with China). 
 

A second reason for higher income potentials for exper­
 ienced MNC's is that even after the first introduction of new 

technologies into foreign markets, these corporations are 

likely to face higher rates of customer acceptance of the new 

products or processes than the inexperienced firm. This 

would result in an overall higher quantity of output sold 
 over time. Because foreign needs can be taken into account 
 early in the R&D process, the output is likely to be more 
 appropriate to foreign use than that of inexperienced firms. 
 Also foreign customers will bear less risk by having direct 
 access to the original producer for early instructional 
 training, minor modifications needed to accommodate their own 
 specific operating conditions, and follow-up servicing and 
 parts. While foreign licensing may help alleviate some of 
 the problems encountered by inexperienced firms in making
 their R&D output suitable for foreign use, it clearly does 
 not serve as a perfect substitute for a local (foreign)
 affiliate. 
 

L 

A third reason for income advantages afforded mature 

MNC's is the lower costs associated with adapting domesticbased technologies to suit foreign needs and transfer these 

technologies to foreign markets. While the inexperienced
 firm may offset the lower level of foreign user acceptance by
 engaging in additional R&D to alter or modify domestic tech­
 nology to accommodate foreign market conditions, it is likely

to find it more expensive to do so than the mature MNC. This 

is so for two reasons: initial domestic configurations of 

technology probably deviate from the appropriate foreign con-
 figuration by a greater degree; and the firms have less 
 
-8-

perfect information about foreign markets, which results in 

more trial and error in the adaptation process. In addition,

inexperienced firms are likely to bear other "disembodied" 7 /

technology transfer costs which the mature multinational cafi 
 minimize. These include the cost of exchange and clarifica­
 tion of engineering and other technical information, special 
 

training of personnel to ensure effective use of the tech­
 

nology, and start-up testing and debugging of production. A 

study by David Teece [19771 indicates that such costs (which

also include adaptation costs) tend to be higher, the less 
 experienced the firm is in transferring technology, all other 
 things equal. g/ 

Finally, mature MNC's tend to face less competition in 

foreign markets than inexperienced firms and so have higher

unit prices or "monopoly rents." In a static framework, the 
 

inexperienced firm, by virtue of the less appropriate tech­
 nology it tends to offer in foreign markets, is presumed to 
 face a greater number and/or clober substitutes for its out-
 put than at home. This decreases the firm's elasticity of 
 demand and potential monopoly rents. In a dynamic framework, 
 product-cycle theories of international trade and investment 
 

based on a presumption of sizable foreign introduction-lags
 for new technology suggest that by the time a firm makes its 
 big push into foreign markets, a certain degree of technical 
 

standardization and knowledge dissemination has already taken 
 place outside the firm. The original monopoly rents extrac­
 ted for proprietary knowledge have dissipated with the entry
 

by imitators and the more competitive pricing of output.
 Indeed, part of the incentive to explore foreign markets is 
 presumed to be the search for cheaper locations of production 
 

in response to new competition. Since we have established 
 that it is principally inexperienced firms that respond with 
 the most notable time-lags, they then would be more likely to 
 be exposed to this erosion of monopoly advantage than mature 
 multinationals. 
 

IV. SOME ALTERNATIVES 
 

Since domestic R&D expenses are often not directly and 
 

unambiguously related to particular sources of income, any
 method of apportionment between domestic and foreign source 
 income is bound to involve compromises. A review of the 

economic literature suggests there are ways in which the current regulations may be improved. The suggested revisions, 
 described below, would result in a more precise matching of 
 income with expenses, and at the same time a more workable 
 and practical format for taxpayers to comply with the 
 statutory intent. 
 
-9-
 

"Net" Sales Method as an Only Option. The first suggestion
 is to use strictly a ''net" sales basis for apportionment.
 Sales provide a reasonably reliable measure of long-run
 profikability since typically they are not volatile on a 
 year-to-year basis. From a practical standpoint, sales 
 figures are generally easy for firms to compile. Eliminating
 the Gross-to-Gross option avoids the asymmetrical problem in 
 defining gross income discussed earlier. 
 

"Netting-out" intracorporate transfers from total sales 
 in a particular geographical location continues to seem 
 reasonable since it enables a better geographical placement
 of real manufacturing activities, eliminates double-counting,
 and provides a better breakdown of the different types of 
 foreign source income (export, subsidiary, etc.). However,
 ''net" sales of foreign affiliates strictly engaged in wholesale or retail activities should be included as part of related product category sales since R&D which develops better 

products and/or cheaper methods of production presumably also 
 benefits the marketing function of a firm. 
 

It is possible, however, that firms should be given the 
 

option of applying a "net" sales method at a simple aggregate
 level or at a more complex disaggregated level (shortly to be 
 specified). Corporations with minimal R&D or in no immediate 

danger of paying foreign taxes in excess of the allowed U.S. 

credit, for instance, may decide that the additional cost of 
 applying a more precise method is not warranted. 
 

Project Basis Allocation. Students of industrial R&D have 

long recognized that formal industrial R&D programs of private enterprise are typically organized along lines of 
 individual projects, which management (and presumably, audi­
 tors) can easily identify and categorize by type, status of 

completion, and budget allocation. Apportioning R&D expenses

between domestic and foreign source income on a project-byproject basis would complement existing methods of corporate
 accounting and hence ease the process of compliance. More 
 importantly, it would permit a distinction to be made between 
 the various types of research. For example, since not all 
 basic research is targeted at the overall product level,
 those projects that are not may be distinguished and treated 
 ' 	 separately. Where short-term development projects exist and 

are expected to give rise only to domestic source income,

those projects can likewise be separated. Finally, deter-
 mining what research is designed principally to develop new 
 

roducts versus new rocesses so they may be treated differ­ ET-;- ent y would again be+ est evaluated at the individual

project level. 
10-
 

Product Category Flexibility. Restricting corporations to 
 

R&D breakdowns associated with no finer than 2-digit SIC 
 product categories probably results in a far too inflexible 
 method if the goal is to achieve the "best" matching of 
 income to expenses. Many corporations are likely to find thei 
 restriction unnatural for their particular operation and 
 method of accounting. Moreover, making strict use of 2-digit
 SIC categories would contradict much of the intent and bene­
 fit of allocating expenses on a project-by-project basis. A 
 method enabling use of the most "appropriate" product cate­
 gories for the corporation in question is needed. At the 
 same time, the decision should not be a completely free-
 floating one for the firm, leaving IRS little or no control 
 

over the monitoring process. Perhaps corporations should be 
 required to submit with their tax return the major and minor 
 product categories used for the purpose of section 1.861-8 
 R&D apportionments--categories to be consistently applied
 from.year to year so that some stsndard can then be afforded 

IRS while at the same time realistic product categories made 

available to corporations. 
 

A New Exclusive Apportionment. Under the current regulations, the fixed "exclusive apportionment" percentage pro­ vides a mechanism to adjust for the assumed lower rate of 

return to domestic R&D earned in foreign markets arising
 from the later introduction and narrower application of new 
 technology in those markets. If product categories used in 
 apportionment were made more flexible, the problem associ­
 ated with category discrepancies would be readily accommo­
 dated. The remaining rationale for a fixed "exclusive 
 apportionment" appears somewhat too simplistic. Foreign
 introduction-lags are only a partial explanation for why a 
 particular firm and/or research project is likely to earn 
 lower foreign rates of return. From the literature we 
 identified two specific circumstances justifying an assumed 
 lower foreign rate--where the intended output of a research 
 project is a new process (rather than new product), and 
 where the corporation involved is internationally inexpe­
 rienced. Large foreign introduction-lags are just one 
 characteristic of inexperienced firms and should probably 
 

not be a decisive criterion for assigning an exclusive 
 apportionment. 
 

For process technology and inexperienced firms, then, 
 some kind of exclusive apportionment to domestic income 
 would be appropriate to compensate for substantially lower 
 foreign returns expected. For experienced firms, however,
 only process technology should be subject to an exclusive 
 apportionment. Operationally, new processes are probably
 easily identified and confirmed on a project-by-project 
 
-11-
 

basis. On the other hand, a workable definition of an inex­
 perienced firm may be more difficult to develop. As one 

suggestion, it might prove acceptable to define "inexperienced firms" as those with less than 20 percent of sales 

from foreign sources or those with R&D expenditures totaling

less than 2 percent of worldwide sales. c 

9/ 
 

What form should the new exclusive apportionment take? 

It is hard to say. One simple solution would be to make an 

exclusive apportionment to domestic source income of 50 percent of the process and product R&D of inexperienced firms,

and 50 percent of the process R&D of experienced firms. 

Basic research and, in the case of experienced firms, product R&D, would not be subject to exclusive apportionment

but would instead be allocated between domestic and foreign 

source income solely on the basis of net sales. 10/ This 
 allocation rule turns out to be equivalent to anassumption
 that, in the case of all process R&D and the product R&D ,of

inexperienced firms, the return per unit of sales is twice 

as high in the domestic market as in the foreign market. 11/

In the case of the product R&D of experienced firms and an 

basic research, the return per unit of sales is the same at 
 

home and abroad. Of course, while these assumptions provide 
 a reasonable standard, others might prove equally
 serviceable. 
 

Treatment of Overseas R&D. A fairer treatment of R&D 

expenses might provide some allocation of foreign R&D 

expenses incurred by U.S. corporations to their domestic 

income. It could be argued that the apportionment of R&D 

expenses would be effectively handled by apportioning all 

Expenses of short-term domestic development projects to 

home" income. Since managers typically claim that the 

principal reason for establishing overseas R&D is "to 

respond to special design needs of the overseas market" 

[Mansfield, et. al. , 19791, all such undertakings might

easily qualify as short-term development projects whose 

expenses should be allocated exclusively to foreign income. 
 

As an alternative (particularly if identifying local 

market-oriented development projects is a difficult matter),

the Sales Method might simply be applied to a corporation's

consolidated R&D. This approach, however, requires accumulating (and IRS monitoring) of detailed information on 

foreign R&D projects as well as domestic projects, which may

lead to its own set of enforcement problems. 
-12-
 

v. CONCLUSION 

This paper has shown that distinctions made in the 

economic literature on R&D may suggest better ways of 

matching RCD expenses and income. While it cannot be said 

that all U.S. multinationals would stand to benefit from the 

implementation of the alternatives described above, many

companies would find that these alternatives would permit

them to allocate less R&D expenses to foreign source income 

and thereby achieve a higher foreign tax credit limitation. 
-13-
 

Technical Appendix 
 

Under the assumption that domestic and foreign returns 
 

to domestic R&D (Rd and Rf, respectively) are each linearly
 proportional to their respective Ifnet" sales (Sa and Sf),
 then we can state, 
 

and Rf = af Sf 
 

where a and af represent domestic and foreign rates of 

return Po domestic R&D from each location. The share of 

total returns to domestic R&D represented by the foreign

contribution is then, 
 

af sf) 
 

Letting total sales, i.e., Sd + Sfl be equal to St, 
 multiplying by St/St, and rearranging terms, the above 
 expression may be written , 
 

= ((af St)/(ad sd + af Sf)) (sf/St) 
 

Where ad = af (i.e., returns to domestic R&D from each 
 

dollar of domestic and foreign sales are equal), the frac­
 tion of R&D returns derived from foreign sales is exactly
 the proportion of total sales represented by foreign sales, 
 i.e., (Sf/St). If the argument is made that under certain 
 circumstances the domestic rate of return is significantly 
 greater than the foreign rate of return, i.e., ad > af' then 
 only some fraction of the foreign sales ratio represents the 
 foreign contribution. By assuming a one-half allocation for 
 process technology and for inexperienced firms, we in effect 
 assume , 
 

At the limit where Sf = 0, this expression reduces to: 
 

indicating the domestic return is at least twice that of the 
 

foreign return, since St = S and since this equation repre­
 sents the limit at S = 0. farger values of Sf need to be 
 accompanied by somewiat larger discrepancies between ad and 
 

af 
 
-14-

Notes 

-1/ The Treasury did not explain why the exclusive apportionment percentage should decline, but presumably the 

purpose was to soften the initial impact of the 

regulations. 

-2/ To illustrate the Gross-to-Gross Method, suppose a I1.S. 

chemical corporation in 1979 has domestic sales of 

chemicals of $loom and foreign sales of $50m. If its 

domestic gross income is $70m and foreign grossed-up

dividends are $lorn, then its $lorn of R&D expenditures 

will be apportioned in the following manner (assuming no 

government-mandated or cost-sharing research): 

Sales Method: 

Exclusive Apportionment to Domestic Source Income 

30 percent of $10m = $3m 

Remainder ($7m in R&D)

To Domestic Source Income 

To Foreign Source Income 

(100/150) x $7117 = $4.7m 

( 50/150) x $7m = S2.3m 

Total apportionment to Domestic Source'Income: 

S3m f S4.7m = S7..7m 

Total apportionment to Foreign Source Income: = $2.3m 

Gross-to-Gross Method: 

Total Apportioned to Domestic Source Income: 

(70/80) x $10m = $8.75111 

Total Apportioned to Foreign Source Income: 

(10/80) x $10m = $1.25m 

Sales Method Limitation on Gross-to-Gross: 

1/2 ($2.3m) = $1.15m 

Since the minimum requirement is met under the Gross-toGross Method, the corporation may elect to allocate 

$1.25111of R&D expenses to foreign source income. Had it 

not been met, a minimum of $1.15m would have to be 

allocated to foreign source income using that method. 

c3/ More formal definitions are provided by the U.S. 

National Science Foundation [19651. 
-15-

-4/ See Mansfield, Romeo, and Wagner [1979]. 

-5/ A corporate study by Vernon and Davidson [1979] documents that multinationals have increased the speed of 

foreign introduction dramatically, particular over time 

(implying achievement of some level of maturity).

Industry studies also tend to confirm the role of multinationals in speeding up the flow of international technology transfers. In industries such as semiconductors,

where multinationals are very active, imitation-lags for 

new innovations have tended to be much shorter than 

those industries, such as textile machinery, where 

multinationals have been far less dominant (compare

studies by Tilton [1971] and Benvignati [1978]). 

-6/ Several studies [Mansfield et.al., 1979; Ronstadt, 1978; 

Conference Board, 29761 approximate that overseas R&D 
 expenditures for larger U.S.-based companies are about 
 10 percent of their domestic R&D expenditures. In particular, the Conference Board discovered that overseas 

R&D primarily occurs when MNC's operate in science-based 

industries (i.e., technology intensive) and more so 

among the larger MNC's (implying a certain level of 

maturity). Furthermore, in a study of 14 U.S. multinationals, Jeannet and Liander [19781 concluded that the 

more mature the MNC's (as measured by the number of 

years passed since the establishment of their first 

manufacturing facility overseas), the more likely they 

were to have developed "competency centers" abroad to 

support the transfer of technology from the Parent 

company. 

-7/ "Embodied" costs would include those devoted to transfer 

of blueprints and other hardware needed, such as 

machinery and special construction materials. 

-8/ Other factors leading to increased costs were found to 

be: the less widespread the usage of the technology 
 among the firms in the industry; and the more manufac­
 turing experience the recipients had. Baranson [19701,

in an earlier piece, hypothesized similar influences 

affecting the transfer process. 

-9/ R&D intensity has been shown to be strongly related with 

a firm's success in penetrating foreign markets via 
 foreign direct investment. 
 
-16-

__. 10/ Arguments presented in Justification of an exclusive 

apportionment for inexperienced firms do not apply very

well to basic research projects, where the outcome is 

not associated with any particular commercial application. Since nothing in the literature suggests inexperienced firms earn distinctively lower foreign returns 

relative to domestic returns from output of basic 

research, it would seem appropriate to give no exclusive 

apportionment in the case of basic research. 

I11/ See Technical Appendix for explanation. 
-17-

References 

Baranson, Jack. "Technology Transfer Through the 

International Firm". 60 American Economic Review (May, 

1980), 435-453. 

Benvignati, Anita. International Technology Lags: The Case 

of Textile Machinery, Unpublished doctoral dissertation,

University of Pennsylvania, 1978. 

Creamer, Daniel. Overseas Research and Development by

United States Multinationals, 1966-1975: Estimates of 

Expenditures and a Statistical Profile (New York: The 

Conference Board, 1976). 

Jeannet, J-P. and Liander, B. "Patterns in Technoloav 

Transfer Within MNC's". Journal of Internationai 

Business Studies, 9 (Winter 197 8)r 108-118. 

Mansfield, E.; Rapoport, J.; Schnee, J.; Wagner, S.; and 

Hamburger, M. Research and Innovation in the Modern -Corporation (N.Y.: W. W. Norton & Co., 197.1). 

Mansfield, Edwin, and Romeo, Anthony. "Technology Transfer 

to Overseas Subsidiaries by U.S.-Based Firms" 

(forthcoming). 

Mansfield, Edwin; Romeo, Anthony: and Wagner, Samuel. 

"Foreign Trade and U.S. Research and Development," The 

Review of Economics and Statistics, bXI (February, 

1979), 49-57. 

Ronstadt, Robert C. "International R&D: The Establishment 

and Evolution of Research and Development Abroad By

Seven U.S. Multinationals". Journal of International 

Business Studies, 9 (Spring/Summer 1978), 7-24. 

Teece, David. "Technology Transfer by Multinational Firms: 

The Resource boss of Transferring Technological KnowHow". 87 The Economic Journal (June, 1977), 242-261. 

Tilton, John. International Diffusion of Technology: The 

Case of Semiconductors (Washington, D.C.: The Brookings

Institution, 1971). 
-18.-

U.S. National Science Foundation. Basic Research, Applied 

Research, and Development in Industry, 1962. (National 

Science Foundation, 1965). 

Vernon, Raymond, and Davidson, W. H. Foreiqn Production Of 

Technoloqy - Intensive Products By U.S.-Based 

Multinational Enterprises. Unpublished manuscript.

Study funded by the National Science Foundation 

(January, 3979).