[Federal Register Volume 60, Number 100 (Wednesday, May 24, 1995)]
[Proposed Rules]
[Pages 27453-27460]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-12621]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0023-95]
RIN 1545-AT49


Allocation and Apportionment of Research and Experimental 
Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document provides guidance concerning the allocation and 
apportionment of research and experimental expenditures for purposes of 
determining taxable income from sources within and without the United 
States. This document affects taxpayers that have income from United 
States and foreign sources and that have made expenditures for research 
and experimentation that the taxpayer deducts under section 174 of the 
Internal Revenue Code of 1986. This document also provides notice of a 
public hearing on these proposed regulations.

DATES: Written comments must be received by August 22, 1995. Outlines 
of topics to be discussed at the public hearing scheduled for September 
8, 1995, at 10 a.m. must be received by August 18, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0023-95), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. In the alternative, submissions may be hand 
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R 
(INTL-0023-95), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue, NW, Washington, DC 20224. The public hearing will 
be held in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Carl 
Cooper [[Page 27454]] at (202) 622-3840; concerning submissions, 
Michael Slaughter, (202) 622-8543 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    This notice of proposed rulemaking does not contain collections of 
information and, therefore, it has not been submitted to the Office of 
Management and Budget for review under the Paperwork Reduction Act (44 
U.S.C. 3504(h)).

Background and Explanation of Provisions

    Section 1.861-8(e)(3) of the Income Tax Regulations provides rules 
regarding the allocation and apportionment of research and experimental 
expenditures for purposes of determining taxable income from sources 
within and without the United States.
    This notice of proposed rulemaking proposes three changes to the 
existing regulations at Sec. 1.861-8(e)(3).
    First, allocation of research and experimental expenditures to 
three digit SIC code product categories of gross income would be 
permitted. Existing regulations require taxpayers to allocate research 
and experimental expenditures to two digit SIC code product categories. 
Use of three digit SIC code product categories would enable taxpayers 
to allocate research and experimental expenditures to narrower classes 
of gross income than the classes of gross income permitted by the 
existing regulations.
    Second, the percentage of research and experimental expenditures 
that may be exclusively apportioned to United States source income 
under the sales method of apportionment under Sec. 1.861-8(e)(3)(ii) 
would be increased from 30 percent to 50 percent. Thus, where an 
apportionment based upon geographic sources of income of a deduction 
for research and experimental expenses is necessary and the sales 
method of apportionment is elected, an amount equal to 50 percent of 
the deduction for research and experimental expenditures shall be 
apportioned exclusively to the statutory or residual grouping of gross 
income, as the case may be, arising from the geographic source where 
the research and experimental activities which account for more than 50 
percent of the amount of the deduction were performed.
    Third, use of the optional gross income methods of apportionment 
would constitute a binding election to use such methods in subsequent 
years. The election would not be revocable without the prior consent of 
the Commissioner.
    These changes would apply to taxable years beginning after December 
31, 1995. However, the taxpayer would have the option to apply the new 
rules, in their entirety, to taxable years beginning after December 31, 
1994.
    Examples (3) through (8) of Sec. 1.861-8(g) are conformed to these 
changes. Examples (9) through (16) and Example (23) are removed and 
reserved.
    The three changes are proposed in part on the basis of an economic 
study performed by the Treasury Department pursuant to Rev. Proc. 92-
56, 1992-2 C.B. 409, which is being simultaneously published by 
Treasury. The Treasury study evaluates the factual relationships 
between taxpayer performed research and experimental expenses and 
income from foreign sources. The study reviewed evidence of foreign 
returns from research and experimental expenditures in the form of both 
royalties and the retained earnings and profits of controlled foreign 
corporations. Estimates of foreign returns attributable to research and 
experimental expenditures were translated into appropriate allocations 
and apportionments using two alternative methodologies. One methodology 
was based on estimated comparable domestic returns for research and 
experimental expenditures. The other methodology simulated the 
relationship expected between the current returns from research and 
experimental expenditures and the level of current research and 
experimental expenditures for taxpayers with ongoing research programs. 
The methodologies generated a range of allocations and apportionments 
to foreign income that were not inconsistent with the available 
evidence. The allocations and apportionments to foreign income which 
would result from adoption of these proposed regulations are within 
that range and are about 25 percent lower than the allocations and 
apportionments to foreign income which result under the current 
regulations.
    In addition, the proposed regulations provide explicit rules for 
allocating and apportioning research and experimental expenses incurred 
by a partnership and for computing a partner's sales for purposes of 
apportioning research and experimental expenses under the sales method.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and therefore, a Regulatory Flexibility 
Analysis is not required. Pursuant to section 7805(f) of the Internal 
Revenue Code, this notice of proposed rulemaking will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for September 8, 1995, at 10 
a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue NW, Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the building lobby more than 15 minutes 
before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by August 22, 1995 and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by August 18, 1995.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.
Drafting Information

    The principal author of these regulations is Carl Cooper, Office of 
the Associate Chief Counsel (International). However, other personnel 
from IRS and Treasury participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows: 
[[Page 27455]] 

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.861-8 is amended by:
    1. Revising paragraph (e)(3).
    2. Revising paragraph (g), Examples (3) through (8).
    3. Removing and reserving paragraph (g), Examples (9) through (16) 
and (23).
    The revisions read as follows:


Sec. 1.861-8  Computation of taxable income from sources within the 
United States and from other sources and activities.

* * * * *
    (e) * * *
* * * * *
    (3) Research and experimental expenditures--(i) Allocation--(A) In 
general. The methods of allocation and apportionment of research and 
experimental expenditures set forth in this paragraph (e)(3) recognize 
that research and experimentation is an inherently speculative 
activity, that findings may contribute unexpected benefits, and that 
the gross income derived from successful research and experimentation 
must bear the cost of unsuccessful research and experimentation. 
Expenditures for research and experimentation which a taxpayer deducts 
under section 174 ordinarily shall be considered deductions which are 
definitely related to all income reasonably connected with the relevant 
broad product category (or categories) of the taxpayer and therefore 
allocable to all items of gross income as a class (including income 
from sales, royalties, and dividends) related to such product category 
(or categories). For purposes of this allocation, the product category 
(or categories) which a taxpayer may be considered to have shall be 
determined in accordance with the provisions of paragraph (e)(3)(i)(B) 
of this section.
    (B) Determination of product categories. Ordinarily, a taxpayer's 
research and experimental expenditures may be divided between the 
relevant product categories. Where research and experimentation is 
conducted with respect to more than one product category, the taxpayer 
may aggregate the categories for purposes of allocation and 
apportionment; however, the taxpayer may not subdivide the categories. 
Where research and experimentation is not clearly identified with any 
product category (or categories), it will be considered conducted with 
respect to all the taxpayer's product categories. A taxpayer shall 
determine the relevant product categories by reference to the three 
digit classification of the Standard Industrial Classification Manual 
(SIC code). A copy may be purchased from the Superintendent of 
Documents, United States Government Printing Office, Washington, DC 
20402. The individual products included within each category are 
enumerated in Executive Office of the President, Office of Management 
and Budget, Standard Industrial Classification Manual, 1987 (or later 
edition, as available). Once a taxpayer selects a product category for 
the first taxable year for which this paragraph (e)(3) is effective 
with respect to the taxpayer, it must continue to use that product 
category in following years, unless the taxpayer establishes to the 
satisfaction of the Commissioner that, due to changes in the relevant 
facts, a change in the product category is appropriate. For this 
purpose, a change in the taxpayer's selection of a product category 
shall include a change from a three digit SIC code category to a two 
digit SIC code category, a change from a two digit SIC code category to 
a three digit SIC code category, or any other aggregation, 
disaggregation or change of a previously selected SIC code category. 
The two digit SIC code category ``Wholesale trade'' is not applicable 
with respect to sales by the taxpayer of goods and services from any 
other of the taxpayer's product categories and is not applicable with 
respect to a domestic international sales corporation (DISC) or foreign 
sales corporation (FSC) for which the taxpayer is a related supplier of 
goods and services from any of the taxpayer's product categories. The 
two digit SIC code category ``Retail trade'' is not applicable with 
respect to sales by the taxpayer of goods and services from any other 
of the taxpayer's product categories, except Wholesale trade, and is 
not applicable with respect to a DISC or FSC for which the taxpayer is 
a related supplier of goods and services from any other of the 
taxpayer's product categories, except Wholesale trade.
    (C) Affiliated Group. (1) Except as provided in paragraph 
(e)(3)(i)(C)(2) of this section, the allocation and apportionment 
required by this paragraph (e)(3) shall be determined as if all members 
of the affiliated group (as defined in Sec. 1.861-14T(d)) were a single 
corporation. See Sec. 1.861-14T.
    (2) For purposes of the allocation and apportionment required by 
this paragraph (e)(3), sales and gross income from products produced in 
whole or in part in a possession by an electing corporation (within the 
meaning of section 936(h)(5)(E)), and dividends from an electing 
corporation, shall not be taken into account, except that this 
paragraph (e)(3)(i)(C)(2) shall not apply to sales of (and gross income 
and dividends attributable to sales of) products with respect to which 
an election under section 936(h)(5)(F) is not in effect.
    (3) The research and experimental expenditures taken into account 
for purposes of this paragraph (e)(3) shall be reduced by the amount of 
such expenditures included in computing the cost-sharing amount 
(determined under section 936(h)(5)(C)(i)(I)).
    (D) Exception. Where research and experimentation is undertaken 
solely to meet legal requirements imposed by a political entity with 
respect to improvement or marketing of specific products or processes, 
and the results cannot reasonably be expected to generate amounts of 
gross income (beyond de minimis amounts) outside a single geographic 
source, the deduction for such research and experimentation shall be 
considered definitely related and therefore allocable only to the 
grouping (or groupings) of gross income within that geographic source 
as a class (and apportioned, if necessary, between such groupings as 
set forth in paragraphs (e)(3)(ii)(B) and (iii) of this section). For 
example, where a taxpayer performs tests on a product in response to a 
requirement imposed by the U.S. Food and Drug Administration, and the 
test results cannot reasonably be expected to generate amounts of gross 
income (beyond de minimis amounts) outside the United States, the costs 
of testing shall be allocated solely to gross income from sources 
within the United States.
    (ii) Apportionment of research and experimentation--sales method--
(A) Exclusive apportionment. Where an apportionment based upon 
geographic sources of income of a deduction for research and 
experimentation is necessary (after applying the exception in paragraph 
(e)(3)(i)(D) of this section), an amount equal to fifty percent (50%) 
of such deduction for research and experimentation shall be apportioned 
exclusively to the statutory grouping of gross income or the residual 
grouping of gross income, as the case may be, arising from the 
geographic source where the research and experimental activities which 
account for more than fifty percent (50%) of the amount of such 
deduction were performed. If the fifty percent test of the preceding 
sentence is not met, then no part of the deduction shall be apportioned 
under this paragraph (e)(3)(ii)(A). This exclusive apportionment 
reflects the view that research and experimentation is often most 
valuable in the country where it is performed, for two reasons. First, 
[[Page 27456]] research and experimentation often benefits a broad 
product category, consisting of many individual products, all of which 
may be sold in the nearest market but only some of which may be sold in 
foreign markets. Second, research and experimentation often is utilized 
in the nearest market before it is used in other markets, and in such 
cases, has a lower value per unit of sales when used in foreign 
markets. The taxpayer may establish to the satisfaction of the 
Commissioner that, in its case, one or both of the conditions mentioned 
in the preceding sentences warrant a significantly greater percent than 
50 percent (50%) because the research and experimentation is reasonably 
expected to have very limited or long delayed application outside the 
geographic source where it was performed. For purposes of establishing 
that only some products within the product category (or categories) are 
sold in foreign markets, the taxpayer shall compare the commercial 
production of individual products in domestic and foreign markets made 
by itself, by uncontrolled parties (as defined under paragraph 
(e)(3)(ii)(C) of this section) of products involving intangible 
property which was licensed or sold by the taxpayer, and by those 
controlled corporations (as defined under paragraph (e)(3)(ii)(D) of 
this section) which can reasonably be expected to benefit directly or 
indirectly from any of the taxpayer's research expense connected with 
the product category (or categories). The individual products compared 
for this purpose shall be limited, for nonmanufactured categories, 
solely to those enumerated in Executive Office of the President, Office 
of Management and Budget Standard Industrial Classification Manual, 
1987 (or later edition, as available), and, for manufactured 
categories, solely to those enumerated at a 7-digit level in the U.S. 
Bureau of the Census, Census of Manufacturers: 1992, Numerical List of 
Manufactured Products, 1993 (or later edition, as available). Copies of 
both of these documents may be purchased from the Superintendent of 
Documents, United States Government Printing Office, Washington, DC 
20402. For purposes of establishing the delayed application of research 
findings abroad, the taxpayer shall compare the commercial introduction 
of its own particular products and processes (not limited by those 
listed in the Standard Industrial Classification Manual or the 
Numerical List of Manufactured Products) in the United States and 
foreign markets, made by itself, by uncontrolled parties (as defined 
under paragraph (e)(3)(ii)(C) of this section) of products involving 
intangible property which was licensed or sold by the taxpayer, and by 
those controlled corporations (as defined under paragraph (e)(3)(ii)(D) 
of this section) which can reasonably be expected to benefit, directly 
or indirectly, from the taxpayer's research expense. For purposes of 
evaluating the delay in the application of research findings in foreign 
markets, the taxpayer shall use a safe haven discount rate of 10 
percent per year of delay unless he is able to establish to the 
satisfaction of the Commissioner, by reference to the cost of money and 
the number of years during which economic benefit can be directly 
attributable to the results of the taxpayer's research, that another 
discount rate is more appropriate.
    (B) Remaining apportionment. The amount equal to the remaining 
portion of such deduction for research and experimentation, not 
apportioned under paragraph (e)(3)(ii)(A) of this section, shall be 
apportioned between the statutory grouping (or among the statutory 
groupings) within the class of gross income and the residual grouping 
within such class in the same proportions that the amount of sales from 
the product category (or categories) which resulted in such gross 
income within the statutory grouping (or statutory groupings) and in 
the residual grouping bear, respectively, to the total amount of sales 
from the product category (or categories). For purposes of this 
paragraph (e)(3), amounts received from the lease of equipment during a 
taxable year shall be regarded as sales receipts for such taxable year. 
Amounts apportioned under this paragraph (e)(3) may exceed the amount 
of gross income related to the product category within the statutory 
grouping. In such case, the excess shall be applied against other gross 
income within the statutory grouping. See paragraph (d)(1) of this 
section for instances where the apportionment leads to an excess of 
deductions over gross income within the statutory grouping.
    (C) Sales of uncontrolled parties. For purposes of the 
apportionment under paragraph (e)(3)(ii)(B) of this section, the sales 
from the product category (or categories) by each party uncontrolled by 
the taxpayer, of particular products involving intangible property 
which was licensed or sold by the taxpayer to such uncontrolled party 
shall be taken fully into account both for determining the taxpayer's 
apportionment and for determining the apportionment of any other member 
of a controlled group of corporations to which the taxpayer belongs if 
the uncontrolled party can reasonably be expected to benefit directly 
or indirectly (through any member of the controlled group of 
corporations to which the taxpayer belongs) from the research expense 
connected with the product category (or categories) of such other 
member. In the case of licensed products, if the amount of sales of 
such products is unknown (for example, where the licensed product is a 
component of a large machine), a reasonable estimate should be made. In 
the case of sales of intangible property, and in cases where a 
reasonable estimate of sales of licensed products cannot be made, the 
sales taken into account shall be an amount which is ten times the 
amount received or accrued for the intangible during the taxpayer's 
taxable year. For purposes of this paragraph (e)(3)(ii)(C), the term 
uncontrolled party means a party which is not a person with a 
relationship to the taxpayer (specified in section 267(b)), or is not a 
member of a controlled group of corporations to which the taxpayer 
belongs (within the meaning of section 993(a)(3) or section 927(d)(4)). 
An uncontrolled party can reasonably be expected to benefit from the 
research expense of a member of a controlled group of corporations to 
which the taxpayer belongs if such member can reasonably be expected to 
license, sell, or transfer intangible property to that uncontrolled 
party or transfer secret processes to that uncontrolled party, directly 
or indirectly, through a member of the controlled group of corporations 
to which the taxpayer belongs.
    (D) Sales of controlled parties. For purposes of the apportionment 
under paragraph (e)(3)(ii)(B) of this section, the sales from the 
product category (or categories) of the taxpayer shall be taken fully 
into account and the sales from the product category (or categories) of 
a corporation controlled by the taxpayer shall be taken into account to 
the extent provided in this paragraph (e)(3)(ii)(D) for determining the 
taxpayer's apportionment, if such corporation can reasonably be 
expected to benefit directly or indirectly (through another member of 
the controlled group of corporations to which the taxpayer belongs) 
from the taxpayer's research expense connected with the product 
category (or categories). However, sales from the product category (or 
categories) between or among such controlled corporations or the 
taxpayer shall not be taken into account more than once; in such a 
situation, the amount sold by the selling corporation to the buying 
corporation shall be subtracted from the sales of the buying 
corporation. For [[Page 27457]] purposes of this paragraph 
(e)(3)(ii)(D), the term a corporation controlled by the taxpayer means 
any corporation other than an uncontrolled party as defined in 
paragraph (e)(3)(ii)(C) of this section. A corporation controlled by 
the taxpayer can reasonably be expected to benefit from the taxpayer's 
research expense if the taxpayer can be expected to license, sell, or 
transfer intangible property to that corporation or transfer secret 
processes to that corporation, either directly or indirectly through a 
member of the controlled group of corporations to which the taxpayer 
belongs. Past experience with research and experimentation shall be 
considered in determining reasonable expectations. However, if the 
corporation controlled by the taxpayer has entered into a bona fide 
cost-sharing arrangement, in accordance with the provisions of 
Sec. 1.482-7, with the taxpayer for the purpose of developing 
intangible property, then that corporation shall not reasonably be 
expected to benefit from the taxpayer's share of the research expense. 
The sales from the product category (or categories) of a corporation 
controlled by the taxpayer taken into account shall be equal to the 
amount of sales that bear the same proportion to total sales of the 
controlled corporation as the taxpayer's direct or indirect ownership, 
as defined in section 1563, of the total combined voting power of all 
classes of stock entitled to vote of such corporation bears to the 
total outstanding combined voting power of all such classes of stock of 
such corporation.
    (iii) Apportionment of research and experimentation--gross income 
methods. In lieu of apportioning the deduction for research and 
experimental expense under paragraph (e)(3)(ii) of this section, a 
taxpayer may make a binding election pursuant to paragraph 
(e)(3)(iii)(C) of this section to apportion such deduction, as 
prescribed in paragraph (e)(3)(iii)(A) or (B) of this section, between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping of gross income. These optional 
methods must be applied to the taxpayer's entire deduction for research 
and experimental expense remaining after applying the exception in 
paragraph (e)(3)(i)(D) of this section, and may not be applied on a 
product category basis. Thus, after the allocation of the taxpayer's 
entire deduction for research and experimental expense under paragraph 
(e)(3)(i) of this section (by attribution to SIC code categories), the 
taxpayer must then apportion as necessary the entire deduction as 
allocated by separate amounts to various product categories, using only 
the sales method under paragraph (e)(3)(ii) of this section or only the 
optional gross income methods under this paragraph (e)(3)(iii). The 
taxpayer may not use the sales method for a portion of the deduction 
and optional gross income methods for the remainder of the deduction 
separately allocated.
    (A) Option one. The taxpayer may apportion its research and 
experimental expenditures ratably on the basis of gross income between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping of gross income in the same 
proportions that the amount of gross income in the statutory grouping 
(or groupings) and the amount of gross income in the residual grouping 
bear, respectively, to the total amount of gross income, if both of the 
following two conditions are met.
    (1) The amount of research and experimental expense ratably 
apportioned to the statutory grouping (or groupings in the aggregate) 
is not less than fifty percent (50%) of the amount which would have 
been so apportioned if the taxpayer had used the method described in 
paragraph (e)(3)(ii) of this section; and
    (2) The amount of research and experimental expense ratably 
apportioned to the residual grouping is not less than fifty percent 
(50%) of the amount which would have been so apportioned if the 
taxpayer had used the method described in paragraph (e)(3)(ii) of this 
section.
    (B) Option two. If, when the amount of research and experimental 
expense is apportioned ratably on the basis of gross income, either of 
the conditions described in paragraph (e)(3)(iii)(A) (1) or (2) of this 
section is not met, the taxpayer may either--
    (1) Where the condition of paragraph (e)(3)(iii)(A)(1) of this 
section is not met, apportion fifty percent (50%) of the amount of 
research and experimental expense which would have been apportioned to 
the statutory grouping (or groupings in the aggregate) under paragraph 
(e)(3)(ii) of this section to such statutory grouping (or to such 
statutory groupings in the aggregate and then among such groupings on 
the basis of gross income within each grouping), and apportion the 
balance of the amount of research and experimental expenses to the 
residual grouping; or
    (2) Where the condition of paragraph (e)(3)(iii)(A)(2) of this 
section is not met, apportion fifty percent (50%) of the amount of 
research and experimental expense which would have been apportioned to 
the residual grouping under paragraph (e)(3)(ii) of this section to 
such residual grouping, and apportion the balance of the amount of 
research and experimental expenses to the statutory grouping (or to the 
statutory groupings in the aggregate and then among such groupings 
ratably on the basis of gross income within each grouping).
    (C) Binding election to use optional gross income methods. A 
taxpayer may use either the sales method under paragraph (e)(3)(ii) of 
this section or the optional gross income methods under this paragraph 
(e)(3)(iii) for its return filed for its first taxable year to which 
this paragraph (e)(3) applies. The taxpayer's use of the optional gross 
income methods for its return filed for its first taxable year to which 
this paragraph (e)(3) applies or for any subsequent taxable year shall 
constitute a binding election to use the optional gross income methods 
for all taxable years thereafter. The taxpayer's election to use the 
optional gross income methods may not be revoked without the prior 
consent of the Commissioner.
    (iv) Special rules for partnerships. For purposes of applying this 
paragraph (e)(3), if research and experimental expenditures are 
incurred by a partnership in which the taxpayer is a partner, the 
taxpayer's research and experimental expenditures shall include the 
taxpayer's distributive share of the partnership's research and 
experimental expenditures. In applying the exception for expenditures 
undertaken to meet legal requirements under paragraph (e)(3)(i)(D) of 
this section and the exclusive apportionment for the sales method under 
paragraph (e)(3)(ii)(A) of this section, a partner's distributive share 
of research and experimental expenditures incurred by a partnership 
shall be treated as incurred by the partner for the same purpose and in 
the same location as incurred by the partnership. In applying the 
remaining apportionment for the sales method under paragraph 
(e)(3)(ii)(B) of this section, a taxpayer's sales from a product 
category shall include the taxpayer's share of any sales from the 
product category of any partnership in which the taxpayer is a partner. 
For purposes of the preceding sentence, a taxpayer's share of sales 
shall be proportionate to the taxpayer's distributive share of the 
partnership's gross income in the product category, but the sales of 
the partnership taken into account by the taxpayer shall in no event be 
less than ten times the amount received or accrued for any intangible 
from the partnership during the taxpayer's taxable year.

[[Page 27458]]

    (v) Examples. Examples (3) through (8) of paragraph (g) of this 
section illustrate the allocation and apportionment of research and 
experimental deductions.
    (vi) Effective date. This paragraph (e)(3) applies to taxable years 
beginning after December 31, 1995. However, the taxpayer may at its 
option, apply this paragraph (e)(3) in its entirety to taxable years 
beginning after December 31, 1994.
* * * * *
    (g) * * *
* * * * *
    Example 3--Research and Experimentation--(i) Facts. X, a 
domestic corporation, is a manufacturer and distributor of small 
gasoline engines for lawn mowers. Gasoline engines are a product 
within the category, Engines and Turbines (SIC Industry Group 351). 
Y, a wholly owned foreign subsidiary of X, also manufactures and 
sells these engines abroad. During 1996, X incurred expenditures of 
$60,000 on research and experimentation, which it deducts as a 
current expense, to invent and patent a new and improved gasoline 
engine. All of the research and experimentation was performed in the 
United States. In 1996, the domestic sales by X of the new engine 
total $500,000 and foreign sales by Y total $300,000. X provides 
technology for the manufacture of engines to Y via a license that 
requires the payment of an arm's length royalty. In 1996, X's income 
is $150,000, of which $140,000 is from domestic sales and $10,000 is 
royalties from Y.
    (ii) Allocation. The research and experimental expenditures were 
incurred in connection with small gasoline engines and they are 
definitely related to the items of gross income to which the 
research gives rise, namely gross income from the sale of small 
gasoline engines in the United States and royalties received from 
subsidiary Y, a foreign manufacturer of gasoline engines. 
Accordingly, the expenses are allocable to this class of gross 
income.
    (iii) Apportionment. (A) For purposes of applying the foreign 
tax credit limitation, the statutory grouping is general limitation 
gross income from sources without the United States and the residual 
grouping is general limitation gross income from sources within the 
United States. Since the related class of gross income derived from 
the use of engine technology consists of both gross income from 
sources without the United States (royalties from Y) and gross 
income from sources within the United States (gross income from 
engine sales), X's deduction of $60,000 for its research and 
experimental expenditure must be apportioned between the statutory 
and residual grouping before the foreign tax credit limitation may 
be determined. Because more than 50 percent of X's research and 
experimental activity was performed in the United States, 50 percent 
of that deduction can be apportioned exclusively to the residual 
grouping of gross income, gross income from sources within the 
United States. The remaining 50 percent of the deduction can then be 
apportioned between the residual and statutory groupings on the 
basis of sales by X and Y. Alternatively, X's deduction for research 
and experimentation can be apportioned under the optional gross 
income method. The apportionment for 1996 is as follows:
    (1) Tentative Apportionment on the Basis of Sales.
    (i) Research and experimental expense to be apportioned between 
residual and statutory groupings of gross income: $60,000.
    (ii) Less: Exclusive apportionment of research and experimental 
expense to the residual grouping of gross income ($60,000 x 50 
percent): $30,000.
    (iii) Research and experimental expense to be apportioned 
between residual and statutory groupings of gross income on the 
basis of sales: $30,000.
    (iv) Apportionment of research and experimental expense to the 
residual grouping of gross income ($30,000 x $500,000/
($500,000+$300,000)): $18,750.
    (v) Apportionment of research and experimental expense to the 
statutory grouping of gross income ($30,000 x $300,000/
($500,000+$300,000)): $11,250.
    (vi) Total apportioned deduction for research and 
experimentation: $60,000.
    (vii) Amount apportioned to the residual grouping 
($30,000+$18,750): $48,750.
    (viii) Amount apportioned to the statutory grouping: $11,250.
    (2) Tentative Apportionment on the Basis of Gross Income.
    (i) Research and experimental expense apportioned to sources 
within the United States (residual grouping) ($60,000 x $140,000/
($140,000+$10,000)): $56,000.
    (ii) Research and experimental expense apportioned to sources 
within country Y (statutory grouping) ($60,000 x $10,000/
($140,000+$10,000)): $4,000.
    (iii) Amount apportioned to the residual grouping: $56,000.
    (iv) Amount apportioned to the statutory grouping: $4,000.
    (B) The total research and experimental expense apportioned to 
the statutory grouping ($4,000) under the gross income method is 
approximately 36 percent of the amount apportioned to the statutory 
grouping under the sales method. Thus, X may use option two of the 
gross income method (paragraph (e)(3)(iii)(B) of this section) and 
apportion to the statutory grouping fifty percent (50%) of the 
$11,250 apportioned to that grouping under the sales method. Thus, X 
apportions $5,625 of research and experimental expense to the 
statutory grouping. X's use of the optional gross income method will 
constitute a binding election to use the optional gross income 
method for all taxable years thereafter.
    Example 4--Research and Experimentation--(i) Facts. Assume the 
same facts as in Example 3 except that X also spends $30,000 in 1996 
for research on steam turbines, all of which is performed in the 
United States, and X has steam turbine sales in the United States of 
$400,000. X's foreign subsidiary Y neither manufactures nor sells 
steam turbines. The steam turbine research is in addition to the 
$60,000 in research which X does on gasoline engines for lawnmowers. 
X thus has a deduction of $90,000 for its research activity. X's 
gross income is $200,000, of which $140,000 is from sales of 
gasoline engines, $50,000 is from sales of steam turbines, and 
$10,000 is royalties from Y.
    (ii) Allocation. X's research expenses generate income from 
sales of small gasoline engines and steam turbines. Both of these 
products are in the same three digit SIC code category, Engines and 
Turbines (SIC Industry Group 351). Therefore, the deduction is 
definitely related to this product category and allocable to all 
items of income attributable to it. These items of X's income are 
gross income from the sale of small gasoline engines and steam 
turbines in the United States and royalties from foreign subsidiary 
Y, a foreign manufacturer and seller of small gasoline engines.
    (iii) Apportionment. (A) For purposes of applying the foreign 
tax credit limitation, the statutory grouping is general limitation 
gross income from sources outside the United States and the residual 
grouping is general limitation gross income from sources within the 
United States. X's deduction of $90,000 must be apportioned between 
the statutory and residual groupings. Because more than 50 percent 
of X's research and experimental activity was performed in the 
United States, 50 percent of that deduction can be apportioned 
exclusively to the residual grouping, general limitation gross 
income from sources within the United States. The remaining 50 
percent of the deduction can then be apportioned between the 
residual and statutory groupings on the basis of total sales by X 
and Y. Alternatively, X's deduction for research and experimentation 
can be apportioned under the optional gross income methods. The 
apportionment for 1996 is as follows:
    (1) Tentative Apportionment on the Basis of Sales.
    (i) Research and experimental expense to be apportioned between 
residual and statutory groupings of gross income: $90,000.
    (ii) Less: Exclusive apportionment of the research and 
experimental expense to the residual grouping of gross income 
($90,000 x 50 percent): $45,000.
    (iv) Research and experimental expense to be apportioned between 
the residual and statutory groupings of gross income on the basis of 
sales: $45,000.
    (iv) Apportionment of research and experimental expense to the 
residual grouping of gross income ($45,000 x ($500,000+400,000)/
($500,000+$400,000+$300,000)): $33,750.
    (v) Apportionment of research and experimental expense to the 
statutory grouping of gross income ($45,000 x $300,000/
($500,000+$400,000+$300,000)): $11,250.
    (vi) Total apportioned deduction for research and 
experimentation: $90,000.
    (vii) Amount apportioned to the residual grouping 
($45,000+$33,750): $78,750.
    (viii) Amount apportioned to the statutory grouping: $11,250.
    (2) Tentative Apportionment on the Basis of Gross Income.
    (i) Research and experimental expense apportioned to sources 
within the United States (residual grouping) 
[[Page 27459]] ($90,000 x $190,000/($140,000+$50,000+10,000)): 
$85,500.
    (ii) Research and experimental expense apportioned to sources 
within country Y (statutory grouping) ($90,000 x $10,000/
($140,000+$50,000+$10,000)): $4,500.
    (iii) Amount apportioned to the residual grouping: $85,500.
    (iv) Amount apportioned to the statutory grouping: $4,500.
    (B) The total research and experimental expense apportioned to 
the statutory grouping ($4,500) under the gross income method is 40 
percent of the amount apportioned to the statutory grouping under 
the sales method. Thus, X, may use option two of the gross income 
method (paragraph (e)(3)(iii)(B) of this section) and apportion to 
the statutory grouping fifty percent (50%) of the $11,250 
apportioned to that grouping under the sales method. Thus, X 
apportions $5,625 of research and experimental expense to the 
statutory grouping. X's use of the optional gross income method will 
constitute a binding election to use the optional gross income 
method for all taxable years thereafter.
    Example 5--Research and Experimentation--(i) Facts. Assume the 
same facts as in Example 3 except that in 1997 X continues its sales 
of the new engines, with sales of $600,000 in the United States and 
$400,000 by subsidiary Y. X also acquires a 60 percent ownership 
interest in foreign corporation Z and a 100 percent ownership 
interest in foreign corporation C. X transfers its engine technology 
to Z for a royalty equal to 5 percent of sales, and X enters into an 
arm's length cost-sharing arrangement with C to share the funding of 
all of X's research activity. In 1997, corporation Z has sales in 
country Z equal to $1,000,000. X incurs expense of $80,000 on 
research and experimentation in 1997, and in addition, X performs 
$15,000 of research on gasoline engines which was funded by the 
cost-sharing arrangement with C. All of Z's sales are from the 
product category, Engines and Turbines (SIC Industry Group 351). X 
performs all of its research in the United States and $20,000 of its 
expenditure of $80,000 is made solely to meet pollution standards 
mandated by law. X establishes, to the satisfaction of the 
Commissioner, that the expenditure in response to pollution 
standards is not expected to generate gross income (beyond de 
minimis amounts) outside the United States.
    (ii) Allocation. The $20,000 of research expense which X 
incurred in connection with pollution standards is definitely 
related and thus allocable to the residual grouping, general 
limitation gross income from sources within the United States. The 
remaining $60,000 in research and experimental expenditure incurred 
by X is definitely related to all gasoline engines and is therefore 
allocable to the class of gross income to which the engines give 
rise, gross income from sales in the United States, royalties from 
country Y, and royalties from country Z. No part of the $60,000 
research expense is allocable to dividends from country C, because 
corporation C has already paid, through its cost-sharing 
arrangement, for research activity performed by X which may benefit 
C.
    (iii) Apportionment. For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general limitation 
gross income from sources without the United States, and the 
residual grouping is general limitation gross income from sources 
within the United States. X's deduction of $60,000 for its research 
and experimental expenditure must be apportioned between these 
groupings. Because more than 50 percent of the research and 
experimentation was performed in the United States, 50 percent of 
the $60,000 deduction can be apportioned exclusively to the residual 
grouping. The remaining 50 percent of the deduction can then be 
apportioned between the residual and the statutory grouping on the 
basis of sales by X, Y, and Z. (If X utilized the optional gross 
income methods in 1996, then its use of such methods constituted a 
binding election to use the optional gross income methods for all 
taxable years thereafter. The optional gross income methods are not 
illustrated in this Example 5 (see instead Examples 3 and 4).) Since 
X has only a 60 percent ownership interest in corporation Z, only 60 
percent of Z's sales (60% of $1,000,000, or $600,000) are included 
for purposes of apportionment. The allocation and apportionment for 
1997 is as follows:
    (A) X's total research expense: $80,000.
    (B) Less: Legally mandated research directly allocated to the 
residual grouping of gross income: $20,000.
    (C) Tentative apportionment on the basis of sales.
    (1) Research and experimental expense to be apportioned between 
residual and statutory groupings of gross income: $60,000.
    (2) Less: Exclusive apportionment of research and experimental 
expense to the residual grouping of gross income ($60,000 x 50 
percent): $30,000.
    (3) Research and experimental expense to be apportioned between 
the residual and the statutory grouping on the basis of sales: 
$30,000.
    (4) Apportionment of research and experimental expense to 
general limitation gross income from sources within the United 
States (residual grouping) ($30,000 x $600,000/
($600,000+$400,000+$600,000)): $11,250.
    (5) Apportionment of research and experimental expense to 
general limitation gross income from countries Y and Z (statutory 
grouping) ($30,000 x $400,000+$600,000/
($600,000+$400,000+$600,000)): $18,750.
    (6) Total apportioned deduction for research and experimentation 
($30,000+$30,000): 60,000.
    (7) Amount apportioned to the residual grouping 
($30,000+$11,250): $41,250.
    (8) Amount apportioned to the statutory grouping of sources 
within countries Y and Z: $18,750.
    Example 6--Research and Experimentation--(i) Facts. X, a 
domestic corporation, manufacturers and sells forklift trucks and 
other types of materials handling equipment in the United States. 
The manufacture and sale of forklift trucks and other materials 
handling equipment belongs to the product category, Construction, 
Mining, and Materials Handling Machinery and Equipment (SIC Industry 
Group 353). X also sells its forklift trucks to a wholesaling 
subsidiary located in foreign country Y (but title passes in the 
United States), and X manufactures forklift trucks in foreign 
country Z. The wholesaling of forklift trucks to country Y also 
belongs to X's product category Transportation equipment and, 
therefore, may not belong to the product category, Wholesale trade 
(SIC Major Group 50 and 51). In 1997, X sold $7,000,000 of forklift 
trucks to purchasers in the United States, $3,000,000 of forklift 
trucks to the wholesaling subsidiary in Y, and transferred forklift 
truck components with an FOB export value of $2,000,000 to its 
branch in Z. The branch's sales of finished forklift trucks were 
$5,000,000. In response to legally mndated emission control 
requirements, X's United States research department has been engaged 
in a research project to improve the performance and quality of 
engine exhaust systems used on its products in the United States. It 
incurs expenses of $100,000 for this purpose in 1997. In the past, X 
has customarily adapted the product improvements developed 
originally for the domestic market to its forklift trucks 
manufactured abroad. During the taxable year 1997, development of an 
improved engine exhaust system is completed and X begins installing 
the new system during the latter part of the taxable year in 
products manufactured and sold in the United States. X continues to 
manufacture and sell forklift trucks in foreign countries without 
the improved engine exhaust systems.
    (ii) Allocation. X's deduction for its research expense is 
definitely related to the income to which it gives rise, namely 
income from the manufacture and sale of forklift trucks within the 
United States and in country Z. Although the research is undertaken 
in response to a legal mandate, it can reasonably be expected to 
generate gross income from the manufacture and sale of trucks by the 
branch in Z. Therefore, the deduction is not allocable solely to 
income from X's domestic sales of forklift trucks. It is allocable 
to income from such sales and income from the sales of X's branch in 
Z.
    (iii) Apportionment. For the method of apportionment on the 
basis of either sales or gross income, see example 3. However, in 
determining the amount of research apportioned to income from 
foreign and domestic sources, the net sales of the branch in Z are 
$3,000,000 ($5,000,000 less $2,000,000) and the sales within the 
United States are $12,000,000 ($7,000,000 plus $3,000,000 plus 
$2,000,000).
    Example 7--Research and Experimentation--(i) Facts. X, a 
domestic corporation, is a drug company which manufactures a wide 
variety of pharmaceutical products for sale in the United States. 
Pharmaceutical products belong to the product category, Drugs (SIC 
Industry Group 283). X exports its pharmaceutical products through a 
foreign sales corporation (FSC). X's wholly owned foreign subsidiary 
Y also manufactures pharmaceutical products. In 1997, X has domestic 
sales of $10,000,000, the FSC has sales of $3,000,000, and Y has 
sales of $5,000,000. In that same year, 1997, X incurs 
[[Page 27460]] expense of $200,000 on research to test a product in 
response to requirements imposed by the United States Food and Drug 
Administration (FDA). X is able to show that, even though country Y 
imposes certain testing requirements on pharmaceutical products, the 
research performed in the United States is not accepted by country Y 
for purposes of its own licensing requirements, and the research has 
minimal use abroad. X is further able to show that its FSC sells 
goods to countries which do not accept or do not require research 
performed in the United States for purposes of their own licensing 
standards.
    (ii) Allocation. Since X's research expense of $200,000 is 
undertaken to meet the requirements of the United States Food and 
Drug Administration, and since it is reasonable to expect that the 
expenditure will not generate gross income (beyond de minimis 
amounts) outside the United States, the deduction is definitely 
related and thus allocable to the residual grouping.
    (iii) Apportionment. No apportionment is necessary since the 
entire expense is allocated to the residual grouping, general 
limitation gross income from sales within the United States.
    Example 8--Research and Experimentation--(i) Facts. X, a 
domestic corporation, is engaged in continuous research and 
experimentation to improve the quality of the products that it 
manufactures and sells, which are floodlights, flashlights, fuse 
boxes, and solderless connectors. X incurs and deducts $100,000 of 
expenditure for research and experimentation in 1997 which was 
performed exclusively in the United States. As a result of this 
research activity, X acquires patents which it uses in its own 
manufacturing activity. X licenses its floodlight patent to Y and Z, 
uncontrolled foreign corporations, for use in their own territories, 
countries Y and Z, respectively. Corporation Y pays X an arm's 
length royalty of $3,000 plus $0.20 for each floodlight sold. Sales 
of floodlights by Y for the taxable year are $135,000 (at $4.50 per 
unit) or 30,000 units, and the royalty is $9,000 
($3,000+$0.20 x 30,000). Y has sales of other products of $500,000. 
Z pays X an arm's length royalty of $3,000 plus $0.30 for each unit 
sold. Z manufactures 30,000 floodlights in the taxable year, and the 
royalty is $12,000 ($3,000+$0.30 x 30,000). The dollar value of Z's 
floodlight sales is not known and cannot be reasonably estimated 
because, in this case, the floodlights are not sold separately by Z 
but are instead used as a component in Z's manufacture of lighting 
equipment for theaters. The sales of all Z's products, including the 
lighting equipment for theaters, are $1,000,000. Y and Z each sell 
the floodlights exclusively within their respective countries. X's 
sales of floodlights for the taxable year are $500,000 and its sales 
of its other products, flashlights, fuse boxes, and solderless 
connectors, are $400,000. X has gross income of $500,000, consisting 
of gross income from domestic sources of $479,000, and royalty 
income of $9,000 and $12,000 from foreign corporations Y and Z 
respectively.
    (ii) Allocation. X's research and experimental expenses are 
definitely related to all of the products that it produces, which 
are floodlights, flashlights, fuse boxes, and solderless connectors. 
All of these products are in the same three digit SIC Code category, 
Electric Lighting and Wiring Equipment (SIC Industry Group 364). 
Thus, X's research and experimental expenses are allocable to all 
items of income attributable to this product category, domestic 
sales income and royalty income from the foreign countries in which 
corporations Y and Z operate.
    (iii) Apportionment. (A) The statutory grouping of gross income 
is general limitation income from sources without the United States. 
The residual grouping is general limitation gross income from 
sources within the United States. X's deduction of $100,000 for its 
research expenditures must be apportioned between the groupings. For 
apportionment on the basis of sales in accordance with paragraph 
(e)(3)(ii) of this section, X is entitled to an exclusive 
apportionment of 50 percent of its research and experimental expense 
to the residual grouping, general limitation gross income from 
sources within the United States, since more than 50 percent of the 
research activity was performed in the United States. The remaining 
50 percent of the deduction can then be apportioned between the 
residual and statutory groupings on the basis of sales. Since Y and 
Z are unrelated licensees of X, only their sales of the licensed 
product, floodlights, are included for purposes of apportionment. 
Floodlight sales of Z are unknown, but are estimated at ten times 
royalties from Z, or $120,000. All of X's sales from the entire 
product category are included for purposes of apportionment on the 
basis of sales. Alternatively, X may apportion its deduction on the 
basis of gross income, in accordance with paragraph (e)(3)(iii) of 
this section. The apportionment is as follows:
    (1) Tentative Apportionment on the basis of sales.
    (i) Research and experimental expense to be apportioned between 
statutory and residual groupings of gross income: $100,000.
    (ii) Less: Exclusive apportionment of research and experimental 
expense to the residual groupings of gross income ($100,000 x 50 
percent): $50,000.
    (iii) Research and experimental expense to be apportioned 
between the statutory and residual groupings of gross income on the 
basis of sales: $50,000.
    (iv) Apportionment of research and experimental expense to the 
residual groupings of gross income ($50,000 x $900,000/
($900,000+$135,000+$120,000)): $38,961.
    (v) Apportionment of research and experimental expense to the 
statutory grouping, royalty income from countries Y and Z 
($50,000 x $135,000+$120,000/($900,000+$135,000+$120,000)): $11,039.
    (vi) Total apportioned deduction for research and 
experimentation: $100,000.
    (vii) Amount apportioned to the residual grouping 
($50,000+$38,961): $88,961.
    (viii) Apportioned to the statutory grouping of sources within 
countries Y and Z: $11,039.
    (2) Tentative apportionment on gross income basis.
    (i) Apportionment of research and experimental expense to the 
residual grouping of gross income ($100,000 x $479,000/$500,000): 
$95,800.
    (ii) Apportionment of research and experimental expense to the 
statutory grouping of gross income ($100,000 x $9,000+$12,000/
$500,000): $4,200.
    (iii) Amount apportioned to the residual grouping: $95,800.
    (iv) Amount apportioned to the statutory grouping of general 
limitation income from sources without the United States: $4,200.
    (B) Since X's apportionment on the basis of gross income to the 
statutory grouping, $4,200, is less than 50 percent of its 
apportionment on the basis of sales to the statutory grouping, 
$11,039 it may use Option two of paragraph (e)(3)(iii)(B) of this 
section and apportion $5,520 (50 percent of $11,039) to the 
statutory grouping.
    Examples (9) through (16)--[Reserved]
* * * * *
    Example (23)--[Reserved]
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-12621 Filed 5-19-95; 9:25 am]
BILLING CODE 4830-01-U