[Federal Register Volume 60, Number 246 (Friday, December 22, 1995)]
[Rules and Regulations]
[Pages 66502-66510]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30901]



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DEPARTMENT OF THE TREASURY
26 CFR Part 1

[TD 8646]
RIN 1545-AT49


Allocation and Apportionment of Research and Experimental 
Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

EFFECTIVE DATE: January 1, 1996.

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

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

    On May 24, 1995, the IRS published a notice of proposed rulemaking 
and notice of public hearing in the Federal Register (60 FR 27453) 
proposing amendments to the Income Tax Regulations (26 CFR part 1) 
under section 861 of the Internal Revenue Code of 1986. Section 1.861-
8(e)(3) of the Income Tax Regulations provides rules regarding the 
allocation and apportionment of research and experimental expenditures 
for purposes of determining taxable income from sources inside and 
outside the United States.
    The notice of proposed rulemaking proposed three principal changes 
to the existing regulations. First, allocation of research and 
experimental expenditures to three-digit SIC code product categories of 
gross income would be permitted. Second, the percentage of research and 
experimental expenditures that may be exclusively apportioned to United 
States source income under the sales method of apportionment under 
Sec. 1.861-8(e)(3)(ii) would be increased from 30 percent to 50 
percent. Third, use of the optional gross income methods of 
apportionment would constitute a binding election to use such methods 
in subsequent years. The election would not be revocable without the 
prior consent of the Commissioner. The three changes were proposed in 
part on the basis of an economic study performed by the Treasury 
Department pursuant to Rev. Proc. 92-56 (1992-2 C.B. 409), ``The 
Relationship Between U.S. Research and Development and Foreign 
Income,'' which was published by the Treasury Department simultaneously 
with the proposed regulations.
    Written comments responding to the notice were received, and a 
public hearing was held on September 8, 1995.
    Regarding the determination of product categories under Sec. 1.861-
8(e)(3)(i)(B) of the proposed regulations, commenters suggested that 
the rule requiring a taxpayer to determine relevant product categories 
by reference to the three-digit classification of the Standard 
Industrial Classification Manual should be modified to allow 
determinations by reference to the five-digit classifications of the 
Manual. This suggestion was not adopted, because such a rule would too 
narrowly restrict the necessarily broad scope of the deduction. The IRS 
continues to believe that research and experimentation is an inherently 
speculative activity, that findings may contribute unexpected benefits, 
and that gross income derived from successful research and 
experimentation must bear the cost of unsuccessful research and 
experimentation.
    Commenters suggested that the regulations permit taxpayers to 
determine product categories by reference to two- or three-digit 
categories at the annual election of the taxpayer. This suggestion was 
not adopted. The regulations provide that a taxpayer may determine 
product categories by reference to two- or three-digit categories. A 
taxpayer may aggregate, disaggregate or change a previously selected 
SIC code category if the taxpayer establishes to the satisfaction of 
the Commissioner that, due to changes in the relevant facts, a change 
in product category is appropriate. This rule provides a simple and 
workable format for balancing the need for consistency with the desire 
for flexibility.
    Referring to current Sec. 1.861-8(g) Example 6 (which has been 
redesignated Sec. 1.861-17(h) Example 4), commenters suggested that the 
regulations allow the use of the Wholesale Trade SIC code category with 
respect to sales from any other category. The current Sec. 1.861-8(g) 
Example 6 was not correct on this point and does not override the rule 
stated parenthetically in the list of two digit SIC code categories in 
present Sec. 1.861-8(e)(3)(i)(A) that wholesale trade may not be 
combined with other product categories. The final regulations include 
this rule along with Example 6 corrected to conform to the rule.
    Regarding the exclusive place of performance apportionment rule 
under Sec. 1.861-8(e)(3)(ii)(A) of the proposed regulations, commenters 
suggested adding a rule providing that if the ratio of foreign research 
and experimental expenditures in a three digit SIC code category of all 
foreign affiliates of a United States consolidated group over foreign 
affiliate sales in that SIC code category exceed fifty percent of the 
ratio of United States consolidated group research and experimental 
expenditures in that SIC code category over United States consolidated 
group sales in that SIC code category, then the United States 
consolidated group research and experimental expenditures should be 
exclusively apportioned to United States source gross income. This 
suggestion has not been adopted. Although a foreign affiliate may incur 
substantial research and experimental expenditures in a given product 
category, the foreign affiliate may still benefit from the research and 
experimental expenditures of the United States consolidated group. See 
Perkin-Elmer Corporation v. Commissioner, 103 T.C. 464 (1994).
    Regarding the optional gross income methods of apportionment under 
Sec. 1.861-8(e)(3)(iii) of the proposed regulations, commenters 
suggested that 

[[Page 66503]]
the final regulations include a fifty percent exclusive place of 
performance apportionment under the optional gross income methods to be 
parallel with Sec. 1.861-8(e)(3)(ii)(A). This suggestion has been 
adopted in part. Section (b)(1)(ii) of the final regulations includes a 
twenty-five percent exclusive place of performance apportionment under 
the optional gross income methods. This twenty-five percent exclusive 
apportionment ensures that taxpayers electing to use one of the 
optional gross income methods also obtain results comparable to those 
obtained by taxpayers electing to use the sales method, i.e., an 
overall allocation that is twenty-five percent lower on average than 
the allocation to foreign source income resulting from the current 
regulations. The Treasury Department study does not support a greater 
exclusive apportionment.
    Commenters suggested that the proposed regulations should be 
modified to reduce the floor on the amount of research and experimental 
expenditures that must be apportioned to foreign source income under 
the optional gross income methods from fifty percent to thirty percent 
of the amount that would have been apportioned under the sales method. 
This suggestion has not been adopted. The adoption of this suggested 
rule in addition to the twenty-five percent exclusive apportionment 
rule is not supported by the Treasury Department study.
    Commenters suggested the elimination of the binding election to use 
the optional gross income methods under Sec. 1.861-8(e)(3)(iii)(C) of 
the proposed regulations. Commenters also suggested that the binding 
election rule should be modified to provide for a change of method 
without the prior consent of the Commissioner after five years' use of 
one method. This suggestion, which recognizes the need for consistency 
while reducing the administrative burden on taxpayers, has been 
adopted.
    Commenters suggested that the effective date election under 
Sec. 1.861-8(e)(3)(vi) of the proposed regulations permit election by 
fiscal year taxpayers whose taxable years begin after August 1, 1994, 
but before January 1, 1995. This suggestion has been adopted.
    Finally, these provisions, which were previously published as 
Sec. 1.861-8(e)(3), have been renumbered and will now be published as 
Sec. 1.861-17. This change has been made solely for the purpose of 
achieving greater clarity in formatting and is not intended to result 
in any additional substantive changes.

Special Analyses

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

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.861-8 is amended by:
    1. Revising paragraph (e)(3) to read as set forth below.
    2. Removing and reserving paragraph (g), Examples 3 through 16 and 
23.


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

* * * * *
    (e) * * *
    (3) Research and experimental expenditures. For rules regarding the 
allocation and apportionment of research and experimental expenditures, 
see Sec. 1.861-17.
* * * * *
    Par. 3. Section 1.861-17 is added to read as follows:


Sec. 1.861-17  Allocation and apportionment of research and 
experimental expenditures.

    (a) Allocation--(1) In general. The methods of allocation and 
apportionment of research and experimental expenditures set forth in 
this section recognize that research and experimentation is an 
inherently speculative activity, that findings may contribute 
unexpected benefits, and that the gross income derived from successful 
research and experimentation must bear the cost of unsuccessful 
research and experimentation. Expenditures for research and 
experimentation that a taxpayer deducts under section 174 ordinarily 
shall be considered deductions that are definitely related to all 
income reasonably connected with the relevant broad product category 
(or categories) of the taxpayer and therefore allocable to all items of 
gross income as a class (including income from sales, royalties, and 
dividends) related to such product category (or categories). For 
purposes of this allocation, the product category (or categories) that 
a taxpayer may be considered to have shall be determined in accordance 
with the provisions of paragraph (a)(2) of this section.
    (2) Product categories--(i) Allocation based on product categories. 
Ordinarily, a taxpayer's research and experimental expenditures may be 
divided between the relevant product categories. Where research and 
experimentation is conducted with respect to more than one product 
category, the taxpayer may aggregate the categories for purposes of 
allocation and apportionment; however, the taxpayer may not subdivide 
the categories. Where research and experimentation is not clearly 
identified with any product category (or categories), it will be 
considered conducted with respect to all the taxpayer's product 
categories.
    (ii) Use of three digit standard industrial classification codes. A 
taxpayer shall determine the relevant product categories by reference 
to the three digit classification of the Standard Industrial 
Classification Manual (SIC code). A copy may be purchased from the 
Superintendent of Documents, United States Government Printing Office, 
Washington, DC 20402. The individual products included within each 
category are enumerated in Executive Office of the President, Office of 
Management and Budget, Standard Industrial Classification Manual, 1987 
(or later edition, as available).
    (iii) Consistency. Once a taxpayer selects a product category for 
the first taxable year for which this section is effective with respect 
to the taxpayer, it must continue to use that product category in 
following years, unless the taxpayer establishes to the satisfaction of 
the Commissioner that, due to changes in the relevant facts, a change 
in the product category is appropriate. For this purpose, a change in 
the 

[[Page 66504]]
taxpayer's selection of a product category shall include a change from 
a three digit SIC code category to a two digit SIC code category, a 
change from a two digit SIC code category to a three digit SIC code 
category, or any other aggregation, disaggregation or change of a 
previously selected SIC code category.
    (iv) Wholesale trade category. The two digit SIC code category 
``Wholesale trade'' is not applicable with respect to sales by the 
taxpayer of goods and services from any other of the taxpayer's product 
categories and is not applicable with respect to a domestic 
international sales corporation (DISC) or foreign sales corporation 
(FSC) for which the taxpayer is a related supplier of goods and 
services from any of the taxpayer's product categories.
    (v) Retail trade category. The two digit SIC code category ``Retail 
trade'' is not applicable with respect to sales by the taxpayer of 
goods and services from any other of the taxpayer's product categories, 
except wholesale trade, and is not applicable with respect to a DISC or 
FSC for which the taxpayer is a related supplier of goods and services 
from any other of the taxpayer's product categories, except wholesale 
trade.
    (3) Affiliated Groups--(i) In general. Except as provided in 
paragraph (a)(3)(ii) of this section, the allocation and apportionment 
required by this section shall be determined as if all members of the 
affiliated group (as defined in Sec. 1.861-14T(d)) were a single 
corporation. See Sec. 1.861-14T.
    (ii) Possessions corporations. (A) For purposes of the allocation 
and apportionment required by this section, sales and gross income from 
products produced in whole or in part in a possession by an electing 
corporation (within the meaning of section 936(h)(5)(E)), and dividends 
from an electing corporation, shall not be taken into account, except 
that this paragraph (a)(3)(ii) shall not apply to sales of (and gross 
income and dividends attributable to sales of) products with respect to 
which an election under section 936(h)(5)(F) is not in effect.
    (B) The research and experimental expenditures taken into account 
for purposes of this section shall be reduced by the amount of such 
expenditures included in computing the cost-sharing amount (determined 
under section 936(h)(5)(C)(i)).
    (4) Legally mandated research and experimentation. Where research 
and experimentation is undertaken solely to meet legal requirements 
imposed by a political entity with respect to improvement or marketing 
of specific products or processes, and the results cannot reasonably be 
expected to generate amounts of gross income (beyond de minimis 
amounts) outside a single geographic source, the deduction for such 
research and experimentation shall be considered definitely related and 
therefore allocable only to the grouping (or groupings) of gross income 
within that geographic source as a class (and apportioned, if 
necessary, between such groupings as set forth in paragraphs (c) and 
(d) of this section). For example, where a taxpayer performs tests on a 
product in response to a requirement imposed by the U.S. Food and Drug 
Administration, and the test results cannot reasonably be expected to 
generate amounts of gross income (beyond de minimis amounts) outside 
the United States, the costs of testing shall be allocated solely to 
gross income from sources within the United States.
    (b) Exclusive apportionment--(1) In general. An exclusive 
apportionment shall be made under this paragraph (b), where an 
apportionment based upon geographic sources of income of a deduction 
for research and experimentation is necessary (after applying the 
exception in paragraph (a)(4) of this section).
    (i) Exclusive apportionment under the sales method. If the taxpayer 
apportions on the sales method under paragraph (c) of this section, an 
amount equal to fifty percent of such deduction for research and 
experimentation shall be apportioned exclusively to the statutory 
grouping of gross income or the residual grouping of gross income, as 
the case may be, arising from the geographic source where the research 
and experimental activities which account for more than fifty percent 
of the amount of such deduction were performed.
    (ii) Exclusive apportionment under the optional gross income 
methods. If the taxpayer apportions on the optional gross income 
methods under paragraph (d) of this section, an amount equal to twenty-
five percent of such deduction for research and experimentation shall 
be apportioned exclusively to the statutory grouping or the residual 
grouping of gross income, as the case may be, arising from the 
geographic source where the research and experimental activities which 
account for more than fifty percent of the amount of such deduction 
were performed.
    (iii) Exception. If the applicable fifty percent geographic source 
test of the preceding paragraph (b)(1)(i) or (ii) is not met, then no 
part of the deduction shall be apportioned under this paragraph (b)(1).
    (2) Facts and circumstances supporting an increased exclusive 
apportionment--(i) In general. The exclusive apportionment provided for 
in paragraph (b)(1) of this section reflects the view that research and 
experimentation is often most valuable in the country where it is 
performed, for two reasons. First, research and experimentation often 
benefits a broad product category, consisting of many individual 
products, all of which may be sold in the nearest market but only some 
of which may be sold in foreign markets. Second, research and 
experimentation often is utilized in the nearest market before it is 
used in other markets, and in such cases, has a lower value per unit of 
sales when used in foreign markets. The taxpayer may establish to the 
satisfaction of the Commissioner that, in its case, one or both of the 
conditions mentioned in the preceding sentences warrant a significantly 
greater exclusive allocation percentage than allowed by paragraph 
(b)(1) of this section because the research and experimentation is 
reasonably expected to have very limited or long delayed application 
outside the geographic source where it was performed. Past experience 
with research and experimentation may be considered in determining 
reasonable expectations.
    (ii) Not all products sold in foreign markets. For purposes of 
establishing that only some products within the product category (or 
categories) are sold in foreign markets, the taxpayer shall compare the 
commercial production of individual products in domestic and foreign 
markets made by itself, by uncontrolled parties (as defined under 
paragraph (c)(2)(i) of this section) of products involving intangible 
property which was licensed or sold by the taxpayer, and by those 
controlled corporations (as defined under paragraph (c)(3)(ii) of this 
section) that can reasonably be expected to benefit directly or 
indirectly from any of the taxpayer's research expense connected with 
the product category (or categories). The individual products compared 
for this purpose shall be limited, for nonmanufactured categories, 
solely to those enumerated in Executive Office of the President, Office 
of Management and Budget Standard Industrial Classification Manual, 
1987 (or later edition, as available), and, for manufactured 
categories, solely to those enumerated at a 7-digit level in the U.S. 
Bureau of the Census, Census of Manufacturers: 1992, Numerical List of 
Manufactured Products, 1993, (or later edition, as available). Copies 
of both of these documents may be purchased from the Superintendent of 
Documents, 

[[Page 66505]]
United States Government Printing Office, Washington, DC 20402.
    (iii) Delayed application of research findings abroad. For purposes 
of establishing the delayed application of research findings abroad, 
the taxpayer shall compare the commercial introduction of its own 
particular products and processes (not limited by those listed in the 
Standard Industrial Classification Manual or the Numerical List of 
Manufactured Products) in the United States and foreign markets, made 
by itself, by uncontrolled parties (as defined under paragraph 
(c)(2)(i) of this section) of products involving intangible property 
that was licensed or sold by the taxpayer, and by those controlled 
corporations (as defined under paragraph (c)(3)(i) of this section) 
that can reasonably be expected to benefit, directly or indirectly, 
from the taxpayer's research expense. For purposes of evaluating the 
delay in the application of research findings in foreign markets, the 
taxpayer shall use a safe haven discount rate of 10 percent per year of 
delay unless he is able to establish to the satisfaction of the 
Commissioner, by reference to the cost of money and the number of years 
during which economic benefit can be directly attributable to the 
results of the taxpayer's research, that another discount rate is more 
appropriate.
    (c) Sales method--(1) In general. The amount equal to the remaining 
portion of such deduction for research and experimentation, not 
apportioned under paragraph (a)(4) or (b)(1)(i) of this section, shall 
be apportioned between the statutory grouping (or among the statutory 
groupings) within the class of gross income and the residual grouping 
within such class in the same proportions that the amount of sales from 
the product category (or categories) that resulted in such gross income 
within the statutory grouping (or statutory groupings) and in the 
residual grouping bear, respectively, to the total amount of sales from 
the product category (or categories).
    (i) Apportionment in excess of gross income. Amounts apportioned 
under this section may exceed the amount of gross income related to the 
product category within the statutory grouping. In such case, the 
excess shall be applied against other gross income within the statutory 
grouping. See Sec. 1.861-8(d)(1) for instances where the apportionment 
leads to an excess of deductions over gross income within the statutory 
grouping.
    (ii) Leased property. For purposes of this paragraph (c), amounts 
received from the lease of equipment during a taxable year shall be 
regarded as sales receipts for such taxable year.
    (2) Sales of uncontrolled parties. For purposes of the 
apportionment under paragraph (c)(1) of this section, the sales from 
the product category (or categories) by each party uncontrolled by the 
taxpayer, of particular products involving intangible property that was 
licensed or sold by the taxpayer to such uncontrolled party shall be 
taken fully into account both for determining the taxpayer's 
apportionment and for determining the apportionment of any other member 
of a controlled group of corporations to which the taxpayer belongs if 
the uncontrolled party can reasonably be expected to benefit directly 
or indirectly (through any member of the controlled group of 
corporations to which the taxpayer belongs) from the research expense 
connected with the product category (or categories) of such other 
member. An uncontrolled party can reasonably be expected to benefit 
from the research expense of a member of a controlled group of 
corporations to which the taxpayer belongs if such member can 
reasonably be expected to license, sell, or transfer intangible 
property to that uncontrolled party or transfer secret processes to 
that uncontrolled party, directly or indirectly through a member of the 
controlled group of corporations to which the taxpayer belongs. Past 
experience with research and experimentation shall be considered in 
determining reasonable expectations.
    (i) Definition of uncontrolled party. For purposes of this 
paragraph (c)(2) the term uncontrolled party means a party that is not 
a person with a relationship to the taxpayer specified in section 
267(b), or is not a member of a controlled group of corporations to 
which the taxpayer belongs (within the meaning of section 993(a)(3) or 
927(d)(4)).
    (ii) Licensed products. In the case of licensed products, if the 
amount of sales of such products is unknown (for example, where the 
licensed product is a component of a large machine), a reasonable 
estimate based on the principles of section 482 should be made.
    (iii) Sales of intangible property. In the case of sales of 
intangible property, regardless of whether the consideration received 
in exchange for the intangible is a fixed amount or is contingent on 
the productivity, use, or disposition of the intangible, if the amount 
of sales of products utilizing the intangible property is unknown, a 
reasonable estimate of sales shall be made annually. If necessary, 
appropriate economic analyses shall be used to estimate sales.
    (3) Sales of controlled parties. For purposes of the apportionment 
under paragraph (c)(1) of this section, the sales from the product 
category (or categories) of the taxpayer shall be taken fully into 
account and the sales from the product category (or categories) of a 
corporation controlled by the taxpayer shall be taken into account to 
the extent provided in this paragraph (c)(3) for determining the 
taxpayer's apportionment, if such corporation can reasonably be 
expected to benefit directly or indirectly (through another member of 
the controlled group of corporations to which the taxpayer belongs) 
from the taxpayer's research expense connected with the product 
category (or categories). A corporation controlled by the taxpayer can 
reasonably be expected to benefit from the taxpayer's research expense 
if the taxpayer can be expected to license, sell, or transfer 
intangible property to that corporation or transfer secret processes to 
that corporation, either directly or indirectly through a member of the 
controlled group of corporations to which the taxpayer belongs. Past 
experience with research and experimentation shall be considered in 
determining reasonable expectations.
    (i) Definition of a corporation controlled by the taxpayer. For 
purposes of this paragraph (c)(3), the term a corporation controlled by 
the taxpayer means any corporation that has a relationship to the 
taxpayer specified in section 267(b) or is a member of a controlled 
group of corporations to which the taxpayer belongs (within the meaning 
of section 993(a)(3) or 927(d)(4).
    (ii) Sales to be taken into account. The sales from the product 
category (or categories) of a corporation controlled by the taxpayer 
taken into account shall be equal to the amount of sales that bear the 
same proportion to the total sales of the controlled corporation as the 
total value of all classes of the stock of such corporation owned 
directly or indirectly by the taxpayer, within the meaning of section 
1563, bears to the total value of all classes of stock of such 
corporation.
    (iii) Sales not to be taken into account more than once. Sales from 
the product category (or categories) between or among such controlled 
corporations or the taxpayer shall not be taken into account more than 
once; in such a situation, the amount sold by the selling corporation 
to the buying corporation shall be subtracted from the sales of the 
buying corporation.
    (iv) Effect of cost-sharing arrangements. If the corporation 
controlled by the taxpayer has entered 

[[Page 66506]]
into a bona fide cost-sharing arrangement, in accordance with the 
provisions of Sec. 1.482-7, with the taxpayer for the purpose of 
developing intangible property, then that corporation shall not 
reasonably be expected to benefit from the taxpayer's share of the 
research expense.
    (d) Gross income methods--(1)(i) In general. In lieu of applying 
the sales method of paragraph (c) of this section, the remaining amount 
of the deduction for research and experimentation, not apportioned 
under paragraph (a)(4) or (b)(1)(ii) of this section, shall be 
apportioned as prescribed in paragraphs (d)(2) and (3) of this section, 
between the statutory grouping (or among the statutory groupings) of 
gross income and the residual grouping of gross income.
    (ii) Optional methods to be applied to all research and 
experimental expenditures. These optional methods must be applied to 
the taxpayer's entire deduction for research and experimental expense 
remaining after applying the exception in paragraph (a)(4) of this 
section, and may not be applied on a product category basis. Thus, 
after the allocation of the taxpayer's entire deduction for research 
and experimental expense under paragraph (a)(2) of this section (by 
attribution to SIC code categories), the taxpayer must then apportion 
as necessary the entire deduction as allocated by separate amounts to 
various product categories, using only the sales method under paragraph 
(c) of this section or only the optional gross income methods under 
this paragraph (d). The taxpayer may not use the sales method for a 
portion of the deduction and optional gross income methods for the 
remainder of the deduction separately allocated.
    (2) Option one. The taxpayer may apportion its research and 
experimental expenditures ratably on the basis of gross income between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping of gross income in the same 
proportions that the amount of gross income in the statutory grouping 
(or groupings) and the amount of gross income in the residual grouping 
bear, respectively, to the total amount of gross income, if the 
conditions described in paragraph (d)(2)(i) and (ii) of this section 
are both met.
    (i) The amount of research and experimental expense ratably 
apportioned to the statutory grouping (or groupings in the aggregate) 
is not less than fifty percent of the amount that would have been so 
apportioned if the taxpayer had used the method described in paragraph 
(c) of this section; and
    (ii) The amount of research and experimental expense ratably 
apportioned to the residual grouping is not less than fifty percent of 
the amount that would have been so apportioned if the taxpayer had used 
the method described in paragraph (c) of this section.
    (3) Option two. If, when the amount of research and experimental 
expense is apportioned ratably on the basis of gross income, either of 
the conditions described in paragraph (d)(2)(i) or (ii) of this section 
is not met, the taxpayer may either--
    (i) Where the condition of paragraph (d)(2)(i) of this section is 
not met, apportion fifty percent of the amount of research and 
experimental expense that would have been apportioned to the statutory 
grouping (or groupings in the aggregate) under paragraph (c) of this 
section to such statutory grouping (or to such statutory groupings in 
the aggregate and then among such groupings on the basis of gross 
income within each grouping), and apportion the balance of the amount 
of research and experimental expenses to the residual grouping; or
    (ii) Where the condition of paragraph (d)(2)(ii) of this section is 
not met, apportion fifty percent of the amount of research and 
experimental expense that would have been apportioned to the residual 
grouping under paragraph (c) of this section to such residual grouping, 
and apportion the balance of the amount of research and experimental 
expenses to the statutory grouping (or to the statutory groupings in 
the aggregate and then among such groupings ratably on the basis of 
gross income within each grouping).
    (e) Binding election--(1) In general. A taxpayer may choose to use 
either the sales method under paragraph (c) of this section or the 
optional gross income methods under paragraph (d) of this section for 
its original return for its first taxable year to which this section 
applies. The taxpayer's use of either the sales method or the optional 
gross income methods for its return filed for its first taxable year to 
which this section applies shall constitute a binding election to use 
the method chosen for that year and for four taxable years thereafter.
    (2) Change of method. The taxpayer's election of a method may not 
be revoked during the period referred to in paragraph (e)(1) of this 
section without the prior consent of the Commissioner. After the 
expiration of that period, the taxpayer may change methods without the 
prior consent of the Commissioner. However, the taxpayer's use of the 
new method shall constitute a binding election to use the new method 
for its return filed for the first year for which the taxpayer uses the 
new method and for four taxable years thereafter. The taxpayer's 
election of the new method may not be revoked during that period 
without the prior consent of the Commissioner.
    (i) Short taxable years. For purposes of this paragraph (e), the 
term taxable year includes a taxable year of less than twelve months.
    (ii) Affiliated groups. In the case of an affiliated group, the 
period referred to in paragraph (e)(1) of this section shall commence 
as of the latest taxable year in which any member of the group has 
changed methods.
    (f) Special rules for partnerships--(1) Research and experimental 
expenditures. For purposes of applying this section, if research and 
experimental expenditures are incurred by a partnership in which the 
taxpayer is a partner, the taxpayer's research and experimental 
expenditures shall include the taxpayer's distributive share of the 
partnership's research and experimental expenditures.
    (2) Purpose and location of expenditures. In applying the exception 
for expenditures undertaken to meet legal requirements under paragraph 
(a)(4) of this section and the exclusive apportionment for the sales 
method and the optional gross income methods under paragraph (b) of 
this section, a partner's distributive share of research and 
experimental expenditures incurred by a partnership shall be treated as 
incurred by the partner for the same purpose and in the same location 
as incurred by the partnership.
    (3) Apportionment under the sales method. In applying the remaining 
apportionment for the sales method under paragraph (c) of this section, 
a taxpayer's sales from a product category shall include the taxpayer's 
share of any sales from the product category of any partnership in 
which the taxpayer is a partner. For purposes of the preceding 
sentence, a taxpayer's share of sales shall be proportionate to the 
taxpayer's distributive share of the partnership's gross income in the 
product category.
    (g) Effective date. This section applies to taxable years beginning 
after December 31, 1995. However, a taxpayer may at his or her option, 
apply this section in its entirety to all taxable years beginning after 
August 1, 1994.
    (h) Examples. The following examples illustrate the application of 
this section:

    Example 1--(i) Facts. X, a domestic corporation, is a 
manufacturer and distributor of small gasoline engines for lawn 
mowers. Gasoline engines are a product within the category, Engines 
and Turbines 

[[Page 66507]]
(SIC Industry Group 351). Y, a wholly owned foreign subsidiary of X, 
also manufactures and sells these engines abroad. During 1996, X 
incurred expenditures of $60,000 on research and experimentation, 
which it deducts as a current expense, to invent and patent a new 
and improved gasoline engine. All of the research and 
experimentation was performed in the United States. In 1996, the 
domestic sales by X of the new engine total $500,000 and foreign 
sales by Y total $300,000. X provides technology for the manufacture 
of engines to Y via a license that requires the payment of an arm's 
length royalty. In 1996, X's gross income is $160,000, of which 
$140,000 is U.S. source income from domestic sales of gasoline 
engines and $10,000 is foreign source royalties from Y, and $10,000 
is U.S. source interest income.
    (ii) Allocation. The research and experimental expenditures were 
incurred in connection with small gasoline engines and they are 
definitely related to the items of gross income to which the 
research gives rise, namely gross income from the sale of small 
gasoline engines in the United States and royalties received from 
subsidiary Y, a foreign manufacturer of gasoline engines. 
Accordingly, the expenses are allocable to this class of gross 
income. The U.S. source interest income is not within this class of 
gross income and, therefore, is not taken into account.
    (iii) Apportionment. (A) For purposes of applying the foreign 
tax credit limitation, the statutory grouping is general limitation 
gross income from sources without the United States and the residual 
grouping is gross income from sources within the United States. 
Since the related class of gross income derived from the use of 
engine technology consists of both gross income from sources without 
the United States (royalties from Y) and gross income from sources 
within the United States (gross income from engine sales), X's 
deduction of $60,000 for its research and experimental expenditure 
must be apportioned between the statutory and residual grouping 
before the foreign tax credit limitation may be determined. Because 
more than 50 percent of X's research and experimental activity was 
performed in the United States, 50 percent of that deduction can be 
apportioned exclusively to the residual grouping of gross income, 
gross income from sources within the United States. The remaining 50 
percent of the deduction can then be apportioned between the 
residual and statutory groupings on the basis of sales of small 
gasoline engines by X and Y. Alternatively, X's deduction for 
research and experimentation can be apportioned under the optional 
gross income method. The apportionment for 1996 is as follows:

(1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned                 
 between residual and statutory groupings of gross income:...    $60,000
(ii) Less: Exclusive apportionment of research and                      
 experimental expense to the residual grouping of gross                 
 income ($60,000 x 50 percent):..............................    $30,000
(iii) Research and experimental expense to be apportioned               
 between residual and statutory groupings of gross income on            
 the basis of sales:.........................................    $30,000
(iv) Apportionment of research and experimental expense to              
 the residual grouping of gross income ($30,000 x $500,000/             
 ($500,000+$300,000)):.......................................    $18,750
(v) Apportionment of research and experimental expense to the           
 statutory grouping of gross income ($30,000 x $300,000/                
 ($500,000+$300,000)):.......................................    $11,250
(vi) Total apportioned deduction for research and                       
 experimentation:............................................    $60,000
(vii) Amount apportioned to the residual grouping                       
 ($30,000+$18,750):..........................................    $48,750
(viii) Amount apportioned to the statutory grouping:.........    $11,250
                                                                        

(2) Tentative Apportionment on the Basis of Gross Income.

(i) Exclusive apportionment of research and experimental                
 expense to the residual grouping of gross income ($60,000 x            
 25 percent):................................................    $15,000
(ii) Research and experimental expense apportioned to sources           
 within the United States (residual grouping) ($45,000 x                
 $140,000/($140,000+$10,000)):...............................    $42,000
(iii) Research and experimental expense apportioned to                  
 sources within country Y (statutory grouping) ($45,000 x               
 $10,000/($140,000+$10,000)):................................     $3,000
(iv) Amount apportioned to the residual grouping:............    $57,000
(v) Amount apportioned to the statutory grouping:............     $3,000
                                                                        

    (B) The total research and experimental expense apportioned to 
the statutory grouping ($3,000) under the gross income method is 
approximately 26 percent of the amount apportioned to the statutory 
grouping under the sales method. Thus, X may use option two of the 
gross income method (paragraph (d)(3) of this section) and apportion 
to the statutory grouping fifty percent (50%) of the $11,250 
apportioned to that grouping under the sales method. Thus, X 
apportions $5,625 of research and experimental expense to the 
statutory grouping. X's use of the optional gross income methods 
will constitute a binding election to use the optional gross income 
methods for 1996 and four taxable years thereafter.
    Example 2--(i) Facts. Assume the same facts as in Example 1  
except that X also spends $30,000 in 1996 for research on steam 
turbines, all of which is performed in the United States, and X has 
steam turbine sales in the United States of $400,000. X's foreign 
subsidiary Y neither manufactures nor sells steam turbines. The 
steam turbine research is in addition to the $60,000 in research 
which X does on gasoline engines for lawnmowers. X thus has a 
deduction of $90,000 for its research activity. X's gross income is 
$200,000, of which $140,000 is U.S. source income from domestic 
sales of gasoline engines, $50,000 is U.S. source income from 
domestic sales of steam turbines, and $10,000 is foreign source 
royalties from Y.
    (ii) Allocation. X's research expenses generate income from 
sales of small gasoline engines and steam turbines. Both of these 
products are in the same three digit SIC code category, Engines and 
Turbines (SIC Industry Group 351). Therefore, the deduction is 
definitely related to this product category and allocable to all 
items of income attributable to it. These items of X's income are 
gross income from the sale of small gasoline engines and steam 
turbines in the United States and royalties from foreign subsidiary 
Y, a foreign manufacturer and seller of small gasoline engines.
    (iii) Apportionment. (A) For purposes of applying the foreign 
tax credit limitation, the statutory grouping is general limitation 
gross income from sources outside the United States and the residual 
grouping is gross income from sources within the United States. X's 
deduction of $90,000 must be apportioned between the statutory and 
residual groupings. Because more than 50 percent of X's research and 
experimental activity was performed in the United States, 50 percent 
of that deduction can be apportioned exclusively to the residual 
grouping, gross income from sources within the United States. The 
remaining 50 percent of the deduction can then be apportioned 
between the residual and statutory groupings on the basis of total 
sales of small gasoline engines and steam turbines by X and Y. 
Alternatively, X's deduction for research and experimentation can be 
apportioned under the optional gross income methods. The 
apportionment for 1996 is as follows:

 (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned                 
 between residual and statutory groupings of gross income:...    $90,000
(ii) Less: Exclusive apportionment of the research and                  
 experimental expense to the residual grouping of gross                 
 income ($90,000 x 50 percent):..............................    $45,000
(iii) Research and experimental expense to be apportioned               
 between the residual and statutory groupings of gross income           
 on the basis of sales:......................................    $45,000
(iv) Apportionment of research and experimental expense to              
 the residual grouping of gross income ($45,000 x                       
 ($500,000+$400,000)/($500,000+$400,000+$300,000)):..........   $33,750 

[[Page 66508]]
                                                                        
(v) Apportionment of research and experimental expense to the           
 statutory grouping of gross income ($45,000 x $300,000/                
 ($500,000+$400,000+$300,000)):..............................    $11,250
(vi) Total apportioned deduction for research and                       
 experimentation:............................................    $90,000
(vii) Amount apportioned to the residual grouping                       
 ($45,000+$33,750):..........................................    $78,750
(viii) Amount apportioned to the statutory grouping:.........    $11,250
                                                                        



 (2) Tentative Apportionment on the Basis of Gross Income

(i) Exclusive apportionment of research and experimental                
 expense to the residual grouping of gross income ($90,000 x            
 25 percent):................................................    $22,500
(ii) Research and experimental expense apportioned to sources           
 within the United States (residual grouping) ($67,500 x                
 $190,000/($140,000+$50,000+$10,000)):.......................    $64,125
(iii) Research and experimental expense apportioned to                  
 sources within country Y (statutory grouping) ($67,500 x               
 $10,000/($140,000+$50,000+$10,000)):........................     $3,375
(iv) Amount apportioned to the residual grouping:............    $86,625
(v) Amount apportioned to the statutory grouping:............     $3,375
                                                                        

    (B) The total research and experimental expense apportioned to 
the statutory grouping ($3,375) under the gross income method is 30 
percent of the amount apportioned to the statutory grouping under 
the sales method. Thus, X may use option two of the gross income 
method (paragraph (d)(3) of this section) and apportion to the 
statutory grouping fifty percent (50%) of the $11,250 apportioned to 
that grouping under the sales method. Thus, X apportions $5,625 of 
research and experimental expense to the statutory grouping. X's use 
of the optional gross income methods will constitute a binding 
election to use the optional gross income methods for 1996 and four 
taxable years thereafter.
    Example 3--(i) Facts. Assume the same facts as in Example 1 
except that in 1997 X continues its sales of the new engines, with 
sales of $600,000 in the United States and $400,000 abroad by 
subsidiary Y. X also acquires a 60 percent (by value) ownership 
interest in foreign corporation Z and a 100 percent ownership 
interest in foreign corporation C. X transfers its engine technology 
to Z for a royalty equal to 5 percent of sales, and X enters into an 
arm's length cost-sharing arrangement with C to share the funding of 
all of X's research activity. In 1997, corporation Z has sales in 
country Z equal to $1,000,000. X incurs expense of $80,000 on 
research and experimentation in 1997, and in addition, X performs 
$15,000 of research on gasoline engines which was funded by the 
cost-sharing arrangement with C. All of Z's sales are from the 
product category, Engines and Turbines (SIC Industry Group 351). X 
performs all of its research in the United States and $20,000 of its 
expenditure of $80,000 is made solely to meet pollution standards 
mandated by law. X establishes, to the satisfaction of the 
Commissioner, that the expenditure in response to pollution 
standards is not expected to generate gross income (beyond de 
minimis amounts) outside the United States.
    (ii) Allocation. The $20,000 of research expense which X 
incurred in connection with pollution standards is definitely 
related and thus allocable to the residual grouping, gross income 
from sources within the United States. The remaining $60,000 in 
research and experimental expenditure incurred by X is definitely 
related to all gasoline engines and is therefore allocable to the 
class of gross income to which the engines give rise, gross income 
from sales of gasoline engines in the United States, royalties from 
country Y, and royalties from country Z. No part of the $60,000 
research expense is allocable to dividends from country C, because 
corporation C has already paid, through its cost-sharing 
arrangement, for research activity performed by X which may benefit 
C.
    (iii) Apportionment. For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general limitation 
gross income from sources without the United States, and the 
residual grouping is gross income from sources within the United 
States. X's deduction of $60,000 for its research and experimental 
expenditure must be apportioned between these groupings. Because 
more than 50 percent of the research and experimentation was 
performed in the United States, 50 percent of the $60,000 deduction 
can be apportioned exclusively to the residual grouping. The 
remaining 50 percent of the deduction can then be apportioned 
between the residual and the statutory grouping on the basis of 
sales of gasoline engines by X, Y, and Z. (If X utilized the 
optional gross income methods in 1996, then its use of such methods 
constituted a binding election to use the optional gross income 
methods in 1996 and for four taxable years thereafter. If X utilized 
the sales method in 1996, then its use of such method constituted a 
binding election to use the sales method in 1996 and for four 
taxable years thereafter.) The optional gross income methods are not 
illustrated in this Example 3 (see instead Examples 1 and 2). Since 
X has only a 60 percent ownership interest in corporation Z, only 60 
percent of Z's sales (60% of $1,000,000, or $600,000) are included 
for purposes of apportionment. The allocation and apportionment for 
1997 is as follows:

(A) X's total research expense:..............................    $80,000
(B) Less: Legally mandated research directly allocated to the           
 residual grouping of gross income:..........................    $20,000
(C) Tentative apportionment on the basis of sales............           
(1) Research and experimental expense to be apportioned                 
 between residual and statutory groupings of gross income:...    $60,000
(2) Less: Exclusive apportionment of research and                       
 experimental expense to the residual grouping of gross                 
 income ($60,000 x 50 percent):..............................    $30,000
(3) Research and experimental expense to be apportioned                 
 between the residual and the statutory groupings on the                
 basis of sales:.............................................    $30,000
(4) Apportionment of research and experimental expense to               
 gross income from sources within the United States (residual           
 grouping) ($30,000 x $600,000/($600,000+$400,000+$600,000)):    $11,250
(5) Apportionment of research and experimental expense to               
 general limitation gross income from countries Y and Z                 
 (statutory grouping) ($30,000 x $400,000+$600,000/                     
 ($600,000+$400,000+$600,000)):..............................    $18,750
(6) Total apportioned deduction for research and                        
 experimentation ($30,000+$30,000):..........................    $60,000
(7) Amount apportioned to the residual grouping                         
 ($30,000+$11,250):..........................................    $41,250
(8) Amount apportioned to the statutory grouping of gross               
 income from sources within countries Y and Z:...............    $18,750
                                                                        

    Example 4--Research and Experimentation--(i) Facts. X, a 
domestic corporation, manufactures and sells forklift trucks and 
other types of materials handling equipment in the United States. 
The manufacture and sale of forklift trucks and other materials 
handling equipment belongs to the product category, Construction, 
Mining, and Materials Handling Machinery and Equipment (SIC Industry 
Group 353). X also sells its forklift trucks to a wholesaling 
subsidiary located in foreign country Y (but title passes in the 
United States), and X manufactures forklift trucks in foreign 
country Z. The wholesaling of forklift trucks to country Y also 
belongs to X's product category Transportation equipment and, 
therefore, may not belong to the product 

[[Page 66509]]
category, Wholesale trade (SIC Major Group 50 and 51). In 1997, X sold 
$7,000,000 of forklift trucks to purchasers in the United States, 
$3,000,000 of forklift trucks to the wholesaling subsidiary in Y, 
and transferred forklift truck components with an FOB export value 
of $2,000,000 to its branch in Z. The branch's sales of finished 
forklift trucks were $5,000,000. In response to legally mandated 
emission control requirements, X's United States research department 
has been engaged in a research project to improve the performance 
and quality of engine exhaust systems used on its products in the 
United States. It incurs expenses of $100,000 for this purpose in 
1997. In the past, X has customarily adapted the product 
improvements developed originally for the domestic market to its 
forklift trucks manufactured abroad. During the taxable year 1997, 
development of an improved engine exhaust system is completed and X 
begins installing the new system during the latter part of the 
taxable year in products manufactured and sold in the United States. 
X continues to manufacture and sell forklift trucks in foreign 
countries without the improved engine exhaust systems.
    (ii) Allocation. X's deduction for its research expense is 
definitely related to the income to which it gives rise, namely 
income from the manufacture and sale of forklift trucks within the 
United States and in country Z. Although the research is undertaken 
in response to a legal mandate, it can reasonably be expected to 
generate gross income from the manufacture and sale of trucks by the 
branch in Z. Therefore, the deduction is not allocable solely to 
income from X's domestic sales of forklift trucks. It is allocable 
to income from such sales and income from the sales of X's branch in 
Z.
    (iii) Apportionment. For the method of apportionment on the 
basis of either sales or gross income, see Example 3. However, in 
determining the amount of research apportioned to income from 
foreign and domestic sources, the net sales of the branch in Z are 
$3,000,000 ($5,000,000 less $2,000,000) and the sales within the 
United States are $12,000,000 ($7,000,000 plus $3,000,000 plus 
$2,000,000). See Sec. 1.861-17(c)(3)(iii).
    Example 5--(i) Facts. X, a domestic corporation, is a drug 
company that manufactures a wide variety of pharmaceutical products 
for sale in the United States. Pharmaceutical products belong to the 
product category, Drugs (SIC Industry Group 283). X exports its 
pharmaceutical products through a foreign sales corporation (FSC). 
X's wholly owned foreign subsidiary Y also manufactures 
pharmaceutical products. In 1997, X has domestic sales of 
pharmaceutical products of $10,000,000, the FSC has sales of 
pharmaceutical products of $3,000,000, and Y has sales of 
pharmaceutical products of $5,000,000. In that same year, 1997, X 
incurs expense of $200,000 on research to test a product in response 
to requirements imposed by the United States Food and Drug 
Administration (FDA). X is able to show that, even though country Y 
imposes certain testing requirements on pharmaceutical products, the 
research performed in the United States is not accepted by country Y 
for purposes of its own licensing requirements, and the research has 
minimal use abroad. X is further able to show that FSC sells goods 
to countries that do not accept or do not require research performed 
in the United States for purposes of their own licensing standards.
    (ii) Allocation. Since X's research expense of $200,000 is 
undertaken to meet the requirements of the United States Food and 
Drug Administration, and since it is reasonable to expect that the 
expenditure will not generate gross income (beyond de minimis 
amounts) outside the United States, the deduction is definitely 
related and thus allocable to the residual grouping.
    (iii) Apportionment. No apportionment is necessary since the 
entire expense is allocated to the residual grouping, gross income 
from sales within the United States.
    Example 6--(i) Facts. X, a domestic corporation, is engaged in 
continuous research and experimentation to improve the quality of 
the products that it manufactures and sells, which are floodlights, 
flashlights, fuse boxes, and solderless connectors. X incurs and 
deducts $100,000 of expenditure for research and experimentation in 
1997 that was performed exclusively in the United States. As a 
result of this research activity, X acquires patents that it uses in 
its own manufacturing activity. X licenses its floodlight patent to 
Y and Z, uncontrolled foreign corporations, for use in their own 
territories, countries Y and Z, respectively. Corporation Y pays X 
an arm's length royalty of $3,000 plus $0.20 for each floodlight 
sold. Sales of floodlights by Y for the taxable year are $135,000 
(at $4.50 per unit) or 30,000 units, and the royalty is $9,000 
($3,000 + $0.20 x 30,000). Y has sales of other products of 
$500,000. Z pays X an arm's length royalty of $3,000 plus $0.30 for 
each unit sold. Z manufactures 30,000 floodlights in the taxable 
year, and the royalty is $12,000 ($3,000 + $0.30 x 30,000). The 
dollar value of Z's floodlight sales is not known and cannot be 
reasonably estimated because, in this case, the floodlights are not 
sold separately by Z but are instead used as a component in Z's 
manufacture of lighting equipment for theaters. The sales of all Z's 
products, including the lighting equipment for theaters, are 
$1,000,000. Y and Z each sell the floodlights exclusively within 
their respective countries. X's sales of floodlights for the taxable 
year are $500,000 and its sales of its other products, flashlights, 
fuse boxes, and solderless connectors, are $400,000. X has gross 
income of $500,000, consisting of gross income from domestic sources 
from sales of floodlights, flashlights, fuse boxes, and solderless 
connectors of $479,000, and royalty income of $9,000 and $12,000 
from foreign corporations Y and Z respectively. X utilized the 
optional gross income methods of apportionment for its return filed 
for its first taxable year to which this section applies.
    (ii) Allocation. X's research and experimental expenses are 
definitely related to all of the products that it produces, which 
are floodlights, flashlights, fuse boxes, and solderless connectors. 
All of these products are in the same three digit SIC Code category, 
Electric Lighting and Wiring Equipment (SIC Industry Group 364). 
Thus, X's research and experimental expenses are allocable to all 
items of income attributable to this product category, domestic 
sales income and royalty income from the foreign countries in which 
corporations Y and Z operate.
    (iii) Apportionment. (A) The statutory grouping of gross income 
is general limitation income from sources without the United States. 
The residual grouping is gross income from sources within the United 
States. X's deduction of $100,000 for its research expenditures must 
be apportioned between the groupings. For apportionment on the basis 
of sales in accordance with paragraph (c) of this section, X is 
entitled to an exclusive apportionment of 50 percent of its research 
and experimental expense to the residual grouping, gross income from 
sources within the United States, since more than 50 percent of the 
research activity was performed in the United States. The remaining 
50 percent of the deduction can then be apportioned between the 
residual and statutory groupings on the basis of sales. Since Y and 
Z are unrelated licensees of X, only their sales of the licensed 
product, floodlights, are included for purposes of apportionment. 
Floodlight sales of Z are unknown, but are estimated at ten times 
royalties from Z, or $120,000. All of X's sales from the entire 
product category are included for purposes of apportionment on the 
basis of sales. Alternatively, X may apportion its deduction on the 
basis of gross income, in accordance with paragraph (d) of this 
section. The apportionment is as follows:

(1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned                 
 between statutory and residual groupings of gross income:...   $100,000
(ii) Less: Exclusive apportionment of research and                      
 experimental expense to the residual groupings of gross                
 income ($100,000 x 50 percent):.............................    $50,000
(iii) Research and experimental expense to be apportioned               
 between the statutory and residual groupings of gross income           
 on the basis of sales:......................................    $50,000
(iv) Apportionment of research and experimental expense to              
 the residual groupings of gross income ($50,000 x $900,000/            
 ($900,000+$135,000+$120,000)):..............................    $38,961
(v) Apportionment of research and experimental expense to the           
 statutory grouping, royalty income from countries Y and Z              
 ($50,000 x $135,000+$120,000/($900,000+$135,000+$120,000)):.   $11,039 

[[Page 66510]]
                                                                        
(vi) Total apportioned deduction for research and                       
 experimentation:............................................   $100,000
(vii) Amount apportioned to the residual grouping                       
 ($50,000+$38,961):..........................................    $88,961
(viii) Amount apportioned to the statutory grouping of                  
 sources within countries Y and Z:...........................    $11,039
                                                                        



(2) Tentative Apportionment on Gross Income Basis

(i) Exclusive apportionment of research and experimental                
 expense to the residual grouping of gross income ($100,000 x           
 25 percent):................................................    $25,000
(ii) Apportionment of research and experimental expense to              
 the residual grouping of gross income ($75,000 x $479,000/             
 $500,000):..................................................    $71,850
(iii) Apportionment of research and experimental expense to             
 the statutory grouping of gross income ($75,000 x                      
 $9,000+$12,000/$500,000):...................................     $3,150
(iv) Amount apportioned to the residual grouping:............    $96,850
(v) Amount apportioned to the statutory grouping of general             
 limitation income from sources without the United States:...     $3,150
                                                                        

    (B) Since X has elected to use the optional gross income methods 
of apportionment and its apportionment on the basis of gross income 
to the statutory grouping, $3,150, is less than 50 percent of its 
apportionment on the basis of sales to the statutory grouping, 
$11,039, it must use Option two of paragraph (d)(3) of this section 
and apportion $5,520 (50 percent of $11,039) to the statutory 
grouping.

Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: December 13, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-30901 Filed 12-21-95; 8:45 am]
BILLING CODE 4830-01-U