Opinion ID: 677811
Heading Depth: 2
Heading Rank: 3

Heading: The Effect of the ERTA Moratorium on DISC CTI Computations

Text: 41 St. Jude argues on appeal that Sec. 223 of ERTA exempts it from allocating any R & D expenditures against its gross export receipts when calculating CTI under the intercompany pricing rules. In response, the Commissioner claims that ERTA does not apply to CTI computations and was intended to affect only determinations involving the allocation and apportionment of R & D expenditures for geographic sourcing purposes. According to the Commissioner, CTI computations simply do not require geographic sourcing allocations. The tax court agreed with the Commissioner, and so do we. 42 The ERTA Moratorium required that all research and experimental expenditures for activities conducted in the United States be allocated to sources within the United States. See supra note 9. Section 223 required (1) the suspension of regulations relating to allocation under Sec. 861 and (2) the allocation or apportionment of domestically performed R & D expenditures to sources within the United States. We must decide the scope of ERTA's mandate regarding domestic R & D allocations, that is, whether ERTA's language applies to DISC CTI computations. 16 43 St. Jude and International's CTI computation required them to allocate R & D expenditures, see Treas.Reg. Sec. 1.994-1(c)(6)(iii), to gross export receipts from the sale of heart valves. See id. St. Jude relies upon ERTA's language mandating the allocation or apportionment of domestically performed R & D expenditures to sources within the United States and contends that this language applies for all purposes under the Code. We agree that ERTA's legislative history indicates that domestic R & D expenditures must be allocated or apportioned to U.S. source income for all purposes under the Code. See H.R. Conf.Rep. No. 215, 97th Cong., 1st Sess. 224 (1981), reprinted in 1981 U.S.C.C.A.N. 105, 285, 314. We, however, do not believe that ERTA permits a taxpayer to allocate domestic R & D expenditures exclusively to a U.S. source when a calculation does not, in the first instance, require allocation to a geographic source, foreign or domestic. 44 The CTI computation rules do not require use of geographic sourcing rules. The sourcing rules are relevant when St. Jude is apportioning its R & D expenditures between its U.S. source income and its foreign source income for foreign tax credit purposes. See, e.g., Treas.Reg. Sec. 1.861-8(f)(1)(i), (ii). For those purposes, St. Jude gets a distinct benefit from the ERTA Moratorium: it need not apportion any of its R & D expenditures to the dividend it is deemed to receive from its DISC. All DISC dividends resulting from qualified export receipts are foreign source income. See I.R.C. Sec. 861(a)(2)(D). 45 In contrast, DISC foreign export receipts need not be categorized as foreign source income. For purposes of determining CTI, St. Jude and its DISC are treated as a single taxpayer. See I.R.C. Sec. 994(a). In a CTI computation, the two relevant worlds are (1) gross export receipts and (2) all other gross income. See Treas.Reg. Sec. 1.861-8(g)(23)(iii). Both worlds may include what could in another calculation be termed foreign source income. For example, the all other gross income category could include foreign source income such as foreign royalty income. See I.R.C. Sec. 862(a)(4). But, CTI computations simply do not require that the taxpayer apply a geographic source label. 46 Attempting to categorize CTI as foreign source or U.S. source income results in potentially disparate results. In a buy-sell DISC, the taxable income of the DISC and the taxpayer is based upon a transfer price that would allow the DISC to derive taxable income attributable to the sale, regardless of the price charged. I.R.C. Sec. 994(a). CTI for buy-sell DISCs determines an illusory price that the domestic/taxpayer corporation charges its domestic subsidiary (the DISC) for goods which it owned. This is a wholly domestic transaction that in theory involves only U.S. source income. See, e.g., Treas.Reg. Sec. 1.861-8(g)(23)(iii) (gross income from exports through a DISC and gross income from sales within the United States are both within the same geographic source, United States income). In contrast, CTI computations for commission DISCs calculate an illusory commission that will be paid by the domestic/taxpayer for a sale made by the DISC in a foreign market. The DISC never owns the goods, but the DISC in theory has performed a service in a foreign market for which it is paid. This commission income could be categorized as foreign source income. See I.R.C. Sec. 862(a)(3) (foreign source income includes compensation for labor or personal services performed without the United States). Using this analysis, it is possible to argue that domestic R & D expenditures should be deducted from the gross export receipts of buy-sell DISCs but not from the gross export receipts of commission DISCs. Such an analysis would create a conflict between Sec. 223 of ERTA and Sec. 994, which requires that commission DISCs have consistent intercompany pricing rules with buy-sell DISCs. We do not believe that Congress intended this result. 47 St. Jude's ERTA claim, made without reference to a sourcing rule, is based on an assumption that the gross export receipts used in CTI computations are foreign source income. St. Jude appears to claim that either the DISC or St. Jude have sold domestically made goods in a foreign market and thus the resulting income must be foreign source income. See id. Sec. 862(a)(6). This view is inconsistent with the purpose behind Sec. 994's intercompany pricing rules. The Sec. 994 intercompany pricing rules were intended to determine a favorable transfer price between the DISC and the domestic/taxpayer corporation. See H.R.Rep. No. 533 at 59, reprinted in 1971 U.S.C.C.A.N. at 1873. If ERTA applied to CTI computations, the computed transfer price would fail to include a significant cost of developing the goods. 48 Furthermore, we believe our view is consistent with ERTA's legislative history. 49 Taxpayers that allocate research and development expenses for purposes of the foreign tax credit claim that the allocation results in more deductions being allocated overseas than is allowed as a deduction by the foreign country. Thus, taxpayers claim that their foreign tax credit limitation is lower than the foreign taxes paid and that they will lose foreign tax credits. 50 Taxpayers argue that because of the application of the regulation, they must transfer research and development activities to the foreign country in order to get a deduction in that country and, thus, get a full foreign tax credit on the income earned in that country. The committee believes that the transfer of research and development activities overseas would not be in the best interest of the United States. Therefore, the committee has concluded that the Treasury should study the impact of the allocation of research and development expenses under Treas.Reg. Sec. 1.861-8 on U.S.-based research and development activities. 51 H.R.Rep. No. 201, 97th Cong., 1st Sess. 131 (1981). 17 ERTA's legislative history reveals that Congress intended through Sec. 223 to halt the deleterious effects Sec. 1.861-8 had on the foreign tax credit and on domestic R & D incentives. 52 We recognize that by affecting DISC income, CTI has a significant secondary impact on the foreign tax credit. CTI computations affect the amount of the deemed dividend eventually subject to taxation. But in terms of ERTA's double taxation concerns, CTI is irrelevant. The legislative history does not indicate that Congress intended without restriction to increase export incentives. Id.; see also 127 Cong.Rec. 17,459 (1981) (statement of Sen. Glenn). 53 We hold that the ERTA Moratorium did not permit St. Jude and International to avoid allocating any of its heart valve R & D expenditures to gross export receipts in its CTI computations. Section 223 was intended to allocate domestically performed R & D expenditures to U.S. sources of income when that allocation was part of a tax calculation. The CTI computation simply does not require a taxpayer to allocate R & D expenditures to geographic sources.