TAXING OF RESEARCH & EXPERIMENTAL EXPENSES.
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Analyzes debate over changes in tax code regulations dealing with business expenses related to domestic- & foreign-incurrred R&E.... More...
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Analyzes debate over changes in tax code regulations dealing with business expenses related to domestic- & foreign-incurrred R&E.
Introduction On May 19, 1995, the Internal Revenue Service issued proposed regulations under section 861 of the Internal Revenue Code, relating to the allocation and apportionment of research and experimental expenses for purposes of determining taxable income from US and foreign sources. The proposed regulations would amend regulations issued in 1977. The issue of research and experimental expenses is a critical one since companies, particularly high-technology companies, depend on these expenses in order to fund their future growth. The ramifications of changing the regulations are far-reaching, and the considerable changes which the regulations have already undergone have caused some amount of upheaval in the business community. This research considers the proposed changes and their possible effect on research and development a
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M., Golden, D. Seltzer, B. This research considers the proposed changes and their possibleeffect on research and development among multinational corporations. The ramifications of changing the regulationsare far-reaching, and the considerable changes which the regulations havealready undergone have caused some amount of upheaval in the businesscommunity. W. However, theTreasury Department argues that R&D expenses which are incurred overseasfor the exclusive benefit of activities overseas should not be given thesame weight as R&D expenses incurred within the United States. Neutral international tax rulesallocating R&D costs. L., & Burgess, J. 1 2-113. 1 4). (1995, March-April).Maximizing opportunities under the new research and experimentationregulations. The new regulations also provide that the taxpayer's use of theoptional gross-income methods for its return filed for the first taxableyear to which the proposed regulations apply will constitute a bindingelection for all subsequent years. The regulations are not a methodof accounting, which generally relates to shifting items of income anddeductions between taxable periods. Introduction On May 19, 1995, the Internal Revenue Service issued proposedregulations under section 861 of the Internal Revenue Code, relating to theallocation and apportionment of research and experimental expenses forpurposes of determining taxable income from US and foreign sources. Critics of the new regulations argue that there should be paritybetween the methods since the 1977 regulations provided for alternativemethods to account for differences in facts and circumstances that couldoccur from one year to the next. The 1977 regulations, which have been in force for fewer than five ofthe 18 years since they were enacted, are held by business analysts to haveadversely affected the competitiveness of American multinationals andencouraged the migration of R&D activities to foreign countries. The new regulations also provide that a taxpayer shall determine therelevant product categories by reference to the three-digit classificationof the Standard Industrial Classification Manual (SIC codes). References Brown, K. Taxpayers should be permitted each year tochoose the method that best reduces double taxation. Tax Notes, pp. In fact, requiring taxpayers utilizing the gross income method to"lock-in" that choice ignores the policy reasons that prompted the IRS andTreasury Department to provide for two methods in the first place. S. L., & Outslay, E. 351). The IRS has alsotreated the two methods consistently, extending the set aside to both thesales and gross income methods. It isunclear at this point whether the new regulations will be enforced any moreconsistently than their predecessors, or whether they will have the effectanticipated by the Treasury Department. The controversy prompted Congress to enact a temporarymoratorium on the application of the Treasury regulations in 1981. The IRSand Department of Treasury have issued proposed regulations that wouldprovide a 5 -percent exclusive apportionment for taxpayers using the salesmethod of allocation. Companies argue that R&D expenses shouldbe deductible regardless of where they occur and whether the expense leadsto domestic or international sales. (1993, August 2). (1995). Inthis way, companies which use the sales method of allocation in their firstyear can choose to change to the gross income method in a subsequentperiod. (1994, October 17). Proposed Regulations The proposed regulations have some significant changes over previousregulations, including increasing the SIC classifications from twosignificant digits to three significant digits (Moore & Outslay, 1995, p.117). 36). 351-353. In contrast, certain fiscal-year taxpayers whose taxable yearsbegin after August 1, 1994, but before January 1, 1995 will suffer a one-year gap during which the 1977 regulations will apply. Theproposed regulations would amend regulations issued in 1977. Allocating R&Dwhen determining foreign tax credit. In this way, a company which chooses touse the gross-income method once is essentially eliminating its option touse the sales method later on. The issue ofresearch and experimental expenses is a critical one since companies,particularly high-technology companies, depend on these expenses in orderto fund their future growth. 641-648. Raby, W. B. Background In 1977, the Treasury Department issued regulations under section 861relating to the allocation and apportionment of domestic research andexperimental (R&E) expenses against foreign income. Sincethat time, the moratorium has been extended and modified nine times bylegislative and administrative actions (Seltzer, Golden, & Monahan, 1995,p. Some analysts suggest that this indicates that the Treasury Departmentitself acknowledges that the 1977 regulations were too restrictive in theirallocation of R&E expenses. E. In enacting and extending the moratorium on the implementation of the1977 regulations, Congress has consistently extended the exclusiveapportionment rule to gross income method taxpayers. There are some analysts who thinkthat taxpayers should be able to narrow the product categories evenfurther. Such parity is also supported by thehistorical response to the 1977 regulations and also by the TreasuryDepartment's own report on the relationship between domestic R&E expensesand foreign income. Therelationship between research expenditures and sales or gross income may beinconsistent from year to year as global market penetration strategies arepursued, and the general rules acknowledge that factual relationships willchange over time. This, of course, is in the company'sbest interest since it would lower their tax liability. US Tax Aspects of Doing BusinessAbroad. Perhaps the greater consideration of the proposed regulations is nottheir content, but the rigorousness with which they will be enforced.Regulations in this area have been selective in their enforcement, andsubject to significant changes as one special interest or another lobbiesfor changes which maximize their own benefit. Fortaxpayers in the latter category, the proposed regulations are similar tothe 1977 regulations, effectively providing no additional relief andinstead provide two methods of allocating R&E expenditures on the basis ofgross income without any exclusive apportionment (Fiore, 1995, p. Manymultinationals are not in the excess credit position that make thisargument viable, and many foreign jurisdictions do allow deductions for R&Econducted in the US. These critics suggest that the fairness deemedparamount in the Treasury report can best be effected by extending theapplication of the set aside to the gross-income method of allocation.Without such parity, taxpayers using the gross-income method willeffectively lose a portion of their research expense deduction. Use of either the gross income orsales method of allocation in one year should not affect the use of thatmethod in the subsequent year. The proposed regulations permit taxpayers using the sales method tosource 5 percent of their R&E expenses to the United States, but they donot provide similar relief for taxpayer using the gross income method. Fiore, N. Recently, Assistant Treasury SecretaryLeslie B. Conclusion The issue of how to handle R&D expenses is likely to continue toplague the Treasury Department. The most recent legislation (enacted as part of the OmnibusBudget Reconciliation Act of 1993) allocated 5 percent of foreign-incurredR&E expenses to foreign-source income and 5 percent of domestic incurredR&E expenses to domestic-source income; the extension, however, expired forcalendar-year taxpayers on December 31, 1994. The use of four-digit SIC code categories would permit morecompanies to segregate their R&E expenses and accomplish a more accuratematching of such costs between domestic and foreign source income. The binding election requirement was not included in the 1977regulations or in any subsequent legislative or regulatory moratorium. Thisprovision reflects a significant change from the 1977 regulations, whichrequired the use of two-digit SIC codes. 36. Newman, J. The 1977 regulations produced a great deal of controversy in thebusiness community since they effectively increased the allocation ofexpenses to foreign-source income and thereby limited the foreign taxcredits available to a multinational corporation to offset its Americanincome tax. Moore, M. However, while it is the activities of some of thesewhich have led to some of the new regulations, these companies may not haveany interest in moving their R&D departments overseas, but are simplytrying to avoid paying taxes (Newman, 1993, p. Samuels expressed the Clinton Administration's support for arevenue neutral extension of section 864(f), under which the sameexclusive apportionment percentage would apply to both methods (Fiore,1995, p. Companies which are unhappywith the proposed regulations might be well advised to simply wait a fewyears for a change in administrations, or at least a change in the statedpolicy of the Treasury Department which, if it acts as it has in the past,is certain to offer additional regulations in the short-term. Tax Notes, pp. Research and development allocationsunder section 861 and 864. Theostensible reasoning behind this is to encourage companies to conduct theirresearch domestically in order to provide jobs (at possibly higher wagesthan overseas) for domestic workers. At the election of the taxpayer, the regulations mayalso be effective for taxable years beginning after December 31, 1994. 233-234. 641). The new regulations are effective for taxable years beginning afterDecember 31, 1995. (1995, May). (1993, July 12). Under the sales method, a 3 percent exclusiveapportionment (set aside) was accorded to the place of performance of theR&D activities. Research and experimentation costs. Tax Notes, pp. A., & Monahan, M. To some degree, the new regulations arose from a desire to allocateresearch expenses on a neutral international principle based on the goalsof fairness, efficiency and revenue maximization. The 1977 regulationsprovided two allocation and apportionment methods for research expenses:the sales method and the optional gross income method (Raby & Burgess,1994, p. The newregulations will force companies using the gross income method to accepteither the risk of double taxation or to move their R&D operations offshore(Seltzer, Golden, & Monahan, 1995, p. However, a similar requirement is notimposed on taxpayers using the sales method of allocation initially. Source income is also re-examined under the new regulations, with a5 percent apportionment provision now included. The proponents of thisview argue that no special incentive should exist to favor domesticresearch sites over foreign locations of a company, but that the 1977regulations did provide such incentives (Brown, 1993, p. More fundamentally, there is no tax or accounting policy that isserved by the binding election provision. Thenew regulations thus give calendar-year taxpayers the option to apply theregulations to their first taxable year following the most recentmoratorium. Tax Executive, pp. Of course, there are some who argue that continuing insistence byAmerican multinationals that R&E expenditures should be considered domestic-source income, thereby allowing them to continue domestic research withoutincurring higher taxes abroad, relies on too many unproven premises. 234). 1 2). 36). New York: American Institute of Certified Public Accountants,Inc. Journalof Accountancy, p.
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