IRS PROVIDES OPTIONS FOR ALLOCATING R&D EXPENSES.

Rev. Proc. 92-56

SECTION 1. PURPOSE

This revenue procedure provides guidance regarding the allocation and apportionment of research and development expenditures incurred during the last six months of a taxpayer's first taxable year beginning after August 1, 1991 and during the immediately succeeding taxable year.

SECTION 2. BACKGROUND

Section 1.861-8(e)(3) of the Income Tax Regulations provides rules for the allocation and apportionment of deductions for research and development expenditures for purposes of sections 861(b), 862(b) and 863(a) of the Internal Revenue Code. The rules of section 1.861- 8(e)(3) implement the requirement of those Code sections that deductions for research and development expenditures be "properly apportioned or allocated" to items of gross income.

Since 1981, the rules of section 1.861-8(e)(3) have been temporarily modified by eight legislative enactments. Most recently, section 864(f) of the Internal Revenue Code, enacted in 1989 and amended in 1990 and 1991, suspended the application of section 1.861- 8(e)(3) and provided a set of statutory rules to govern the allocation and apportionment to geographic sources of deductions for qualified research and development expenditures incurred during a taxpayer's first two taxable years beginning after August 1, 1989 and during the first six months of a taxpayer's first taxable year beginning after August 1, 1991.

The allocation and apportionment rules of section 1.861-8(e)(3) are applicable (upon expiration of section 864(f)) with respect to research and development expenditures incurred during the last six months of a taxpayer's first taxable year beginning after August 1, 1991 and during subsequent taxable years. The Treasury Department and the Internal Revenue Service understand, however, that many affected taxpayers believe that section 1.861-8(e)(3) does not result in a "proper apportionment or allocation," as required by sections 861(b), 862(b) and 863(a), based on the factual relationship between deductions for research and development expenditures and items of gross income or on such other factors (if any) as may be relevant. Accordingly, the Treasury Department and the Internal Revenue Service have undertaken a review of section 1.861-8(e)(3). If, after this review, the Treasury Department and the Internal Revenue Service determine that section 1.861-8(e)(3) does not result in a "proper apportionment or allocation" of deductions for research and development expenditures, appropriate modifications to that regulation will be proposed.

Taxpayers are hereby invited to provide any information that may be relevant for purposes of this review. In particular, taxpayer comments are requested regarding the extent to which exploitation of research and development in the place of performance differs (e.g., in timing, profitability or the range of affected products) from its exploitation elsewhere and the manner in which section 1.861-8(e)(3) should take into account the current deductibility of research and development expenditures under section 174 in reflecting the factual relationship between those expenditures and gross income.

In light of the ongoing review of section 1.861-8(e)(3), the Internal Revenue Service will not require that taxpayers apply the rules of section 1.861-8(e)(3) with respect to allocation and apportionment to geographic sources of deductions for research and development expenditures incurred during the transition period specified in section 3.01 of this revenue procedure, provided that such deductions are allocated and apportioned in accordance with the transition method provided in section 3.02 through 3.05. This transition method is not intended to suggest any views about the proper allocation and apportionment of research and development expenditures. It is intended solely to provide taxpayers with transition relief and to minimize audit controversy and facilitate business planning during the conduct of the regulatory review.

SECTION 3. ALLOCATION AND APPORTIONMENT

01 IN GENERAL. A taxpayer will not be required to apply the rules of section 1.861-8(e)(3) with respect to allocation and apportionment to geographic sources of deductions for research and development expenditures incurred during the last six months of a taxpayer's first taxable year beginning after August 1, 1991 and during the immediately succeeding taxable year, provided that deductions for such expenses are allocated and apportioned in accordance with the transition method set forth in paragraphs .02 through .05 of this section.

02 LEGAL REQUIREMENTS. Where research and development 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 development expenditures shall be allocated only to the grouping (or groupings) of gross income within that geographic source as a class (and apportioned, if necessary, between such groupings in accordance with the method chosen under paragraph .04 below).

03. PERCENTAGE RULE. In the case of research and development expenditures not allocated under paragraph .02 --

(i) to the extent that such expenditures are attributable to activities conducted in the United States, 64 percent of such expenditures shall be allocated to income from sources within the United States and deducted from such income in determining the amount of taxable income from sources within the United States, and

(ii) to the extent that such expenditures are attributable to activities conducted outside the United States, 64 percent of such expenditures shall be allocated to income from sources outside the United States and deducted from such income in determining the amount of taxable income from sources outside the United States.

For purposes of this paragraph .03, research and development activities conducted by a United States person in space, on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States, or in Antarctica shall be treated as conducted in the United States. Any such activities conducted by a person other than a United States person shall be treated as conducted outside the United States.

04. REMAINING PORTION. The remaining portion of research and development expenditures (not allocated under paragraphs .02 and .03) shall be apportioned, at the annual election of the taxpayer, on the basis of gross sales revenue or gross income, except that if the taxpayer elects to apportion on the basis of gross income, the amount apportioned to income from sources outside the United States shall be at least 30 percent of the amount which would be so apportioned on the basis of gross sales revenue. For purposes of this paragraph .04, gross sales revenue shall include sales revenue of uncontrolled and controlled parties to the extent that such sales revenue would be taken into account under section 1.861-8(e)(3)(ii)(C) and (D) if section 1.861-8(e)(3) were applied.

05. ADDITIONAL RULES. The rules of this section shall be applied by a taxpayer that is a member of an affiliated group (within the meaning of section 1.861-14T(d) of the Regulations) as if all members of the affiliated group were a single corporation. This revenue procedure is inapplicable to any taxpayer whose allocation and apportionment of research and development expenditures incurred during the transition period specified in paragraph .01 is not made in accordance with the transition method provided in this section. Such a taxpayer will be governed solely by section 1.861-8(e)(3) of the Regulations.

SECTION 4. EFFECT ON OTHER DOCUMENTS

This revenue procedure provides guidance regarding the allocation and apportionment of research and development expenditures incurred during the transition period specified in section 3.01 and does not affect any other documents.

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective on June 23, 1992, for the period specified in section 3.01.

DRAFTING INFORMATION

The principal author of this revenue procedure is Carl Cooper of the Office of Associate Chief Counsel (International). For further information regarding this revenue procedure, contact Mr. Cooper on (202) 566-6645 (not a toll-free call).