--The Center shall promote and engage in a broadly-based
joint industry-university research program in areas of
new and emerging technology which will establish it as
a leader in the development of new, commercially appli-
cable technology.

--The Center shall focus on research that is longer range and more broadly applicable than that normally conducted in industrial research laboratories.

--The Center shall provide small firms with access to shared research resources that are especially important for their success.

--The Center shall promote actively the transfer of the technology it develops to participating companies and to others, as appropriate, for rapid commercial application.

This Center represents an outgrowth of a long history of university/industry cooperation in Washington State, most recently in the advanced technology area. It is a partnership which, I believe, should be encouraged through legislation such as S. 2165 and H.R. 4475.

Once

Mr. Chairman, that concludes my testimony today. again, let me take this opportunity to thank you and the Committee for its leadership in this area. I very much appreciated the opportunity to testify before it today.

Senator DURENBERGER. Senator Danforth.

Senator DANFORTH. Thank you, Mr. Chairman.

Gentlemen, thank you very much for excellent and very persua

sive testimony

One of the key issues, I guess the most significant issue, that will be before us is whether to make the extension permanent or to make it for a period of 3 years.

My understanding of the position taken by the business community and by the academic community is that it is very important to make the extension permanent, that business and academia have to look ahead for more than a period of 3 years to plan research and development activities.

I think that both of you have testified as to the importance of a permanent extension, but I would like you to reiterate, if you would, or state your views as to the importance of a permanent extension.

Mr. ZSCHAU. Yes. In the statement I just made, I touched on that. Even though we weren't doing basic research or we weren't making breakthroughs, if you will, in the electronics area, most of the development programs that we undertook were of a 3 to 5 year duration. Major developments are even more important than the ones that my small company was doing. You can't motivate that kind of behavior with a temporary tax credit. If you believe in the importance of research and development, and you believe in the risk-taking associated with major development programs, you've got to have a permanent tax credit.

If you are not quite sure, then maybe we shouldn't have it at all, but a temporary tax credit does not motivate the kind of behavior that is necessary for this country to maintain its industrial competitiveness.

Mr. CHANDLER. I would just like to underscore it. That is certainly the testimony that I hear from the electronics industry in our area. Many people think that our area is only Boeing-well, it's not. Physiocontrol has developed very important lifesaving equipment dealing with the heart; and other electronic firms thereSunstrand, among them-all of them tell me, if you are only talking about 3 years, you are simply not going to get the job done. The planning and the commitment must be for much longer than that, and I just wanted to endorse my colleague's statements that it should be made permanent.

Senator DURENBERGER. Thank you both very much.

Senator Mitchell.

Senator MITCHELL. No questions, Mr. Chairman.

Senator Chafee.

Senator CHAFEE. Thank you, Mr. Chairman.

I have a statement I would like to insert in the record, if I might. Senator DURENBERGER. Without objection, it will be made a part of the record.

Senator CHAFEE. And I want to compliment the Representatives, particularly Mr. Zschau. We have heard him here before testifying in connection with these efforts to encourage the high tech industry. And we appreciate the zest and energy that he has put into it. I believe you have a group over there in the House that is devoted to this effort that you have headed. Is that not correct?

Mr. ZSCHAU. Yes, Senator Chafee. We have a task force on the Republican side that has 138 members who are focusing on the issues of industrial competitiveness and high technology innovation. We will be releasing shortly a rather complete legislative agenda, specific initiatives that we think are important to maintain our industrial competitiveness and enhance our technological leadership.

S. 2165 is specifically one of those initiatives that we think is among the most important.

Senator CHAFEE. Well, Mr. Chairman, in this subcommittee we have had a lot of testimony on this topic. We had our first hearings in January of 1983; at that time, Mr. Zschau and the AEA, the American Electronics Association, chose the extension of the R&D tax credit as the single most important piece of legislation on its agenda.

So it is an important piece I look forward to getting on with it, and I hope Treasury will approve it.

Thank you.

Senator DURENBERGER. Thank you.
Gentlemen, thank you very much.

Mr. ZSCHAU. Thank you, Mr. Chairman.
Mr. CHANDLER. Thank you.

Senator DURENBERGER. Our next witness is the Honorable John E. Chapoton, Assistant Secretary for Tax Policy, Department of the Treasury.

Welcome, Buck.

STATEMENT OF HON. JOHN E. CHAPOTON, ASSISTANT SECRETARY FOR TAX POLICY, DEPARTMENT OF THE TREASURY, WASHINGTON, DC

Mr. CHAPOTON. Thank you, Mr. Chairman.

I've got a rather lengthy statement, and I will attempt to summarize it. I will summarize it, briefly, but I want to spend most of my time on the definition of the credit. I think that is the point that we spent a lot of time on and that I think is of interest to the subcommittee.

I want to stress that several of the points I make are still under active review in our Department. We may be furnishing further views to the subcommittee at a later time.

We have testified before this subcommittee many times on this subject. We made the point before that a business will invest in R&D to the point where the expected return on the investment is equal to the return on other investments but that the profit motive may not lead to socially optimal levels of R&D because a private investor may not enjoy the full return realized from his innovations. To the extent that the market fails to reward the efforts, then we think government may be appropriate for R&E, particularly appropriate for basic research, but it is appropriate for research beyond that generally termed "basic."

We have in the law now, adopted in 1981, section 44F, which gives a tax credit equal to 25 percent of qualified research expenditures over those expenses during a base period, being a 3-year base period preceding the current year.

The legislative history of the credit indicates that you are supposed to let the existing definition under section 174 to determine what was the research or experimentation, but when we looked at 174 we found no precise definition. In many cases under that law, which allowed a deduction only, the taxpayer would have had a deduction either under the 174 or section 162 as an ordinary necessary business expense, so there wasn't much attention on that definition.

We thus had a case where there was a vague definition under existing law that did allow taxpayers to assert that the cost of developing virtually any product qualified for the credit.

We had some little experience with the credit now; we have been able to analyze pretty thoroughly the 1981 returns. The credit became available for investment, R&D expenses, after July 1, 1981.

Our sample of tax returns indicates that 12,300 corporations reported $3.4 billion of qualified incremental R&E expenditures on their 1981 returns. They claimed $858 million of R&E credit.

Of the total amount, half went to 53 companies which reported $2.3 million of credit. This shouldn't be surprising; these are all very large companies and all have very large R&D budgets.

The credit also went to companies outside of manufacturing and utility areas. About one-third of the companies in the 1983 returns had principal lines of business outside of those areas. These companies were the trade, service, and financial sectors, and they claimed growth in qualified R&E from 1980 to 1981 of some 91 percent.

Taxpayers in other industries also claimed the credit in 1981, businesses such as fast-food restaurants, baked goods, home building, publishing, banking, stock brokerage, and movie production. All claimed the credit.

I think it is pretty clear that we have some cases far from the high technology research area.

S. 2165 is an effort to narrow the scope of the present credit by adopting a new definition of "qualified research." We think S. 2165 represents an improvement over existing law, but we have some concerns about how the bill defines "new or significantly improved" business items which would qualify for the credit. And unless this definition is narrowed to confine it to items which in fact are new and significantly improved from the technological standpoint, we could not support the definition in S. 2165.

Let me look at the terminology used in 2165. It could result in an extremely low threshhold for the credit, which would enable taxpayers to claim the credit for virtually all preproduction expenses as qualifying for the credit. If this occurs, the credit will apply to an overly-broad range of activities and thus will be an ill-effective tool in encouraging innovative research and experimentation.

The critical definition is of the words "new" and "significantly improved." We think, as we read the legislation and as we discussed it with some of its supporters, this definition will exclude only purely stylistic changes. We believe even trivial functional improvements would qualify.

We point out in our testimony some examples that we think would qualify under the bill. Development of products which involve no technological innovation, or development of products that

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incorporate well established, known technology might well qualify for the credit under the bill.

We think that to provide various incentives or increased levels of innovative R&E, the definition of "research" and "experimental" should be targeted to truly innovative activities. We believe the intended credit as an incentive will be dissipated if products designed to produce any functional improvement receive the credit.

We suggest that the expenses associated with an activity should qualify for the credit only if, as of the time the taxpayer commences the activity, the taxpayer intends to achieve a significant technological improvement in a business component.

We would focus on the business component, that is the most basic element or component part of a product or process, with respect to withdrawing the activities undertaken, to see if the required substantial technological improvement is found.

If all the activities relating to the entire product or process, then the entire development cost of the entire product would be creditable; but, if the R&E activities are undertaken to produce substantial technological improvement only with respect to a component part, and the taxpayer incurs more than an insignificant amount of non-R&E development costs with respect to other aspects of the product or process, and only the R&E costs related to the component would be eligible for the credit.

We think that focusing on the particular component which is substantially improved would prevent routine product development costs from qualifying for the credit. We give an example in the testimony that if a taxpayer were going to develop a new personal computer, but combines existing widely available component parts in the development of the computer, except that he develops an entirely new type of screen which would cause less eye strain and produce better graphics, and incurs substantial R&E expenditures in the development of the screen and substantial engineering costs in combining the various parts in developing the new computer, we would think that the cost of developing the entire computer would not qualify for the credit, but the cost of the substantial improvement in the screen would qualify for the credit.

In determining how you define or how the taxpayer knows whether he is setting out to make a significant technological improvement, we think that it will be necessary, unfortunately, to examine all of the facts and circumstances of a case. It is difficult to determine precisely the proper scope of the credit, but we think it is possible to articulate factors which tend to indicate whether or not the taxpayer sought a significant technological improvement.

One factor we think should be conclusive; that is, if it can be shown that the taxpayer faced a substantial risk that the technology result that he sought could not be achieved, then that, in all events, should make the costs involved creditable. And that determination should be made with respect to each component of the product.

But even where there is no clear showing that a substantial technological risk is present, but factors could indicate that the taxpayer sought a technological improvement and therefore the credit would be available, we list factors such as the taxpayer showing that he sought a meaningful functional improvement in a business