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or research are primarily for the benefit of the grantor (Treas. Regs. sec. 1.117-4(c)). However, amounts received under Federal programs that are used for qualified tuition and related expenses are not disqualified from the exclusion merely because the recipient agrees to perform future services as a Federal employee or in a health manpower shortage area (sec. 117(c)).

Forgiveness of debt.-As a general rule, income is realized when indebtedness is forgiven or cancelled (sec. 61(a)(12)).

S. 1194 (section 4) and S. 1195 (section 4)

The bills would provide a new Code section under which gross income would not include amounts received by graduate science students as a scholarship, fellowship grant, or qualified student loan forgiveness, notwithstanding that the recipient is required to perform future teaching services as a condition of receiving such amounts.

The new provision would apply to students who are engaged in postgraduate study as degree candidates in mathematics, engineering, the physical or biological sciences, or certain computer fields at qualified educational organizations. To be eligible for the exclusion where future teaching services are required, the scholarship, grant, or loan forgiveness amount must be used for qualified tuition and related expenses, including tuition and fees, books, supplies, and equipment required for courses.

The scholarship and loan forgiveness provisions of the bills would apply to taxable years beginning after the date of enactment.

II. DESCRIPTION OF BILLS

1. S. 654-Senators Wallop, Armstrong, Symms, Boren, Durenberger, Danforth, Roth, Glenn, Heinz, Packwood, Chafee, Bentsen, and Baucus

Rules for Allocating Research Expenditures to U.S.-Source

Income

Treasury Regulations

In determining foreign-source taxable income for purposes of computing the foreign tax credit limitation (sec. 904), and for other tax purposes, Code sections 861-863 require taxpayers to allocate or apportion expenses between foreign-source income and U.S.-source income. Treasury Regulation section 1.861-8 sets forth rules for allocating and apportioning these expenses.

Under this regulation, research and development expenditures ("research expenditures") are allocated to income based on a broad classification of 32 product groups enumerated in the Standard Industrial Classification ("SIC") Manual. Research expenditures are not allocable solely to the income generated by the particular product which benefited from the research activity. Instead, these expenditures are allocable to all the income within the SIC product group in which the product is classified. Accordingly, once a research expenditure is identified with a SIC product group, it is apportioned to foreign sources based on the ratio of total foreign source sales receipts or income within the SIC product group to the total worldwide sales receipts or income within the SIC product group.

Treasury Regulation section 1.861-8 provides certain "safe harbors" when more than 50 percent of the research expenditures are incurred either within or without the United States. For years beginning in 1979, the regulation allows a taxpayer to apportion 30 percent of the research expenditures to the geographic source in which more than 50 percent of such expenditures were incurred. The regulation also provides that if the taxpayer's results of operations justify a geographic apportionment of research expenditures to the country in which the research is performed that would be higher than the 30 percent allowed under this safe harbor rule, then the taxpayer may make such higher allocation. The remaining portion of the research expenditures is then apportioned based upon the SIC formula.

Explanation of 1981 Provision

In the Economic Recovery Tax Act of 1981 (ERTA), the Congress directed the Treasury Department to study the impact of the research expenditure allocation provisions of Treasury Regulation

section 1.861-8 on research activities conducted in the United States and on the availability of the foreign tax credit. The study, with recommendations to the Congress, is to be submitted by the Secretary of the Treasury to the Senate Committee on Finance and the House Committee on Ways and Means.

Also, for a taxpayer's first two taxable years beginning after the date of enactment of ERTA (August 13, 1981), all research and experimental expenditures (within the meaning of Code sec. 174) which are paid or incurred in those taxable years (and only in those taxable years) for research activities conducted in the United States are to be allocated or apportioned to sources within the United States for all purposes under the Code (sec. 223 of ERTA). One reason for enacting this two-year suspension was that some foreign countries do not allow deductions under their tax laws for expenses of research activities conducted in the United States. It was argued that this disallowance results in unduly high foreign taxes and that, absent changes in the foreign tax credit limitation, U.S. taxpayers would lose foreign tax credits. Because those taxpayers could take their deductions if the research occurs in the foreign country, it was argued that there was incentive for taxpayers to shift their research expenditures to those foreign countries whose laws disallow tax deductions for research activities conducted in the United States but allow tax deductions for research expenditures incurred locally.

Accordingly, the Congress concluded that the Treasury should study the impact of the allocation of research expenses under Regulations section 1.861-8 on U.S.-based research activities. While that study is being conducted by the Treasury and considered by the Congress, the Congress concluded that expenses should be charged to the cost of generating U.S.-source income, whether or not such research directly or indirectly is a cost of producing foreign-source income.

General rule

Explanation of the Bill

S. 654 would provide that for purposes of Code sections 861(b) and 862(b), all amounts allowable as a deduction for research and experimental expenditures (within the meaning of sec. 174) attributable to activities conducted in the United States are to be allocated to sources within the United States.

Effective date

The amendment made by the bill would apply retroactively to taxable years beginning after 1980.

2. S. 738-Senators Danforth, Bentsen, Chafee, Glenn, Grassley, Symms, Boren, Tsongas, Durenberger, Wilson, and Cohen Make Permanent the Credit for Increased Research Expenditures Present Law

Current deduction for certain research expenditures

General rule.-As a general rule, business expenditures to develop or create an asset which has a useful life that extends beyond the taxable year, such as expenditures to develop a new product or improve a production process, must be capitalized. However, Code section 174 permits a taxpayer to elect to deduct currently the amount of "research or experimental expenditures" incurred in connection with the taxpayer's trade or business. For example, a taxpayer may elect to expense the costs of wages paid for services performed in qualifying research activities, and of supplies and materials used in such activities, even though these research costs otherwise would have to be capitalized.

The section 174 election does not apply to expenditures for the acquisition or improvement of depreciable property, or land, to be used in connection with research. Thus, for example, the cost of a research building or of equipment used for research cannot be expensed under 174. However, depreciation (cost recovery) allowances with respect to depreciable property used for research may be expensed under the election. Under ACRS, machinery and equipment used in connection with research and experimentation are classified as three-year recovery property and are eligible for a six-percent regular investment tax credit.

Qualifying expenditures.-The Code does not specifically define "research or experimental expenditures" eligible for the section 174 deduction election (except to exclude certain costs). Treasury regulations (sec. 1.174-2(a)) define this term to mean "research and development costs in the experimental or laboratory sense." This includes generally "all such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property", and also the costs of obtaining a patent on such property.

The present regulations provide that qualifying research expenditures do not include expenditures "such as those for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotions." Also, the section 174 election cannot be applied to costs of acquiring another person's patent, model, production, or process or to research expenditures incurred in connection with literary, historical, or similar projects (Reg. sec. 1.174-2(a)).

Credit for increasing certain research expenditures

Overview

General rule.-An income tax credit is allowed for certain qualified research expenditures paid or incurred by a taxpayer during the taxable year in carrying on a trade or business of the taxpayer (Code sec. 44F, enacted in the Economic Recovery Tax Act of 1981). The credit applies only to the extent that the taxpayer's qualified research expenditures for the taxable year exceed the average amount of the taxpayer's yearly qualified research expenditures in the specified base period (generally, the preceding three taxable years). The rate of the credit is 25 percent of the incremental research expenditure amount.

Under present law, the section 44F credit applies to qualified research expenditures paid or incurred after June 30, 1981 and before January 1, 1986.

Qualifying expenditures.-For purposes of the section 44F credit, the definition of research is the same as that used for purposes of the special deduction rules under section 174, but subject to certain exclusions. A taxpayer's research expenditures eligible for the section 44F incremental credit consist of (1) "in-house" expenditures by the taxpayer for research wages and supplies used in research, plus certain amounts paid for research use of laboratory equipment, computers, or other personal property; (2) 65 percent of amounts paid by the taxpayer for contract research conducted on the taxpayer's behalf; and (3) if the taxpayer is a corporation, 65 percent of the taxpayer's expenditures (including grants or contributions) pursuant to a written research agreement for basic research to be performed by universities or certain scientific research organizations.

Relation to deduction.-The credit is available for incremental qualified research expenditures for the taxable year whether or not the taxpayer has elected under section 174 to expense research expenditures. The amount of any section 174 deduction to which the taxpayer is entitled is not reduced by the amount of any credit allowed for qualified research expenditures.

Explanation of incremental credit

Definition of qualifying research

General rule.-Subject to certain exclusions, the credit provision adopts the definition of research as used in section 174. That is, the term "qualified research" for purposes of section 44F has the same meaning, subject to the specified exclusions, as has the term "research or experimental" under section 174.1

Computer software development costs.-The Internal Revenue Service has taken the position that certain costs of developing computer software may be treated in a manner similar to costs in

1 While the definition of research generally is the same for purposes both of section 174 deduction election and the credit, particular research expenditures which qualify for the section 174 deduction election may be ineligible for the credit, e.g., because the expenditures fail to satisfy the section 162 trade or business requirement for the credit, because the expenditures do not fall within the categories of research expenditures (such as direct research wages) which qualify for the credit, or because the expenditures fall within one of the exclusions from the credit.

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