Thursday, July 2, 2020
Stephen E. Shay (Harvard), Reuven S. Avi-Yonah (Michigan), Patrick Driessen, J. Clifton Fleming, Jr. (BYU) & Robert J. Peroni (Texas), Why R&D Should Be Allocated to Subpart F and GILTI, 167 Tax Notes Fed. 2081 (June 22, 2020):
In this article, the authors critically appraise the government’s proposal not to allocate research and development deductions to subpart F inclusions and global intangible low-taxed income for foreign tax credit limitation purposes. They say the proposal is an unprecedented interpretation of the statute unsupported by any relevant legislative history that would radically change an R&D allocation method in place since 1977. They argue that the justifications provided in the proposed regulations’ preamble do not stand up to scrutiny.
The proposed regulations’ failure to allocate R&D expense to subpart F inclusions and GILTI is a radical change to the long-standing regulatory interpretation of taxable income from sources outside the United States. There is no indication in the TCJA legislative history that Congress sought that change, and there is a long contrary history indicating congressional blessing of or acquiescence to the approach of the current regulations.
The proposed regulations’ justifications for a non-allocation rule do not withstand scrutiny. The assertion that R&D ultimately results in intangible property disregards the substantial expenditures made for unsuccessful R&D that do not result in intangible property. The assertion that R&D resulting in intangible property will be compensated by returns to that property disregards the substantial R&D performed to develop or support intangible property licensed under open-license or royalty-free business models. It also disregards the difficulty of associating R&D with intangible property developed long after the R&D expense was incurred. Finally, the assumption that the section 482 transfer pricing authority granted to the government will assure that all returns from intangible property developed from R&D will be paid by CFCs defies the practical realities of enforcing transfer pricing and belies the congressional purpose for adopting the GILTI regime to restrict profits shifting despite the availability of section 482.
The effect of the proposed regulations’ R&D allocation rule will be to overstate taxable income from non-U.S. sources in the numerator of the FTC limitation fraction and thereby inappropriately reimburse taxpayers for foreign taxes on U.S. income. That will benefit the foreign countries whose taxes would be reimbursed by the United States.
The proposed regulations’ exclusion of subpart F inclusions and GILTI from R&D expense allocation should not be adopted. Instead, R&D deductions should be allocated across all categories of income in groupings of three-digit SIC product categories, and those allocations should otherwise follow reg. section 1.861-17 as it would be modified by the proposed regulations.