[Code of Federal Regulations]
[Title 26, Volume 9]
[Revised as of April 1, 2002]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.861-17]

[Page 240-252]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1--INCOME TAXES--Table of Contents
 
Sec. 1.861-17  Allocation and apportionment of research and experimental expenditures.

    (a) Allocation--(1) In general. The methods of allocation and 
apportionment of research and experimental expenditures set forth in 
this section recognize that research and experimentation is an 
inherently speculative activity, that findings may contribute unexpected 
benefits, and that the gross income derived from successful research and 
experimentation must bear the cost of unsuccessful research and 
experimentation. Expenditures for research and experimentation that a 
taxpayer deducts under section 174 ordinarily shall be considered 
deductions that are definitely related to all income reasonably 
connected with the relevant broad product category (or categories) of 
the taxpayer and therefore allocable to all items of gross income as a 
class (including income from sales, royalties, and dividends) related

[[Page 241]]

to such product category (or categories). For purposes of this 
allocation, the product category (or categories) that a taxpayer may be 
considered to have shall be determined in accordance with the provisions 
of paragraph (a)(2) of this section.
    (2) Product categories--(i) Allocation based on product categories. 
Ordinarily, a taxpayer's research and experimental expenditures may be 
divided between the relevant product categories. Where research and 
experimentation is conducted with respect to more than one product 
category, the taxpayer may aggregate the categories for purposes of 
allocation and apportionment; however, the taxpayer may not subdivide 
the categories. Where research and experimentation is not clearly 
identified with any product category (or categories), it will be 
considered conducted with respect to all the taxpayer's product 
categories.
    (ii) Use of three digit standard industrial classification codes. A 
taxpayer shall determine the relevant product categories by reference to 
the three digit classification of the Standard Industrial Classification 
Manual (SIC code). A copy may be purchased from the Superintendent of 
Documents, United States Government Printing Office, Washington, DC 
20402. The individual products included within each category are 
enumerated in Executive Office of the President, Office of Management 
and Budget, Standard Industrial Classification Manual, 1987 (or later 
edition, as available).
    (iii) Consistency. Once a taxpayer selects a product category for 
the first taxable year for which this section is effective with respect 
to the taxpayer, it must continue to use that product category in 
following years, unless the taxpayer establishes to the satisfaction of 
the Commissioner that, due to changes in the relevant facts, a change in 
the product category is appropriate. For this purpose, a change in the 
taxpayer's selection of a product category shall include a change from a 
three digit SIC code category to a two digit SIC code category, a change 
from a two digit SIC code category to a three digit SIC code category, 
or any other aggregation, disaggregation or change of a previously 
selected SIC code category.
    (iv) Wholesale trade category. The two digit SIC code category 
``Wholesale trade'' is not applicable with respect to sales by the 
taxpayer of goods and services from any other of the taxpayer's product 
categories and is not applicable with respect to a domestic 
international sales corporation (DISC) or foreign sales corporation 
(FSC) for which the taxpayer is a related supplier of goods and services 
from any of the taxpayer's product categories.
    (v) Retail trade category. The two digit SIC code category ``Retail 
trade'' is not applicable with respect to sales by the taxpayer of goods 
and services from any other of the taxpayer's product categories, except 
wholesale trade, and is not applicable with respect to a DISC or FSC for 
which the taxpayer is a related supplier of goods and services from any 
other of the taxpayer's product categories, except wholesale trade.
    (3) Affiliated Groups--(i) In general. Except as provided in 
paragraph (a)(3)(ii) of this section, the allocation and apportionment 
required by this section shall be determined as if all members of the 
affiliated group (as defined in Sec. 1.861-14T(d)) were a single 
corporation. See Sec. 1.861-14T.
    (ii) Possessions corporations. (A) For purposes of the allocation 
and apportionment required by this section, sales and gross income from 
products produced in whole or in part in a possession by an electing 
corporation (within the meaning of section 936(h)(5)(E)), and dividends 
from an electing corporation, shall not be taken into account, except 
that this paragraph (a)(3)(ii) shall not apply to sales of (and gross 
income and dividends attributable to sales of) products with respect to 
which an election under section 936(h)(5)(F) is not in effect.
    (B) The research and experimental expenditures taken into account 
for purposes of this section shall be reduced by the amount of such 
expenditures included in computing the cost-sharing amount (determined 
under section 936(h)(5)(C)(i)).
    (4) Legally mandated research and experimentation. Where research 
and experimentation is undertaken solely to meet legal requirements 
imposed by a political entity with respect to improvement or marketing 
of specific

[[Page 242]]

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 
experimentation shall be considered definitely related and therefore 
allocable only to the grouping (or groupings) of gross income within 
that geographic source as a class (and apportioned, if necessary, 
between such groupings as set forth in paragraphs (c) and (d) of this 
section). For example, where a taxpayer performs tests on a product in 
response to a requirement imposed by the U.S. Food and Drug 
Administration, and the test results cannot reasonably be expected to 
generate amounts of gross income (beyond de minimis amounts) outside the 
United States, the costs of testing shall be allocated solely to gross 
income from sources within the United States.
    (b) Exclusive apportionment--(1) In general. An exclusive 
apportionment shall be made under this paragraph (b), where an 
apportionment based upon geographic sources of income of a deduction for 
research and experimentation is necessary (after applying the exception 
in paragraph (a)(4) of this section).
    (i) Exclusive apportionment under the sales method. If the taxpayer 
apportions on the sales method under paragraph (c) of this section, an 
amount equal to fifty percent of such deduction for research and 
experimentation shall be apportioned exclusively to the statutory 
grouping of gross income or the residual grouping of gross income, as 
the case may be, arising from the geographic source where the research 
and experimental activities which account for more than fifty percent of 
the amount of such deduction were performed.
    (ii) Exclusive apportionment under the optional gross income 
methods. If the taxpayer apportions on the optional gross income methods 
under paragraph (d) of this section, an amount equal to twenty-five 
percent of such deduction for research and experimentation shall be 
apportioned exclusively to the statutory grouping or the residual 
grouping of gross income, as the case may be, arising from the 
geographic source where the research and experimental activities which 
account for more than fifty percent of the amount of such deduction were 
performed.
    (iii) Exception. If the applicable fifty percent geographic source 
test of the preceding paragraph (b)(1)(i) or (ii) is not met, then no 
part of the deduction shall be apportioned under this paragraph (b)(1).
    (2) Facts and circumstances supporting an increased exclusive 
apportionment--(i) In general. The exclusive apportionment provided for 
in paragraph (b)(1) of this section reflects the view that research and 
experimentation is often most valuable in the country where it is 
performed, for two reasons. First, research and experimentation often 
benefits a broad product category, consisting of many individual 
products, all of which may be sold in the nearest market but only some 
of which may be sold in foreign markets. Second, research and 
experimentation often is utilized in the nearest market before it is 
used in other markets, and in such cases, has a lower value per unit of 
sales when used in foreign markets. The taxpayer may establish to the 
satisfaction of the Commissioner that, in its case, one or both of the 
conditions mentioned in the preceding sentences warrant a significantly 
greater exclusive allocation percentage than allowed by paragraph (b)(1) 
of this section because the research and experimentation is reasonably 
expected to have very limited or long delayed application outside the 
geographic source where it was performed. Past experience with research 
and experimentation may be considered in determining reasonable 
expectations.
    (ii) Not all products sold in foreign markets. For purposes of 
establishing that only some products within the product category (or 
categories) are sold in foreign markets, the taxpayer shall compare the 
commercial production of individual products in domestic and foreign 
markets made by itself, by uncontrolled parties (as defined under 
paragraph (c)(2)(i) of this section) of products involving intangible 
property which was licensed or sold by the taxpayer, and by those 
controlled corporations (as defined under paragraph (c)(3)(ii) of this 
section) that can reasonably be expected to benefit directly

[[Page 243]]

or indirectly from any of the taxpayer's research expense connected with 
the product category (or categories). The individual products compared 
for this purpose shall be limited, for nonmanufactured categories, 
solely to those enumerated in Executive Office of the President, Office 
of Management and Budget Standard Industrial Classification Manual, 1987 
(or later edition, as available), and, for manufactured categories, 
solely to those enumerated at a 7-digit level in the U.S. Bureau of the 
Census, Census of Manufacturers: 1992, Numerical List of Manufactured 
Products, 1993, (or later edition, as available). Copies of both of 
these documents may be purchased from the Superintendent of Documents, 
United States Government Printing Office, Washington, DC 20402.
    (iii) Delayed application of research findings abroad. For purposes 
of establishing the delayed application of research findings abroad, the 
taxpayer shall compare the commercial introduction of its own particular 
products and processes (not limited by those listed in the Standard 
Industrial Classification Manual or the Numerical List of Manufactured 
Products) in the United States and foreign markets, made by itself, by 
uncontrolled parties (as defined under paragraph (c)(2)(i) of this 
section) of products involving intangible property that was licensed or 
sold by the taxpayer, and by those controlled corporations (as defined 
under paragraph (c)(3)(i) of this section) that can reasonably be 
expected to benefit, directly or indirectly, from the taxpayer's 
research expense. For purposes of evaluating the delay in the 
application of research findings in foreign markets, the taxpayer shall 
use a safe haven discount rate of 10 percent per year of delay unless he 
is able to establish to the satisfaction of the Commissioner, by 
reference to the cost of money and the number of years during which 
economic benefit can be directly attributable to the results of the 
taxpayer's research, that another discount rate is more appropriate.
    (c) Sales method--(1) In general. The amount equal to the remaining 
portion of such deduction for research and experimentation, not 
apportioned under paragraph (a)(4) or (b)(1)(i) of this section, shall 
be apportioned between the statutory grouping (or among the statutory 
groupings) within the class of gross income and the residual grouping 
within such class in the same proportions that the amount of sales from 
the product category (or categories) that resulted in such gross income 
within the statutory grouping (or statutory groupings) and in the 
residual grouping bear, respectively, to the total amount of sales from 
the product category (or categories).
    (i) Apportionment in excess of gross income. Amounts apportioned 
under this section may exceed the amount of gross income related to the 
product category within the statutory grouping. In such case, the excess 
shall be applied against other gross income within the statutory 
grouping. See Sec. 1.861-8(d)(1) for instances where the apportionment 
leads to an excess of deductions over gross income within the statutory 
grouping.
    (ii) Leased property. For purposes of this paragraph (c), amounts 
received from the lease of equipment during a taxable year shall be 
regarded as sales receipts for such taxable year.
    (2) Sales of uncontrolled parties. For purposes of the apportionment 
under paragraph (c)(1) of this section, the sales from the product 
category (or categories) by each party uncontrolled by the taxpayer, of 
particular products involving intangible property that was licensed or 
sold by the taxpayer to such uncontrolled party shall be taken fully 
into account both for determining the taxpayer's apportionment and for 
determining the apportionment of any other member of a controlled group 
of corporations to which the taxpayer belongs if the uncontrolled party 
can reasonably be expected to benefit directly or indirectly (through 
any member of the controlled group of corporations to which the taxpayer 
belongs) from the research expense connected with the product category 
(or categories) of such other member. An uncontrolled party can 
reasonably be expected to benefit from the research expense of a member 
of a controlled group of corporations to which the taxpayer belongs if 
such member can reasonably be expected to license, sell, or transfer 
intangible property to that uncontrolled

[[Page 244]]

party or transfer secret processes to that uncontrolled party, directly 
or indirectly through a member of the controlled group of corporations 
to which the taxpayer belongs. Past experience with research and 
experimentation shall be considered in determining reasonable 
expectations.
    (i) Definition of uncontrolled party. For purposes of this paragraph 
(c)(2) the term uncontrolled party means a party that is not a person 
with a relationship to the taxpayer specified in section 267(b), or is 
not a member of a controlled group of corporations to which the taxpayer 
belongs (within the meaning of section 993(a)(3) or 927(d)(4)).
    (ii) Licensed products. In the case of licensed products, if the 
amount of sales of such products is unknown (for example, where the 
licensed product is a component of a large machine), a reasonable 
estimate based on the principles of section 482 should be made.
    (iii) Sales of intangible property. In the case of sales of 
intangible property, regardless of whether the consideration received in 
exchange for the intangible is a fixed amount or is contingent on the 
productivity, use, or disposition of the intangible, if the amount of 
sales of products utilizing the intangible property is unknown, a 
reasonable estimate of sales shall be made annually. If necessary, 
appropriate economic analyses shall be used to estimate sales.
    (3) Sales of controlled parties. For purposes of the apportionment 
under paragraph (c)(1) of this section, the sales from the product 
category (or categories) of the taxpayer shall be taken fully into 
account and the sales from the product category (or categories) of a 
corporation controlled by the taxpayer shall be taken into account to 
the extent provided in this paragraph (c)(3) for determining the 
taxpayer's apportionment, if such corporation can reasonably be expected 
to benefit directly or indirectly (through another member of the 
controlled group of corporations to which the taxpayer belongs) from the 
taxpayer's research expense connected with the product category (or 
categories). A corporation controlled by the taxpayer can reasonably be 
expected to benefit from the taxpayer's research expense if the taxpayer 
can be expected to license, sell, or transfer intangible property to 
that corporation or transfer secret processes to that corporation, 
either directly or indirectly through a member of the controlled group 
of corporations to which the taxpayer belongs. Past experience with 
research and experimentation shall be considered in determining 
reasonable expectations.
    (i) Definition of a corporation controlled by the taxpayer. For 
purposes of this paragraph (c)(3), the term a corporation controlled by 
the taxpayer means any corporation that has a relationship to the 
taxpayer specified in section 267(b) or is a member of a controlled 
group of corporations to which the taxpayer belongs (within the meaning 
of section 993(a)(3) or 927(d)(4).
    (ii) Sales to be taken into account. The sales from the product 
category (or categories) of a corporation controlled by the taxpayer 
taken into account shall be equal to the amount of sales that bear the 
same proportion to the total sales of the controlled corporation as the 
total value of all classes of the stock of such corporation owned 
directly or indirectly by the taxpayer, within the meaning of section 
1563, bears to the total value of all classes of stock of such 
corporation.
    (iii) Sales not to be taken into account more than once. Sales from 
the product category (or categories) between or among such controlled 
corporations or the taxpayer shall not be taken into account more than 
once; in such a situation, the amount sold by the selling corporation to 
the buying corporation shall be subtracted from the sales of the buying 
corporation.
    (iv) Effect of cost-sharing arrangements. If the corporation 
controlled by the taxpayer has entered into a bona fide cost-sharing 
arrangement, in accordance with the provisions of Sec. 1.482-7, with the 
taxpayer for the purpose of developing intangible property, then that 
corporation shall not reasonably be expected to benefit from the 
taxpayer's share of the research expense.
    (d) Gross income methods--(1)(i) In general. In lieu of applying the 
sales method of paragraph (c) of this section, the remaining amount of 
the deduction for research and experimentation, not apportioned under 
paragraph (a)(4) or

[[Page 245]]

(b)(1)(ii) of this section, shall be apportioned as prescribed in 
paragraphs (d)(2) and (3) of this section, between the statutory 
grouping (or among the statutory groupings) of gross income and the 
residual grouping of gross income.
    (ii) Optional methods to be applied to all research and experimental 
expenditures. These optional methods must be applied to the taxpayer's 
entire deduction for research and experimental expense remaining after 
applying the exception in paragraph (a)(4) of this section, and may not 
be applied on a product category basis. Thus, after the allocation of 
the taxpayer's entire deduction for research and experimental expense 
under paragraph (a)(2) of this section (by attribution to SIC code 
categories), the taxpayer must then apportion as necessary the entire 
deduction as allocated by separate amounts to various product 
categories, using only the sales method under paragraph (c) of this 
section or only the optional gross income methods under this paragraph 
(d). The taxpayer may not use the sales method for a portion of the 
deduction and optional gross income methods for the remainder of the 
deduction separately allocated.
    (2) Option one. The taxpayer may apportion its research and 
experimental expenditures ratably on the basis of gross income between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping of gross income in the same proportions 
that the amount of gross income in the statutory grouping (or groupings) 
and the amount of gross income in the residual grouping bear, 
respectively, to the total amount of gross income, if the conditions 
described in paragraph (d)(2)(i) and (ii) of this section are both met.
    (i) The amount of research and experimental expense ratably 
apportioned to the statutory grouping (or groupings in the aggregate) is 
not less than fifty percent of the amount that would have been so 
apportioned if the taxpayer had used the method described in paragraph 
(c) of this section; and
    (ii) The amount of research and experimental expense ratably 
apportioned to the residual grouping is not less than fifty percent of 
the amount that would have been so apportioned if the taxpayer had used 
the method described in paragraph (c) of this section.
    (3) Option two. If, when the amount of research and experimental 
expense is apportioned ratably on the basis of gross income, either of 
the conditions described in paragraph (d)(2)(i) or (ii) of this section 
is not met, the taxpayer may either--
    (i) Where the condition of paragraph (d)(2)(i) of this section is 
not met, apportion fifty percent of the amount of research and 
experimental expense that would have been apportioned to the statutory 
grouping (or groupings in the aggregate) under paragraph (c) of this 
section to such statutory grouping (or to such statutory groupings in 
the aggregate and then among such groupings on the basis of gross income 
within each grouping), and apportion the balance of the amount of 
research and experimental expenses to the residual grouping; or
    (ii) Where the condition of paragraph (d)(2)(ii) of this section is 
not met, apportion fifty percent of the amount of research and 
experimental expense that would have been apportioned to the residual 
grouping under paragraph (c) of this section to such residual grouping, 
and apportion the balance of the amount of research and experimental 
expenses to the statutory grouping (or to the statutory groupings in the 
aggregate and then among such groupings ratably on the basis of gross 
income within each grouping).
    (e) Binding election--(1) In general. A taxpayer may choose to use 
either the sales method under paragraph (c) of this section or the 
optional gross income methods under paragraph (d) of this section for 
its original return for its first taxable year to which this section 
applies. The taxpayer's use of either the sales method or the optional 
gross income methods for its return filed for its first taxable year to 
which this section applies shall constitute a binding election to use 
the method chosen for that year and for four taxable years thereafter.
    (2) Change of method. The taxpayer's election of a method may not be 
revoked during the period referred to in paragraph (e)(1) of this 
section without the prior consent of the Commissioner.

[[Page 246]]

After the expiration of that period, the taxpayer may change methods 
without the prior consent of the Commissioner. However, the taxpayer's 
use of the new method shall constitute a binding election to use the new 
method for its return filed for the first year for which the taxpayer 
uses the new method and for four taxable years thereafter. The 
taxpayer's election of the new method may not be revoked during that 
period without the prior consent of the Commissioner.
    (i) Short taxable years. For purposes of this paragraph (e), the 
term taxable year includes a taxable year of less than twelve months.
    (ii) Affiliated groups. In the case of an affiliated group, the 
period referred to in paragraph (e)(1) of this section shall commence as 
of the latest taxable year in which any member of the group has changed 
methods.
    (f) Special rules for partnerships--(1) Research and experimental 
expenditures. For purposes of applying this section, if research and 
experimental expenditures are incurred by a partnership in which the 
taxpayer is a partner, the taxpayer's research and experimental 
expenditures shall include the taxpayer's distributive share of the 
partnership's research and experimental expenditures.
    (2) Purpose and location of expenditures. In applying the exception 
for expenditures undertaken to meet legal requirements under paragraph 
(a)(4) of this section and the exclusive apportionment for the sales 
method and the optional gross income methods under paragraph (b) of this 
section, a partner's distributive share of research and experimental 
expenditures incurred by a partnership shall be treated as incurred by 
the partner for the same purpose and in the same location as incurred by 
the partnership.
    (3) Apportionment under the sales method. In applying the remaining 
apportionment for the sales method under paragraph (c) of this section, 
a taxpayer's sales from a product category shall include the taxpayer's 
share of any sales from the product category of any partnership in which 
the taxpayer is a partner. For purposes of the preceding sentence, a 
taxpayer's share of sales shall be proportionate to the taxpayer's 
distributive share of the partnership's gross income in the product 
category.
    (g) Effective date. This section applies to taxable years beginning 
after December 31, 1995. However, a taxpayer may at his or her option, 
apply this section in its entirety to all taxable years beginning after 
August 1, 1994.
    (h) Examples. The following examples illustrate the application of 
this section:

    Example 1 --(i) Facts. X, a domestic corporation, is a manufacturer 
and distributor of small gasoline engines for lawn mowers. Gasoline 
engines are a product within the category, Engines and Turbines (SIC 
Industry Group 351). Y, a wholly owned foreign subsidiary of X, also 
manufactures and sells these engines abroad. During 1996, X incurred 
expenditures of $60,000 on research and experimentation, which it 
deducts as a current expense, to invent and patent a new and improved 
gasoline engine. All of the research and experimentation was performed 
in the United States. In 1996, the domestic sales by X of the new engine 
total $500,000 and foreign sales by Y total $300,000. X provides 
technology for the manufacture of engines to Y via a license that 
requires the payment of an arm's length royalty. In 1996, X's gross 
income is $160,000, of which $140,000 is U.S. source income from 
domestic sales of gasoline engines and $10,000 is foreign source 
royalties from Y, and $10,000 is U.S. source interest income.
    (ii) Allocation. The research and experimental expenditures were 
incurred in connection with small gasoline engines and they are 
definitely related to the items of gross income to which the research 
gives rise, namely gross income from the sale of small gasoline engines 
in the United States and royalties received from subsidiary Y, a foreign 
manufacturer of gasoline engines. Accordingly, the expenses are 
allocable to this class of gross income. The U.S. source interest income 
is not within this class of gross income and, therefore, is not taken 
into account.
    (iii) Apportionment. (A) For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general limitation gross 
income from sources without the United States and the residual grouping 
is gross income from sources within the United States. Since the related 
class of gross income derived from the use of engine technology consists 
of both gross income from sources without the United States (royalties 
from Y) and gross income from sources within the United States (gross 
income from engine sales), X's deduction of $60,000 for its research and 
experimental expenditure must

[[Page 247]]

be apportioned between the statutory and residual grouping before the 
foreign tax credit limitation may be determined. Because more than 50 
percent of X's research and experimental activity was performed in the 
United States, 50 percent of that deduction can be apportioned 
exclusively to the residual grouping of gross income, gross income from 
sources within the United States. The remaining 50 percent of the 
deduction can then be apportioned between the residual and statutory 
groupings on the basis of sales of small gasoline engines by X and Y. 
Alternatively, X's deduction for research and experimentation can be 
apportioned under the optional gross income method. The apportionment 
for 1996 is as follows:

            (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned          $60,000
 between residual and statutory groupings of gross income:...
(ii) Less: Exclusive apportionment of research and               $30,000
 experimental expense to the residual grouping of gross
 income ($60,000x50 percent):................................
(iii) Research and experimental expense to be apportioned        $30,000
 between residual and statutory groupings of gross income on
 the basis of sales:.........................................
(iv) Apportionment of research and experimental expense to       $18,750
 the residual grouping of gross income ($30,000x$500,000/
 ($500,000+$300,000)):.......................................
(v) Apportionment of research and experimental expense to the    $11,250
 statutory grouping of gross income ($30,000x$300,000/
 ($500,000+$300,000)):.......................................
(vi) Total apportioned deduction for research and                $60,000
 experimentation:............................................
(vii) Amount apportioned to the residual grouping                $48,750
 ($30,000+$18,750):..........................................
(viii) Amount apportioned to the statutory grouping:.........    $11,250


        (2) Tentative Apportionment on the Basis of Gross Income.

(i) Exclusive apportionment of research and experimental         $15,000
 expense to the residual grouping of gross income ($60,000x25
 percent):...................................................
(ii) Research and experimental expense apportioned to sources    $42,000
 within the United States (residual grouping)
 ($45,000x$140,000/($140,000+$10,000)):......................
(iii) Research and experimental expense apportioned to            $3,000
 sources within country Y (statutory grouping)
 ($45,000x$10,000/($140,000+$10,000)):.......................
(iv) Amount apportioned to the residual grouping:............    $57,000
(v) Amount apportioned to the statutory grouping:............     $3,000


    (B) The total research and experimental expense apportioned to the 
statutory grouping ($3,000) under the gross income method is 
approximately 26 percent of the amount apportioned to the statutory 
grouping under the sales method. Thus, X may use option two of the gross 
income method (paragraph (d)(3) of this section) and apportion to the 
statutory grouping fifty percent (50%) of the $11,250 apportioned to 
that grouping under the sales method. Thus, X apportions $5,625 of 
research and experimental expense to the statutory grouping. X's use of 
the optional gross income methods will constitute a binding election to 
use the optional gross income methods for 1996 and four taxable years 
thereafter.
    Example 2 --(i) Facts. Assume the same facts as in Example 1 except 
that X also spends $30,000 in 1996 for research on steam turbines, all 
of which is performed in the United States, and X has steam turbine 
sales in the United States of $400,000. X's foreign subsidiary Y neither 
manufactures nor sells steam turbines. The steam turbine research is in 
addition to the $60,000 in research which X does on gasoline engines for 
lawnmowers. X thus has a deduction of $90,000 for its research activity. 
X's gross income is $200,000, of which $140,000 is U.S. source income 
from domestic sales of gasoline engines, $50,000 is U.S. source income 
from domestic sales of steam turbines, and $10,000 is foreign source 
royalties from Y.
    (ii) Allocation. X's research expenses generate income from sales of 
small gasoline engines and steam turbines. Both of these products are in 
the same three digit SIC code category, Engines and Turbines (SIC 
Industry

[[Page 248]]

Group 351). Therefore, the deduction is definitely related to this 
product category and allocable to all items of income attributable to 
it. These items of X's income are gross income from the sale of small 
gasoline engines and steam turbines in the United States and royalties 
from foreign subsidiary Y, a foreign manufacturer and seller of small 
gasoline engines.
    (iii) Apportionment. (A) For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general limitation gross 
income from sources outside the United States and the residual grouping 
is gross income from sources within the United States. X's deduction of 
$90,000 must be apportioned between the statutory and residual 
groupings. Because more than 50 percent of X's research and experimental 
activity was performed in the United States, 50 percent of that 
deduction can be apportioned exclusively to the residual grouping, gross 
income from sources within the United States. The remaining 50 percent 
of the deduction can then be apportioned between the residual and 
statutory groupings on the basis of total sales of small gasoline 
engines and steam turbines by X and Y. Alternatively, X's deduction for 
research and experimentation can be apportioned under the optional gross 
income methods. The apportionment for 1996 is as follows:

            (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned          $90,000
 between residual and statutory groupings of gross income:...
(ii) Less: Exclusive apportionment of the research and           $45,000
 experimental expense to the residual grouping of gross
 income ($90,000x50 percent):................................
(iii) Research and experimental expense to be apportioned        $45,000
 between the residual and statutory groupings of gross income
 on the basis of sales:......................................
(iv) Apportionment of research and experimental expense to       $33,750
 the residual grouping of gross income
 ($45,000x($500,000+$400,000)/($500,000+$400,000+$300,000)):.
(v) Apportionment of research and experimental expense to the    $11,250
 statutory grouping of gross income ($45,000x$300,000/
 ($500,000+$400,000+$300,000)):..............................
(vi) Total apportioned deduction for research and                $90,000
 experimentation:............................................
(vii) Amount apportioned to the residual grouping                $78,750
 ($45,000+$33,750):..........................................
(viii) Amount apportioned to the statutory grouping:.........    $11,250


         (2) Tentative Apportionment on the Basis of Gross Income

(i) Exclusive apportionment of research and experimental         $22,500
 expense to the residual grouping of gross income ($90,000x25
 percent):...................................................
(ii) Research and experimental expense apportioned to sources    $64,125
 within the United States (residual grouping)
 ($67,500x$190,000/($140,000+$50,000+$10,000)):..............
(iii) Research and experimental expense apportioned to            $3,375
 sources within country Y (statutory grouping)
 ($67,500x$10,000/($140,000+$50,000+$10,000)):...............
(iv) Amount apportioned to the residual grouping:............    $86,625
(v) Amount apportioned to the statutory grouping:............     $3,375


    (B) The total research and experimental expense apportioned to the 
statutory grouping ($3,375) under the gross income method is 30 percent 
of the amount apportioned to the statutory grouping under the sales 
method. Thus, X may use option two of the gross income method (paragraph 
(d)(3) of this section) and apportion to the statutory grouping fifty 
percent (50%) of the $11,250 apportioned to that grouping under the 
sales method. Thus, X apportions $5,625 of research and experimental 
expense to the statutory grouping. X's use of the optional gross income 
methods will constitute a binding election to use the optional gross 
income methods for 1996 and four taxable years thereafter.
    Example 3 --(i) Facts. Assume the same facts as in Example 1 except 
that in 1997 X continues its sales of the new engines, with sales of 
$600,000 in the United States and

[[Page 249]]

$400,000 abroad by subsidiary Y. X also acquires a 60 percent (by value) 
ownership interest in foreign corporation Z and a 100 percent ownership 
interest in foreign corporation C. X transfers its engine technology to 
Z for a royalty equal to 5 percent of sales, and X enters into an arm's 
length cost-sharing arrangement with C to share the funding of all of 
X's research activity. In 1997, corporation Z has sales in country Z 
equal to $1,000,000. X incurs expense of $80,000 on research and 
experimentation in 1997, and in addition, X performs $15,000 of research 
on gasoline engines which was funded by the cost-sharing arrangement 
with C. All of Z's sales are from the product category, Engines and 
Turbines (SIC Industry Group 351). X performs all of its research in the 
United States and $20,000 of its expenditure of $80,000 is made solely 
to meet pollution standards mandated by law. X establishes, to the 
satisfaction of the Commissioner, that the expenditure in response to 
pollution standards is not expected to generate gross income (beyond de 
minimis amounts) outside the United States.
    (ii) Allocation. The $20,000 of research expense which X incurred in 
connection with pollution standards is definitely related and thus 
allocable to the residual grouping, gross income from sources within the 
United States. The remaining $60,000 in research and experimental 
expenditure incurred by X is definitely related to all gasoline engines 
and is therefore allocable to the class of gross income to which the 
engines give rise, gross income from sales of gasoline engines in the 
United States, royalties from country Y, and royalties from country Z. 
No part of the $60,000 research expense is allocable to dividends from 
country C, because corporation C has already paid, through its cost-
sharing arrangement, for research activity performed by X which may 
benefit C.
    (iii) Apportionment. For purposes of applying the foreign tax credit 
limitation, the statutory grouping is general limitation gross income 
from sources without the United States, and the residual grouping is 
gross income from sources within the United States. X's deduction of 
$60,000 for its research and experimental expenditure must be 
apportioned between these groupings. Because more than 50 percent of the 
research and experimentation was performed in the United States, 50 
percent of the $60,000 deduction can be apportioned exclusively to the 
residual grouping. The remaining 50 percent of the deduction can then be 
apportioned between the residual and the statutory grouping on the basis 
of sales of gasoline engines by X, Y, and Z. (If X utilized the optional 
gross income methods in 1996, then its use of such methods constituted a 
binding election to use the optional gross income methods in 1996 and 
for four taxable years thereafter. If X utilized the sales method in 
1996, then its use of such method constituted a binding election to use 
the sales method in 1996 and for four taxable years thereafter.) The 
optional gross income methods are not illustrated in this Example 3 (see 
instead Examples 1 and 2). Since X has only a 60 percent ownership 
interest in corporation Z, only 60 percent of Z's sales (60% of 
$1,000,000, or $600,000) are included for purposes of apportionment. The 
allocation and apportionment for 1997 is as follows:

(A) X's total research expense:..............................    $80,000
(B) Less: Legally mandated research directly allocated to the    $20,000
 residual grouping of gross income:..........................
(C) Tentative apportionment on the basis of sales............
(1) Research and experimental expense to be apportioned          $60,000
 between residual and statutory groupings of gross income:...
(2) Less: Exclusive apportionment of research and                $30,000
 experimental expense to the residual grouping of gross
 income ($60,000x50 percent):................................
(3) Research and experimental expense to be apportioned          $30,000
 between the residual and the statutory groupings on the
 basis of sales:.............................................
(4) Apportionment of research and experimental expense to        $11,250
 gross income from sources within the United States (residual
 grouping) ($30,000x$600,000/($600,000+$400,000+$600,000)):..
(5) Apportionment of research and experimental expense to        $18,750
 general limitation gross income from countries Y and Z
 (statutory grouping) ($30,000x$400,000+$600,000/
 ($600,000+$400,000+$600,000)):..............................
(6) Total apportioned deduction for research and                 $60,000
 experimentation ($30,000+$30,000):..........................
(7) Amount apportioned to the residual grouping                  $41,250
 ($30,000+$11,250):..........................................
(8) Amount apportioned to the statutory grouping of gross        $18,750
 income from sources within countries Y and Z:...............



[[Page 250]]

    Example 4 --Research and Experimentation--(i) Facts. X, a domestic 
corporation, manufactures and sells forklift trucks and other types of 
materials handling equipment in the United States. The manufacture and 
sale of forklift trucks and other materials handling equipment belongs 
to the product category, Construction, Mining, and Materials Handling 
Machinery and Equipment (SIC Industry Group 353). X also sells its 
forklift trucks to a wholesaling subsidiary located in foreign country Y 
(but title passes in the United States), and X manufactures forklift 
trucks in foreign country Z. The wholesaling of forklift trucks to 
country Y also belongs to X's product category Transportation equipment 
and, therefore, may not belong to the product category, Wholesale trade 
(SIC Major Group 50 and 51). In 1997, X sold $7,000,000 of forklift 
trucks to purchasers in the United States, $3,000,000 of forklift trucks 
to the wholesaling subsidiary in Y, and transferred forklift truck 
components with an FOB export value of $2,000,000 to its branch in Z. 
The branch's sales of finished forklift trucks were $5,000,000. In 
response to legally mandated emission control requirements, X's United 
States research department has been engaged in a research project to 
improve the performance and quality of engine exhaust systems used on 
its products in the United States. It incurs expenses of $100,000 for 
this purpose in 1997. In the past, X has customarily adapted the product 
improvements developed originally for the domestic market to its 
forklift trucks manufactured abroad. During the taxable year 1997, 
development of an improved engine exhaust system is completed and X 
begins installing the new system during the latter part of the taxable 
year in products manufactured and sold in the United States. X continues 
to manufacture and sell forklift trucks in foreign countries without the 
improved engine exhaust systems.
    (ii) Allocation. X's deduction for its research expense is 
definitely related to the income to which it gives rise, namely income 
from the manufacture and sale of forklift trucks within the United 
States and in country Z. Although the research is undertaken in response 
to a legal mandate, it can reasonably be expected to generate gross 
income from the manufacture and sale of trucks by the branch in Z. 
Therefore, the deduction is not allocable solely to income from X's 
domestic sales of forklift trucks. It is allocable to income from such 
sales and income from the sales of X's branch in Z.
    (iii) Apportionment. For the method of apportionment on the basis of 
either sales or gross income, see Example 3. However, in determining the 
amount of research apportioned to income from foreign and domestic 
sources, the net sales of the branch in Z are $3,000,000 ($5,000,000 
less $2,000,000) and the sales within the United States are $12,000,000 
($7,000,000 plus $3,000,000 plus $2,000,000). See Sec. 1.861-
17(c)(3)(iii).
    Example 5 --(i) Facts. X, a domestic corporation, is a drug company 
that manufactures a wide variety of pharmaceutical products for sale in 
the United States. Pharmaceutical products belong to the product 
category, Drugs (SIC Industry Group 283). X exports its pharmaceutical 
products through a foreign sales corporation (FSC). X's wholly owned 
foreign subsidiary Y also manufactures pharmaceutical products. In 1997, 
X has domestic sales of pharmaceutical products of $10,000,000, the FSC 
has sales of pharmaceutical products of $3,000,000, and Y has sales of 
pharmaceutical products of $5,000,000. In that same year, 1997, X incurs 
expense of $200,000 on research to test a product in response to 
requirements imposed by the United States Food and Drug Administration 
(FDA). X is able to show that, even though country Y imposes certain 
testing requirements on pharmaceutical products, the research performed 
in the United States is not accepted by country Y for purposes of its 
own licensing requirements, and the research has minimal use abroad. X 
is further able to show that FSC sells goods to countries that do not 
accept or do not require research performed in the United States for 
purposes of their own licensing standards.
    (ii) Allocation. Since X's research expense of $200,000 is 
undertaken to meet the requirements of the United States Food and Drug 
Administration, and since it is reasonable to expect that the 
expenditure will not generate gross income (beyond de minimis amounts) 
outside the United States, the deduction is definitely related and thus 
allocable to the residual grouping.
    (iii) Apportionment. No apportionment is necessary since the entire 
expense is allocated to the residual grouping, gross income from sales 
within the United States.
    Example 6 --(i) Facts. X, a domestic corporation, is engaged in 
continuous research and experimentation to improve the quality of the 
products that it manufactures and sells, which are floodlights, 
flashlights, fuse boxes, and solderless connectors. X incurs and deducts 
$100,000 of expenditure for research and experimentation in 1997 that 
was performed exclusively in the United States. As a result of this 
research activity, X acquires patents that it uses in its own 
manufacturing activity. X licenses its floodlight patent to Y and Z, 
uncontrolled foreign corporations, for use in their own territories, 
countries Y and Z, respectively. Corporation Y pays X an arm's length 
royalty of $3,000 plus $0.20 for each floodlight sold. Sales of 
floodlights by Y for the taxable year are $135,000 (at $4.50 per unit) 
or 30,000 units, and the royalty is $9,000 ($3,000 + $0.20 x 30,000). Y 
has sales of other products of $500,000. Z pays X an arm's length 
royalty of $3,000 plus $0.30 for each unit sold. Z manufactures 30,000

[[Page 251]]

floodlights in the taxable year, and the royalty is $12,000 ($3,000 + 
$0.30 x 30,000). The dollar value of Z's floodlight sales is not known 
and cannot be reasonably estimated because, in this case, the 
floodlights are not sold separately by Z but are instead used as a 
component in Z's manufacture of lighting equipment for theaters. The 
sales of all Z's products, including the lighting equipment for 
theaters, are $1,000,000. Y and Z each sell the floodlights exclusively 
within their respective countries. X's sales of floodlights for the 
taxable year are $500,000 and its sales of its other products, 
flashlights, fuse boxes, and solderless connectors, are $400,000. X has 
gross income of $500,000, consisting of gross income from domestic 
sources from sales of floodlights, flashlights, fuse boxes, and 
solderless connectors of $479,000, and royalty income of $9,000 and 
$12,000 from foreign corporations Y and Z respectively. X utilized the 
optional gross income methods of apportionment for its return filed for 
its first taxable year to which this section applies.
    (ii) Allocation. X's research and experimental expenses are 
definitely related to all of the products that it produces, which are 
floodlights, flashlights, fuse boxes, and solderless connectors. All of 
these products are in the same three digit SIC Code category, Electric 
Lighting and Wiring Equipment (SIC Industry Group 364). Thus, X's 
research and experimental expenses are allocable to all items of income 
attributable to this product category, domestic sales income and royalty 
income from the foreign countries in which corporations Y and Z operate.
    (iii) Apportionment. (A) The statutory grouping of gross income is 
general limitation income from sources without the United States. The 
residual grouping is gross income from sources within the United States. 
X's deduction of $100,000 for its research expenditures must be 
apportioned between the groupings. For apportionment on the basis of 
sales in accordance with paragraph (c) of this section, X is entitled to 
an exclusive apportionment of 50 percent of its research and 
experimental expense to the residual grouping, gross income from sources 
within the United States, since more than 50 percent of the research 
activity was performed in the United States. The remaining 50 percent of 
the deduction can then be apportioned between the residual and statutory 
groupings on the basis of sales. Since Y and Z are unrelated licensees 
of X, only their sales of the licensed product, floodlights, are 
included for purposes of apportionment. Floodlight sales of Z are 
unknown, but are estimated at ten times royalties from Z, or $120,000. 
All of X's sales from the entire product category are included for 
purposes of apportionment on the basis of sales. Alternatively, X may 
apportion its deduction on the basis of gross income, in accordance with 
paragraph (d) of this section. The apportionment is as follows:

            (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned         $100,000
 between statutory and residual groupings of gross income:...
(ii) Less: Exclusive apportionment of research and               $50,000
 experimental expense to the residual groupings of gross
 income ($100,000x50 percent):...............................
(iii) Research and experimental expense to be apportioned        $50,000
 between the statutory and residual groupings of gross income
 on the basis of sales:......................................
(iv) Apportionment of research and experimental expense to       $38,961
 the residual groupings of gross income ($50,000x$900,000/
 ($900,000+$135,000+$120,000)):..............................
(v) Apportionment of research and experimental expense to the    $11,039
 statutory grouping, royalty income from countries Y and Z
 ($50,000x$135,000+$120,000/($900,000+$135,000+$120,000)):...
(vi) Total apportioned deduction for research and               $100,000
 experimentation:............................................
(vii) Amount apportioned to the residual grouping                $88,961
 ($50,000+$38,961):..........................................
(viii) Amount apportioned to the statutory grouping of           $11,039
 sources within countries Y and Z:...........................


            (2) Tentative Apportionment on Gross Income Basis

(i) Exclusive apportionment of research and experimental         $25,000
 expense to the residual grouping of gross income
 ($100,000x25 percent):......................................
(ii) Apportionment of research and experimental expense to       $71,850
 the residual grouping of gross income ($75,000x$479,000/
 $500,000):..................................................

[[Page 252]]


(iii) Apportionment of research and experimental expense to       $3,150
 the statutory grouping of gross income
 ($75,000x$9,000+$12,000/$500,000):..........................
(iv) Amount apportioned to the residual grouping:............    $96,850
(v) Amount apportioned to the statutory grouping of general       $3,150
 limitation income from sources without the United States:...


    (B) Since X has elected to use the optional gross income methods of 
apportionment and its apportionment on the basis of gross income to the 
statutory grouping, $3,150, is less than 50 percent of its apportionment 
on the basis of sales to the statutory grouping, $11,039, it must use 
Option two of paragraph (d)(3) of this section and apportion $5,520 (50 
percent of $11,039) to the statutory grouping.

[T.D. 8646, 60 FR 66503, Dec. 22, 1995]