DOMESTIC CORPORATION'S R&D EXPENSES UNDER GROUP AGREEMENT WILL BE DEDUCTIBLE.

Index Nos.: 0174.00-00, 0861.00-00

December 18, 1980

Refer Reply to: T:C:C:2:2

The facts as presented indicate that X is a *** corporation. M, a *** corporation, owns directly or indirectly *** percent of the issued and outstanding voting stock of X. The remainder of X's stock is widely held and publicly traded. X and its subsidiaries are engaged in the business of manufacturing and distributing various *** products. Through the *** products business, X and its subsidiaries are involved in the *** business to a significant degree.

M, directly or indirectly, owns a majority interest in each of the corporations which are a party to the cost sharing agreement described below.

Briefly, N, O, P, Q, R, and S (the Foreign Parties) and X have all entered into a cost sharing agreement (Agreement) to perform research and development (R&D) in the *** field for the stated purpose of achieving overall economies and efficiencies for all concerned. It is stated that neither M or any of the Foreign Parties are engaged in the conduct of a trade or business in the United States.

X and certain of the Foreign Parties presently conduct research and development involving *** at their own facilities and with their own personnel and equipment at their own cost.

The Agreement will be administered by representatives of all of the parties meeting at least annually and as often as is otherwise necessary. It is stated that the joint determinations made at this meeting would establish, among other things, what research and development was to be done and the specific facilities at which it would be performed, as well as various budgeting decisions.

As set forth in the Agreement, the parties will share the cost and expenses incurred in connection with the R&D Program in proportion to their total sales of *** products during the preceding year. To the extent that a party's personnel, plant, equipment, or other fixed property are utilized in carrying out the R&D Program, the amount of such party's gross contribution (determined by reference to its *** sales) shall be adjusted to reach a net contribution by taking into account the direct and indirect R&D expenses that the party incurred.

Each party will have a joint ownership interest in any industrial property rights developed through the R&D Program ("*** Technology"). Each party's ownership interest in the *** Technology will be proportional to such party's share of the total costs of the R&D Program. Generally, each of the parties has the right to use all *** Technology developed by the R&D Program in its own business without compensation or charge to the other parties. The Agreement requires the parties to transfer legal title in the *** Technology to a "grouping of economic interest" ("GIE"), a newly formed *** entity, for purposes of centralizing, obtaining, protecting, and licensing, any such industrial property rights. Among the administrative functions performed by the *** are: the administration of programs to protect worldwide property rights in the *** Technology; administration of certain pre-existing third-party licensing agreements involving *** Technology, and the administration of any new third-party licensing arrangements involving the *** Technology. The parties will retain beneficial interest in the *** Technology in proportion to their respective shares of the total R&D Program costs.

The Agreement provides that the Agreement has retroactive effect as of January 1, *** and shall exist for a period of ten years unless terminated or extended by the parties.

Article 6 of the Agreement contains a number of miscellaneous provisions. Article 6.01 expressed the clear intention of the parties that, under the Agreement, they are not forming, and do not intend to form, a legal entity. Article 6.02 indicates that each of the parties will have access to the books and records of the other parties for purposes of administering the Agreement. Under Article 6.05, the Agreement is binding on the successor to any of the original parties if the successor is at least a 50% subsidiary of Corporation M.

Under the Agreement, the R&D Program expenditures are exclusively for the development of new experimental or pilot models, industrial processes, products, formulas, and improvements of already existing processes within the *** Field. No funds are to be expended for the acquisition of another's patent, model, production or process. Within the framework of the Agreement the parties will not acquire land, or depreciable or depletable property.

Also, X has stated that it paid or was deemed to have paid creditable foreign income taxes of approximately *** million in 1979, and claimed full credit against its federal income tax liability for those foreign taxes. Apportioning the R&D deductions as between domestic and foreign source income, under section 861 of the Code, has not resulted in any diminution of X's available foreign tax credits, due to tax rate differentials or the availability of similar apportionment methods in computing X's foreign tax obligations.

Under the Agreement, it is anticipated that X will make total expenditures for R&D in the *** Field of approximately *** million in *** million in cash paid to the *** budget and *** million expended through utilization of X's own R&D facilities in furtherance of the R&D Program.

X has requested a ruling that its share of expenditures made pursuant to the Agreement will be treated as "research experimental expenditure" made by X.

Section 174 of the Code provides, in part, that a taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to a capital account. The expenditures so treated shall be allowed as a deduction.

Section 1.174 -- 2(a)(1) of the Income Tax Regulations defines the term "research or experimental expenditures" to mean expenditures incurred in connection with the taxpayer's trade or business which represents research or development costs in the experimental or laboratory sense. The term 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 the improvement of already existing property of the type mentioned.

Section 1.174 -- 2(a)(2) of the regulations provides, in part, that section 174 of the Code shall also apply to expenditures paid or incurred by the taxpayer for research or experimentation carried on in its behalf by another person or organization.

Rev. Rul. 73-2, 1973 -- 1 C.B. 133, and Rev. Rul. 73-324, 1973 -- 2 C.B. 72).

Generally the expenditures made by X pursuant to the Agreement are for new models, processes, products etc. of a type which would qualify as "experimental or laboratory" expenditures.

Accordingly, based upon the above statement of facts and consistent with the Agreement, it is held that the program expenditures made exclusively for the development of experimental or pilot models, industrial processes, products, formulas, and improvements of already existing property are research or experimental expenditures under section 174 of the Code. Therefore, the amounts expended by X for direct research as well as amounts incurred for research by others would qualify for a deduction pursuant to section 174(a).

X has also requested the following rulings:

(1) For purposes of the exclusive apportionment rules of section 1.861 -- 8(e)(3)(ii)(A) of the regulations, the geographic source where the research and development activities, which account for more than 50 percent of the research and development expense deduction, were performed, will be determined solely by reference to X's research and development activities; and X's expenditures pursuant to the Agreement thus will be treated as having a geographic source within the United States to the extent of X's contributions in kind performed in the United States.

(2) If it is determined on audit that the Agreement is a bona fide cost sharing arrangement within the meaning of section 1.482 -- 2(d)(4) for the purpose of developing intangible property then in apportioning the remaining portion of X's research and development expense deduction not apportioned under section 1.861 -- 8(e)(3)(ii)(A), X will not take into account for purposes of the fraction stated in section 1.861 -- 8(e)(3)(ii)(B), sales from the product category (or categories) of any "corporation controlled by the taxpayer" (as defined in section 1.861 -- 8(e)(3)(ii)(D)) which is a party to the Arrangement.

Section 1.861 -- 8(e)(3) of the regulations provides rules for the allocation and apportionment of research and experimental expenditures. Section 1.861 -- 8(e)(3)(i)(A) provides, in part, that expenditures for research and development which a taxpayer deducts under section 174 shall ordinarily be considered deductions which are definately 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 to the product category (or categories) listed in section 1.861 -- 8(e)(3)(i)(A). For purposes of this allocation, the product category (or categories) which a taxpayer may be considered to have is limited to the list provided in section 1.861 -- 8(e)(3)(1)(A).

Section 1.861 -- 8(e)(3)(ii)(A) of the regulations provides, in part, that where an apportionment based upon geographic sources of income of a deduction for research and development is necessary, an amount equal to 30 percent, in the case of a taxable year beginning during 1979, and thereafter, of such deduction for research and development 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 development activities which account for more than 50 percent of the amount of such deduction were performed. If the 50 percent test of the preceding sentence is not met, then no part of the deduction all be apportioned under this subdivision (ii)(A).

Section 1.861 -- 8(e)(3)(ii)(B) of the regulations provides, in part, that the amount equal to the remaining portion of such deduction for research and development not apportioned under (A) of this subdivision (ii), 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) which 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).

Section 1.861 -- 8(e)(3)(ii)(c) of the regulations provides in part, that for purposes of the apportionment under (B) of this subdivision (ii), the sales from the product category (or categories) by each party uncontrolled by the taxpayer, of particular products involving intangible property which 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. For purposes of this subdivision (ii)(c), the term "uncontrolled party" means a party which 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)).

Section 1.861 -- 8(e)(3)(ii)(D) of the regulations, provides in part, and in general, that for purposes of the apportionment under (B) of this subdivision (ii), 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 (1) or (2) of this subdivision (ii)(D) 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). For purpose of this subdivision (ii)(D), the term "a corporation controlled by the taxpayer" means any corporation other than an "uncontrolled party" as defined in (c) of this subdivision (ii). However, if the corporation controlled by the taxpayer has entered into a bona fide cost sharing arrangement in accordance with the provisions of section 1.482 -- 2(d)(4), with the taxpayer for the purpose of developing intangible property, then that corporation cannot be expected to benefit from the taxpayer's share of the research expense.

Section 1.861 -- 8(e)(3)(iii) of the regulations provides an optional gross income method for apportionment of research and development expense.

With respect to the ruling requested regarding exclusive apportionment of R&D expenses, section 1.861 -- 8(e)(3)(ii)(A) of the regulations provides, in part, that where an apportionment based on geographic sources of income of a deduction is necessary, an amount equal to 30 percent in the case of a taxable year beginning during 1979 and thereafter, of such deduction for research and development shall be apportioned exclusively to the statutory grouping of gross income, as the case may be, arising from the geographic source where the research and development activities which account for more than 50 percent of the amount of such deduction were performed. The regulations indicate that in applying the 50 percent test of the exclusive apportionment rules (section 1.861 -- 8(e)(3)(ii)(A)), the appropriate reference point is the geographic source where the research and development activities which account for more than 50 percent of the amount of such deduction (i.e., the research and development deduction claimed under section 174 by a taxpayer) were performed. As a result, for purposes of the exclusive apportionment rules of section 1.861 -- 8(e)(3)(ii)(A) the geographic source where the research and development activities which account for more than 50 percent of the research and development expense deduction were performed, will be determined solely by reference to the taxpayer's research and development activities. Further since the taxpayer's contributions in kind to the cost sharing agreement will be performed in the United States, such in kind contributions will be treated as having a geographic source within the United States for purposes of section 1.861 -- 8(e)(3)(ii)(A).

With respect to the taxpayer's ruling request regarding apportionment of amounts not exclusively apportioned under section 1.861 -- 8(e)(3)(ii)(A), section 1.861 -- 8(e)(3)(ii)(D) of the regulations provides, in general, that sales from the product category of a corporation controlled by the taxpayer shall be taken into account for determining the taxpayer's apportionment if such corporation can reasonably be expected to benefit directly or indirectly from the taxpayer's research expense connected with the product category. However, if the corporation controlled by the taxpayer has entered into a bona fide cost sharing arrangement in accordance with the provisions of section 1.482 -- 2(d)(4), 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. Therefore, if it is determined on audit that the cost sharing agreement is a bona fide cost sharing arrangement within the meaning of section 1.482 -- 2(d)(4) for the purpose of developing intangible property, then in apportioning the remaining portion of the taxpayer's research and development expense deduction not apportioned under section 1.861 -- 8(e)(3)(ii)(A), the taxpayer will not take into account for purposes of the fraction stated in section 1.861 -- 8(e)(3)(ii)(B), sales from the product category (or categories) of any "corporation controlled by the taxpayer" (as defined in section 1.861 -- 8(d)(3)(ii)(D)) which is a party to the cost sharing arrangement.

Accordingly, based solely upon the above statement of fact and representations, it is held that:

(A) For purposes of the exclusive apportionment rules of section 1.861 -- 8(e)(3)(ii)(A) of the regulations, the geographic source where the research and development activities which account for more than 50 percent of the research and development expense deduction were performed, will be determined solely by reference to the taxpayer's research and development activities; and the taxpayer's expenditures pursuant to the cost sharing agreement will be treated as having a geographic source within the United States to the extent that the taxpayer's contributions in kind were performed in the United States.

(B) If it is determined on audit that the Agreement is a bona fide cost sharing arrangement within the meaning of section 1.482 -- 2(d)(4) of the regulations for the purpose of developing intangible property, then in apportioning the remaining portion of the taxpayer's research and development expense deduction not apportioned under section 1.861 -- 8(e)(3)(ii)(A), the taxpayer will not take into account for purposes of the fraction stated in section 1.861 -- 8(e)(3)(ii)(B), sales from the product category (or categories) of any "corporation controlled by the taxpayer" (as defined in section 1.861 -- 8(e)(3)(ii)(D)) which is a party to the cost sharing arrangement.

Pursuant to a power of attorney on file with this office a copy of this letter is being sent to your authorized representative.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

A copy of this letter should be attached to the appropriate federal income tax returns for the year in which the transaction in question is consummated.

Sincerely yours,