Attorneys Suggest Method for Allocating Research Credit Among Controlled Group Members
Attorneys Suggest Method for Allocating Research Credit Among Controlled Group Members
- AuthorsMoll, Charles J., IIIMacIntyre, Joy S.
- Institutional AuthorsMorrison & Foerster LLP
- Cross-Reference
- Code Sections
- Subject Area/Tax Topics
- Index Termsresearch credit
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 2000-23681 (19 original pages)
- Tax Analysts Electronic Citation2000 TNT 179-26
=============== SUMMARY ===============
Charles J. Moll III and Joy S. MacIntyre of Morrison & Foerster LLP, San Francisco, have urged Treasury to adopt the "incremental method" to allocate a controlled group's research credit among each group member under the proposed research credit regs. (For a summary of REG-105606-99, see Tax Notes, Jan. 10, 2000, p. 164; for the full text, see Doc 2000-834 (6 original pages), 1999 TNT 250-2 , or H&D, Dec. 30, 1999, p. 3545.)
According to Moll and MacIntyre, a special rule treating a consolidated group as a single "member" of a controlled group for allocation purposes is both "necessary and appropriate" to eliminate the potential for abuse. Also, they say, the incremental method is consistent with the statute and the purpose of the research credit.
=============== FULL TEXT ===============
August 7, 2000
By Overnight Delivery Service
The Honorable Jonathan Talisman
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220
Re: Proposed Regulations Under Section 41(f)(1) of the Internal
Revenue Code
Dear Mr. Talisman:
[1] This letter is submitted in response to your request for comments on proposed regulations, promulgated on January 4, 2000, implementing the aggregation rules under section 41(f)(1) of the Internal Revenue Code. 1 The proposed regulations (REG-105606-99) address two primary issues regarding the aggregation rules in light of statutory changes made by the Omnibus Reconciliation Act of 1989, Public Law 101-239, (the "1989 Act"): First, the manner in which the research credit is computed for a controlled group of corporations, and second, the manner in which the controlled group's research credit is allocated to each member of the group. In the preamble to the proposed regulations, Treasury also solicited comments on special rules for allocating the research credit among members of a controlled group that contains a consolidated group of corporations. Subsequent to the publication of the proposed regulations, Treasury has received comments critical of the regulations' approach to allocation and of the potential retroactivity of the regulations. 2
This letter is intended to:
o comment on the proposed regulations' approach to allocating
the group credit and potential retroactivity,
o comment on previously submitted criticisms of the proposed
regulations, and
o respond to Treasury's request for comments on the treatment of
consolidated groups.
[2] We applaud Treasury's efforts in providing guidance in this area. As will be discussed in greater detail herein, we believe the method chosen by Treasury to allocate the research credit to members of a controlled group is appropriate and consistent with the clearly expressed legislative intent behind the aggregation rules. In addition, we believe that a special rule treating a consolidated group as a single "member" of a controlled group for allocation purposes is both necessary and appropriate to eliminate the potential for abuse that exists in groups with such strong common interests. Finally, we believe Treasury has the requisite authority to apply the proposed regulations retroactively, at least in the case of abusive allocations.
I. BACKGROUND
[3] The general rules for computing the credit under Section 41(a)(1), as amended by the 1989 Act, are as follows:
o R&D Credit = 20%x [current Year Qualified Research
Expenditures ("QREs") - Base Amount]
o where Base Amount = Average gross receipts for preceding
four years x the Base Percentage, but in no event less
than 50% of current year QRE, and
o Base Percentage = 1984-1988 QRE/1984-1988 gross receipts,
but in no event greater than 16%.
[4] Section 41(f)(1), as amended by the 1989 Act, provides rules for computing the research credit for a controlled group of corporations, with "control" generally defined for this purpose as greater than 50-percent ownership. The statute provides that in general all group members are treated as a single taxpayer for purposes of computing the credit, and that the portion of the group credit allowable to each member is proportionate to its share of "qualified research expenses GIVING RISE TO THE CREDIT." (emphasis added). This "aggregation rule" was included in the research credit as originally enacted by the Economic Recovery Act of 1981 (the "1981 Act"). 3 The legislative history to the 1981 Act provides that the aggregation rules were intended "[t]o prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related entities."
[5] When enacted in 1981, the purpose of the aggregation rules was to serve as anti-abuse rules, specifically, to prohibit taxpayers from generating artificial increases in their current qualified research expenses over their base period qualified research expenses by shifting qualified research expenses between members of a controlled group. Because the 1989 Act changed the method by which the credit is computed, there are two potential abuses that the aggregation rules now must address, i.e., the manipulation of the credit by creating artificial increases in qualified research expenses AND the manipulation of the credit by artificial decreases in gross receipts, in either case by shifting expenses or gross receipts between members of the group. Thus, the aggregation rules have always been anti-abuse rules and, as such, should only in very limited circumstances interfere with the normal computation rules for the research credit in section 41(c) and thwart the intent of Congress to reward taxpayers who increase their research spending as a percentage of their gross receipts.
[6] The legislative history of the 1981 Act and Treasury Regulations thereunder contain a nearly identical example that unquestionably reflects the manner in which Congress intended the aggregation rules to function. 4 However, the amendments to section 41(c) made by the 1989 Act make the application of the examples under prior law somewhat uncertain for taxable years beginning after December 31, 1989. Importantly, however, Congress expressly provided in the legislative history to the 1989 Act that its amendments were not intended to alter the existing aggregation rules. 5
[7] In computing the credit for a "controlled group," as defined in section 41(f), the method adopted by the proposed regulations is to combine the aggregate qualified research expenses and the aggregate gross receipts for all members of the group for taxable years beginning after December 31, 1983, and before January 1, 1989, and compute an aggregate fixed-base percentage for the group to use in computing the group's base amount and credit. That method will be referred to herein as the "Complete Aggregation Method."
II. ALLOCATION OF THE CREDIT
[8] There are two theoretical ways in which the credit for the group, once computed using the Complete Aggregation Method, could be allocated to the members of the group. The credit could be allocated ratably to each member based on that member's contribution to the group's total increment over its base amount, with no credit being allocated to any member that did not have qualified research expenses in excess of its base amount (the "Incremental Method"). This is the method explicitly adopted by Congress in 1981 when the credit rules were enacted, and is the method contained in both the final and proposed regulations under section 1.41-8. The other method (the "Expenditure Method") is to allocate the credit ratably to each member based on its contribution to the group's total qualified research expense for the year.
[9] The proposed regulations adopt the Incremental Method, with each member's base amount equal to its four year average gross receipts times the group's fixed base percentage. We agree that the Incremental Method is the only allocation method that is consistent with the intent of Congress to reward those taxpayers who increase their research spending relative to their gross receipts. Moreover, the Incremental Method is the only method that is consistent with the statutory mandate that credits be allocated to those members whose QREs "give rise to the credit." Further, the Expenditure Method is subject to manipulation that the Incremental Method is not.
A. THE INCREMENTAL METHOD IS CONSISTENT WITH THE STATUTE AND THE PURPOSE OF THE CREDIT
[10] It is clear that under the law prior to amendment by the 1989 Act, the group credit was allocated among the members based upon the relative incremental QRE of the members. A member's incremental QRE equaled the member's QRE minus the member's base amount. If a member's QRE did not exceed its base amount, that member received no credit allocation because that member's QREs did not "give rise to the credit." The approach taken in the Incremental Method is nearly identical to that taken under prior law, except for those changes (for example, in the computation of the base amount) that result from the 1989 Act amendments. Thus, in order to be allocated any portion of the credit under the Incremental Method, a member must have achieved an excess of QREs over that member's base amount.
[11] In contrast, the Expenditure Method is a radical departure from prior law, as it would simply reward members with the greatest amounts of research spending without regard to whether that spending "gave rise to the credit." Indeed, as the following examples illustrate, a member might be allocated a credit under the Expenditure Method notwithstanding the fact that that member's QREs actually represent a DECREMENT that had the effect of REDUCING the amount of the credit to which the group was entitled. Such a result can hardly be considered consistent with Congress' statement that the 1989 Act did not change the aggregation rules.
[12] The following example illustrates this point. Assume that in 1998 X and Y are both C corporations using the calendar year as their taxable year, and that X owns an amount of Y's stock that constitutes "control" for purposes of section 41(f). Without regard to the aggregation rules in section 41(f), X and Y would have received the following amount of research credit:
EXAMPLE #1 -- X AND Y RESEARCH CREDIT WITHOUT AGGREGATION
_____________________________________________________________________
Fixed 4 Year Base Current Increment/
Corp Base % Avg. GR Amount QREs Decrement Credit
_____________________________________________________________________
X 2,000/100,000 (2%) 400,000 8,000 7,000 (1,000) 0
Y 1,000150,000 (2%) 150,000 3,000 5,000 2,000 400
[13] Using the Complete Aggregation Method, the two corporations would compute their research credit as follows, with the total credit for the two corporations equaling $200:
EXAMPLE #2 -- XY GROUP CREDIT
____________________________________________________________________
Fixed 4 Year Base Current Increment/
Group Base % Avg. GR Amount QREs Decrement Credit
____________________________________________________________________
XY 3,000/150,000 (2%) 550,000 11,000 12,000 1,000 200
EXAMPLE #3 -- ALLOCATION USING THE INCREMENTAL METHOD
_____________________________________________________________________
Corp Increment Allocation Group Allocated
Proportion Credit Credit
_____________________________________________________________________
X (1,000) 0/2,000 200 0
Y 2,000 2,000/2,000 200 200
Group 1,000 200 200
[14] Example #3 illustrates that the Incremental Method allocates the majority of the credit to the member that has the greater increment in qualified research expenses over its base amount, a result more consistent with that under obtained prior law as compared to the Expenditure Method.
EXAMPLE #4 -- ALLOCATION USING THE EXPENDITURE METHOD
____________________________________________________________________
Corp Current Year QRE Allocation Group Allocated
Proportion Credit Credit
____________________________________________________________________
X 7,000 7,000/12,000 200 116
Y 5,000 5,000/12,000 200 84
Group 12,000 200 200
[15] Example #4 illustrates that the Expenditure Method allocates the majority of the group's credit to the member of the group with the largest amount of qualified research expense notwithstanding that such member has no INCREMENTAL qualified research expense giving rise to the credit. This result is clearly in direct conflict with the pre-1989 Act law, the principles of section 41(c) and the legislative intent to the 1989 Act that the aggregation rules be left unchanged.
[16] It is also important to note that the loss of the tax benefit to Y is a permanent economic loss to Y's shareholders.
[17] The statutory language providing for the allocation must be interpreted against the backdrop of what the overall statute was intended to accomplish. The clearly expressed purpose behind the research credit is to encourage taxpayer investment in research, and the clearly expressed reasons for the changes made by the 1989 Act were to eliminate the disincentive effect of the "moving base" that existed under the 1981 Act, and make the credit available to a greater number of entities, including start-up companies. To those ends, a number of very detailed provisions were enacted in the 1989 Act, including the fixed base percentage and the phase-in for start- up companies. Various permutations of a floor (as to the base amount) and a ceiling (as to the base percentage) were considered before arriving at 50% and 16%, respectively. The legislative history to the 1989 Act describes the provisions Congress enacted and the intended effects of those provisions in great detail, confirming the extensive effort that went into designing those provisions to maximize the incentive effect of the credit. It is inconceivable that in the course of this detailed overhaul, Congress would have adopted, without discussion, an approach to allocating the credit for controlled groups that, as previously demonstrated, differs substantially from the results achieved under prior law. Such a rule hardly seems capable of being referred to as the same "rules" Congress referred to in the 1989 Act legislative history. By contrast, the results obtained through the Incremental Method are consistent with those obtained under prior law.
[18] Even though the aggregation rules in section 41(f)(1) are intended only to be anti-abuse rules, because the majority of the research credits claimed each year by taxpayers are claimed by larger businesses operating in controlled group situations the "anti-abuse" rules will likely apply in the majority of cases, whether or not any abuse actually or potentially exists. Thus, if the Expenditure Method is adopted it will grossly distort and potentially eliminate the incentive effect of the credit for the U.S. economy.
[19] Proponents of the Expenditure Method have argued that the 1989 Act's deletion of the word "increase" from the description of QREs giving rise to the credit was intended by Congress to move away from the incremental method of allocating the credit, to a flat allocation based solely on proportionate QREs. However, if Congress had intended to create a flat allocation method, presumably the language "giving rise to the credit" would also have been deleted from the allocation provision. Indeed, even while deleting the word "increase," Congress clearly stated that the allocation rules were not being changed. Moreover, if the phrase "giving rise to the credit" is to have any meaning, it can only be interpreted to mean QREs that exceed a member's base amount. That statutory language cannot be ignored as meaningless, as proponents of the Expenditure Method have argued. Nor would it be logical to believe that, having created an incremental credit, Congress would require an allocation of the credit among members of a controlled group based solely on absolute expenditures and having no relationship whatsoever to the incremental nature of the credit.
[20] Proponents of the Expenditure Method also have argued that the Incremental Method "conflicts with the statute" because, in order to apply the method, one must utilize concepts, such as a member's base amount, that are not otherwise required under the Complete Aggregation Method. This argument ignores the statutory language "giving rise to the credit" and would have Treasury believe that the statute itself prevents Treasury from effectuating the intent behind the statute. Such an argument defies reason. In any event, Treasury has had little trouble interpreting even very specific statutory mandates of Congress in a manner that did not reflect the letter of the statutory rule, in order to issue regulatory guidance that reflects the intent of the rule, makes sense and is more administrable. 6 It is especially appropriate for Treasury to issue sensible, administrable guidance in this case. It is not only fitting but necessary that Treasury should interpret the statute in a manner that is most consistent with the clear legislative history behind the aggregation, rules and the credit more generally. In this case, that requires that Treasury adopt the Incremental Method.
[21] Those proponents also have argued that the Incremental Method imposes substantial administrative burdens in computing numbers one would not otherwise need. This argument obviously is incorrect. Taxpayers will not be required to keep any additional records to perform the Incremental Method allocation than they would be required to keep if they used the Expenditure Method. For both methods, the members of the group will need to know the exact same information about each member of the group. The additional computations required to compute each member's separate base amount and increment or decrement would take only a few minutes to complete -- even with a very large group -- with the help of a desk-top computer spreadsheet.
B. THE RESULTS PRODUCED UNDER THE INCREMENTAL METHOD ARE FAIRER THAN THE RESULTS OF THE EXPENDITURE METHOD, ESPECIALLY AS TO MINORITY SHAREHOLDERS
[22] In describing the allocation of the credit, the preamble to the proposed regulations refers to a rule that "allocates the credit to those members whose share of current year [QREs] exceeds their share of the base amount," and further provides that the credit is "allocated to each member based on the ratio that the member's increase in its [QREs] over its base amount bears to the sum of each member's increase in [QREs] over its base amount." The dual purposes of the rules as described in the preamble are achieved by the proposed regulations because, first, under the Incremental Method a member whose QREs do not exceed that member's base amount will not be allocated any of the group's credit, and second, the members who do experience an increment in QREs over their base amount share proportionately in the group's credit. In this respect, the approach taken in the proposed regulations is similar to that taken under prior law.
[23] Proponents of the Expenditure Method have argued, however, that the proposed regulations "do not achieve their stated purpose." Those proponents describe the "stated purpose" of the regulations as "allocating the group's Research Credit among the members based on their relative contributions to the group's increase in qualified research expenses as a percentage of the group's gross receipts." 7 The proponents of the Expenditure Method cite Example 1 of the proposed regulations as an example of the failure of the proposed regulations to achieve what those proponents believe to be the stated purpose" of the regulations. It is true that computing the amount of the credit on a controlled group basis, using the Complete Aggregation Method, will, in some circumstances, limit the ability of the Incremental Method to comport precisely with the intent of the statute to reward members in accordance with their proportionate incremental QREs over their base amounts. It is important to note, however, that if the Expenditure Method appears to "cure" any potential unfairness on the facts of Example 1 of the proposed regulations, it is only as a result of the numbers used in that example.
[24] Assume instead that in Example 1 in the proposed regulation C spent more on qualified research than any other member of the group, but because it had reduced its research spending measured as a percentage of its gross receipts, C received no research credit in the current year on an individual basis. If C joined the AB group during the current taxable year, because the amount of the credit is a group computation under the Complete Aggregation Method the ABC group may receive less credit than the AB group would have otherwise received -- in fact the ABC group may receive no credit at all. Assuming the ABC group receives some credit, C will in all cases receive the largest portion of the credit. Thus, using the Expenditure Method, C will be "taking" credit from A and B twice: first, by adversely affecting their fixed-base percentage, and second, by getting a larger allocation of the group's credit. This is, essentially, the exact complaint proponents of the Expenditure Method have with the approach of the proposed regulations. However, at least the Incremental Method of allocation attempts to reward taxpayers that are actually increasing their research spending. The Expenditure Method makes no attempt to prohibit a corporation that is not entitled to any credit on an individual basis from receiving substantial research credits by joining a controlled group. While it may be true that in some cases the Expenditure Method could yield an allocation that seems "fairer" to the members experiencing increments, it is equally possible that the opposite result will occur, solely dependent upon the members' gross QREs. The results produced under the Expenditure Method simply have no correlation whatsoever to incremental research spending. This is patently inconsistent with the clearly expressed rules under pre- 1989 Act law, and there is no policy reason to recommend such an approach.
[25] Finally, in evaluating the inherent unfairness in the Expenditure Method, it is important that Treasury bear in mind that many taxable entities that are subject to the aggregation rules are only part of a "controlled group" for research credit purposes by the operation of the Code's 50-plus percent threshold. For all other purposes, controlled group members often are independent entities, and many such entities are large publicly held companies. The method of allocation selected must take into account the economic interests of the minority, and often public, shareholders in allocating the group credit. The distorted allocations illustrated above have a real and lasting economic impact on the shareholders of the companies involved. The Incremental Method of allocation does not produce such distortive allocations, is consistent with the purpose of the credit and the legislative history, and is therefore the method that should be adopted in the regulations.
C. USE OF GROUP'S FIXED BASE PERCENTAGE
[26] In adopting the Incremental Method, the proposed regulations provide that a member's base amount is that member's four year average gross receipts multiplied by the GROUP's fixed base percentage. The use of the group's fixed base percentage for allocation purposes is consistent with the Complete Aggregation Method chosen by Treasury to effectuate the statutory mandate that the controlled group be treated as one taxpayer.
[27] Nevertheless, critics have attempted to justify the Expenditure Method on the basis that if the Complete Aggregation Method is used to compute the group credit, an individual member's incremental spending has no meaning because the increment is not measured by the member's own fixed-base percentage. Proponents of the Expenditure Method have attacked the use of the group's fixed base percentage as an "apples and oranges" approach, because it incorporates some of the member's stand-alone inputs with the group's fixed base percentage. As a result of the use of the group's fixed base percentage, they argue, a member's increment and therefore its allocable share is based not on the relationship that member's current QREs relative to its current gross receipts bears to those same items measured during that member's test period. Instead, use of the group's fixed base percentage for each member causes the credit to be allocated to the members based solely on their relative proportion of QREs to gross receipts, without regard to whether a given member's current proportion is an increment or decrement over its own historic proportion. Thus, the proponents of the Expenditure Method argue that because the proposed regulations as written do not result in an allocation that captures perfectly the incremental nature of the credit, Treasury should abandon its attempt even to approach that ideal and should simply use an allocation method that does not even claim to take incremental research spending into account.
[28] The answer simply cannot be that the Incremental Method with group fixed base percentage should be abandoned because it does not perfectly implement Congress' incentive goal. Because Treasury has proposed using the Complete Aggregation Method for computing the credit, the group's fixed base percentage is used in computing the credit. It is therefore appropriate, and perhaps even required, that it is the group's fixed base percentage that also is used in allocating the credit. However, if the credit is to be ALLOCATED (as the statute clearly requires) in a manner that effectuates the incremental nature of the credit (again, as the statute clearly requires) then the members' own individual gross receipts must be used in the computation of base amount. Otherwise, the credit cannot be meaningfully allocated among the members consistent with the purpose of the statute.
[29] In a revealing passage from a letter to Treasury, proponents of the Expenditure Method argue repeatedly that the statute as revised in 1989 simply leaves no room for the idea of a member's base amount or fixed base percentage, and then go on to state "That is why the statutory change in 1989 required a different allocation method. It was no longer possible to allocate the group's Research Credit based on the increase or excess of a member's current year qualified research expenses over the member's base amount." This statement openly admits that the Expenditure Method is a "different allocation method" as compared with the allocation method under prior law. This admission, in turn, demonstrates that the Expenditure Method is contrary to Congress' clear statement in 1989 that, "The rules relating to aggregation of related persons . . . are the same as under present law . . .
D. SPECIAL RULE FOR CONSOLIDATED GROUPS
[30] Treasury requested comments on whether special rules were appropriate in the case of consolidated groups that are members of controlled groups. We believe such rules are necessary to prevent abuse and are within the scope of Treasury's regulatory authority. Whatever method for allocating the group's credit to the members is adopted in the regulations, the possibility exists to shift qualified research expenses between members of the controlled group to allocate the credit to the member who can receive the greatest tax benefit from the credit. The risk of this abuse is greatest in situations involving groups with the greatest control, including controlled group members that file consolidated returns. Such groups are less susceptible to the "policing" function served by a sizeable minority group of shareholders, and the economic and tax interests of such entities are often very closely aligned.
[31] Practicalities are relevant in assessing the need for this type of anti-abuse rule. Many taxable entities that are subject to the aggregation rules are only part of a "controlled group" for research credit purposes by the operation of the Code's 50-plus percent threshold. For all other purposes, controlled group members often are independent entities with divergent interests. Many such entities are large publicly held companies. Oftentimes a group consists of dozens of entities joined by a common holding company that owns greater than 50 percent, but less than 80 percent, of each of the other members. In most of these situations, it is impossible for the 50-plus percent owner/parent to so dramatically impact the business of its subsidiaries as to effect the abuse created by shifting both qualified research expenses and gross receipts of one entity to another without diminishing the financial performance of the company or otherwise inappropriately adversely affecting the minority shareholders of the company.
[32] It is also unreasonable to assume that any such business would dramatically shift the economic relationships of the members of the group solely in order to effect a small increase in the research credit. Thus in the context of the many entities that are just over 50-percent owned, the possibility for abuse is rather remote.
[33] By contrast, a consolidated group of entities will have a much higher level of common control, communication and shared objectives. The natural disincentives present as to less-controlled entities are not sufficient comfort that abuses will not be effected by consolidated groups within a controlled group. Although as a general matter Treasury is likely to be indifferent to the manner in which a credit is allocated, that will not be the case if members are not similarly situated, for example, if one group has sizeable net operating losses and therefore cannot use the credit.
[34] For example, assume Group A and Group B are two consolidated return groups that are part of the same "controlled group" for section 41(f) purposes by virtue of the fact that they have a common parent P. Group A does not have sufficient tax liability to use much of the research credit. However, Group B does. In the absence of an anti-abuse rule, P could shift qualified research expenses among the members of Group B to cause certain members of Group B to have proportionally higher qualified research expenses and larger increments over their "share" of the group's base amount. While this will not result in any additional credit for the P controlled group as a whole, it will result in a greater portion of the controlled group's credit being allocated to consolidated Group B.
[35] The ease with which abuses might be effected in the consolidated group context cannot be overstated, as demonstrated by the following example. Assume for this example that X, Y, and Z are all C corporations using a calendar taxable year. Assume that X owns 100 percent of Y's stock, that X and Y file a consolidated income tax return, and that X owns 51 percent of the stock of Z.
EXAMPLE #5 -- X, Y, AND Z RESEARCH CREDIT WITHOUT AGGREGATION
_____________________________________________________________________
Fixed 4 Year Base Current Increment/
Corp Base% Avg. GR Amount QREs Decrement Credit
_____________________________________________________________________
X 2,000/100,000 (2%) 400,000 8,000 7,000 (1,000) 0
Y 1,000/50,000 (2%) 150,000 3,000 5,000 2,000 400
Z 2,500/150,000 (1.67%) 500,000 8,350 12,000 3,650 730
[36] The research credit for the XYZ group is computed as follows.
____________________________________________________________________
Fixed 4 Year Base Current Increment/
Group Base% Avg. GR Amount QREs Decrement Credit
____________________________________________________________________
XYZ 5,500/300,000 1,050,000 19,215 24,000 4,785 957
(1.83%)
[37] If the group credit of $957 is allocated using the Incremental Method in the proposed regulations, it will be allocated as follows.
_____________________________________________________________________
Fixed 4 Year Base Current Increment/ Credit
Corp Base% Avg. GR Amount QREs Decrement
______________________________________________________________________
X 5,500/300,000 400,000 7,320 7,000 (320)
(1.83%)
Y 5,500/300,000 150,000 2,745 5,000 2,255
(1.83%)
Z 5,500/300,000 500,000 9,150 12,000 2,850
(1.83%)
XYZ 5,500/300,000 1,050,000 19,215 24,000 4,785 957
(1.83%)
Corp Increment Allocation Group Allocated
Proportion Credit Credit
X (0) 0/5,105 8 957 0
Y 2,255 2,255/5,105 957 421
Z 2,850 2,850/5,105 957 536
[38] Assume that the XY consolidated return group can receive a greater tax benefit from the research credit than Z can. In order to obtain more credit for the XY consolidated return, X shifts $5,000 of its current QREs to Y. Example #6, below shows the effect of this shifting.
EXAMPLE #6 -- X, Y, AND Z CREDIT ALLOCATION WITH SHIFTING
_____________________________________________________________________
Fixed 4 Year Base Current Increment/
Corp Base% Avg. GR Amount QREs Decrement Credit
_____________________________________________________________________
X 5,500/300,000 400,000 7,320 2,000 (5,320)
(1.83%)
Y 5,500/300,000 150,000 2,745 10,000 7,255
(1.83%)
Z 5,500/300,000 500,000 9,150 12,000 2,850
(1.83%)
XYZ 5,500/300,000 11,050,000 19,215 24,000 4,785 957
(1.83%)
Corp Increment Allocation Group Allocated
Proportion Credit Credit
X (0) 0/10,105 9 957 0
Y 2,255 7,255/10,105 957 689
Z 2,850 2,850/10,105 957 268
[39] While the shifting of QREs from X to Y does not increase the group's total research credit, it does create a larger increment within the XY consolidated return group and permits X and Y to receive a greater benefit from the credit to the detriment of Z, the member who on a stand-alone basis is the member of the group that is doing the most to increase its research spending as a percentage of its revenue.
[40] These abuses can be avoided by treating each consolidated group as a separate member of the controlled group for allocation purposes. The facts in Example #6 can be used to illustrate how such a rule would operate. For Example #7, below, assume the same facts in Example #6, except that X and Y are treated as a single member of the XYZ controlled group.
EXAMPLE #7 -- X AND Y AS SINGLE MEMBER FOR ALLOCATION PURPOSES
_____________________________________________________________________
Fixed 4 Year Base Current Increment/
Corp Base% Avg. GR Amount QREs Decrement Credit
_____________________________________________________________________
XY 5,500/300,000 550,000 10,065 12,000 1,935
(1.83%)
Z 5,500/300,000 500,000 9,150 12,000 2,850
(1.83%)
Group 5,500/300,000 1,050,000 19,215 24,000 4,785 957
(1.83%)
Corp Increment Allocation Group Allocated
Proportion Credit Credit
XY 1,935 1,953/4,785 957 392
Y 2,850 2,850/4,785 957 565
Group 4,785 957 957
[41] Shifting expenses between members within a consolidated group would not result in any additional credit being allocated to that consolidated group. Thus, treating each consolidated return group as a member of the section 41(f)(1) controlled group does not change the group credit, but does prevent manipulation of the credit between members of the controlled group if one or more consolidated groups are in the controlled group.
[42] The mere fact that the statute speaks to allocations made to "each such member" does not prohibit Treasury from specially defining "member" for this purpose in order to prevent abuse. Indeed, precedent exists for such an interpretation. For example, that was the approach taken by Treasury in sections 1.382-8(f) and(g), Example 4. Similarly, section 1.1502-3 effectively treats each consolidated return group as a component member of a controlled group for purposes of allocating the section 38 limitation for credits, including the research credit under section 41. Moreover, it is consistent with the number of other circumstances in which Treasury has treated consolidated return groups of corporations specially for tax purposes. 10 The ability to file a consolidated return for tax purposes is a privilege granted by Congress and Treasury, and in appropriate circumstances consolidated taxpayers have been required to pay a price for that privilege. Certainly this is such a situation, when such tremendous potential for abuse exists in the consolidated group context.
[43] In addition, treating a consolidated group as a single member for allocation purposes reflects the realities of the taxable entities involved. Again, the aggregation rules are intended to be anti-abuse rules, and should be implemented in a manner that does as little disservice as possible to the manner in which entities would be treated on a single-entity basis. In the case of a consolidated group of corporations, the reality is that the group is, for tax purposes, essentially the equivalent of a single entity. If the overall expenditures of a consolidated group of entities would not be sufficient to entitle that group to a credit on a "single entity" basis (because in the aggregate more members are in a decrement position), it is difficult to see why that same group should be able to procure a credit as a member of a controlled group simply as the result of the allocation rules. Such a result is clearly detrimental to the remaining members of the controlled group and cannot be reconciled with the intention of Congress to reward increasing investment.
III. EFFECTIVE DATE
[44] The preamble to the proposed regulations provides that the proposed rules are to be applied for taxable years ending on or after the date the proposed regulations are filed with the Federal Register. However, the preamble also indicates that the proposed rules are to be applied on a retroactive basis "to prevent abuse," and goes on to state:
To prevent taxpayers that are members of a controlled group from
together claiming in excess of 100% of the credit with respect
to prior taxable years, the rules for allocating the group
credit would apply to any taxable year beginning after December
31, 1989, in which, as a result of inconsistent methods of
allocation, the members of a controlled group as a whole claimed
more than 100% of the allowable group credit. In the case of a
group whose members have different taxable years and whose
members used inconsistent methods of allocation, the members of
the group as a whole shall be deemed to have claimed more than
100% of the allowable group credit.
[45] Treasury's intention to apply these proposed regulations retroactively to prevent abuse by controlled corporations is reasonable and is consistent with the purpose of the aggregation rules to prevent manipulation of the credit by members of a controlled group. Congress' grant of regulatory authority clearly indicates that regulations can be applied retroactively to prevent abuse. 11 Certainly a controlled group attempting to claim more than 100% of the allowable group credit constitutes a manipulation of the credit. Although the 10 year lag period between the statutory change and the proposed regulations was characterized by uncertainty as to how the aggregation rules should be applied, it can hardly be considered "reasonable" for the members of a controlled group to have believed that regulations, when issued, would permit the group members to take a credit in excess of the allowable group credit.
[46] In enacting the aggregation rules, Congress determined that greater than 50 percent ownership, and not some higher threshold, was sufficient control to present risk of abusing the credit. Consequently, rules were enacted that effectively require entities meeting that 50 percent ownership standard to share information relevant to the computation of the group credit, and since its enactment the statute has required that the credit be allocated to the various members of the control group. Against that backdrop it is difficult to see how an entity that is a member of a controlled group could believe that its determination of the credit allocation could reasonably be made in a vacuum, without regard to the amounts claimed by the other members of the group, simply because the members file separate tax returns. This is not merely a circumstance in which some taxpayers win and some lose when an uncertain law is clarified; in this abusive case, the controlled group members will always win, at the expense of the Treasury. It is unquestionably a reasonable use of Treasury's power to apply regulations retroactively to prevent such manipulation.
[47] Moreover, arguably express retroactivity is not even necessary as to the allocation provisions because, as with the 1994 amendments to the regulations under section 174, the proposed regulations "merely clarify" existing law. 12 As discussed above, regardless of the uncertainty that existed in advance of the proposed regulations as to the computation of the group credit, it has always been the case that not more than 100 percent of the credit, once computed, can be allocated among the members of a controlled group. If Treasury determines that these regulations are a mere clarification of existing law, we recommend so stating in the preamble as was done with the section 174 regulations.
IV. CONCLUSION
[48] Congress very explicitly illustrated the operation of the aggregation rules for the research credit when it enacted them in 1981. In the legislative history to the 1989 Act, Congress also explicitly stated its intention that the 1989 Act's changes to the language in section 41(f) were not designed to change the law under section 41(f). The Expenditure Method of allocating a group's credit to the members of the group is completely antithetical to the guidance provided by Congress in 1981. It simply is not conceivable that Congress would have characterized such an approach as the same as the prior law's incremental allocation. At best, the Expenditure Method provides completely random results related to the allocation of a group's research credit, and thereby eliminates the intended incentive effect of the research credit. At worst, the Expenditure Method opens the door to new abuses that are NOT possible under the Incremental Method.
[49] To allocate the group credit, Treasury should adopt the Incremental Method, using the group's fixed base percentage as is consistent with the Complete Aggregation Method, and with consolidated return groups treated as a single member of the group. Thus, members of each consolidated return group within a controlled group would compute their individual increments and decrements, which would be combined on a consolidated group basis, and the combined consolidated group increment or decrement would then be used to allocate to the consolidated group its ratable share of the controlled group's credit as if the consolidated group were a single member of the controlled group. This will insure that each member of the controlled group gets its ratable share of the group's credit based on its actual contribution to the controlled group's credit, and prohibit shifting of the credit between consolidated return groups within the controlled group. Finally, it is appropriate that these regulations be applied retroactively, at least to prevent abusive allocations of more than the allowable group credit.
[50] If you have any questions concerning these comments, you may contact me at (415) 268-7045. I appreciate your time and consideration of this matter.
Respectfully submitted,
Charles J. Moll III
Joy S. MacIntyre
MORRISON & FOERSTER LLP
San Francisco, California
cc: Joseph M. Mikrut
Tax Legislative Counsel
Robert P. Hanson
Deputy Tax Legislative Counsel - Regulatory Affairs
Christopher J. Ohmes
Tax Specialist
Office of Tax Legislative Counsel
Christine Ellison
Branch Chief
Branch 7
Passthroughs and Special Industries
Chief Counsel
Internal Revenue Service
Lisa J. Shuman
Attorney-Advisor
Branch 7
Passthroughs and Special Industries
Chief Counsel
Internal Revenue Service
1 Unless otherwise indicated, all citations herein are to the Internal Revenue Code of 1986, as amended (the "Code") or to Treasury regulations promulgated thereunder.
2 See "Attorneys Criticize Proposed Regs on Research Allocation," Tax Notes Today, 2000 TNT 116-16 (June 15, 2000); "Attorney Objects to How Research Credit is Allocated Among Controlled Group Members," Tax Notes Today, 2000 TNT 82-20 (Apr. 27, 2000).
3 Consistent with the statute and legislative history, this letter uses the term "aggregation rules" to refer to both the rule for computing the credit and the rule for allocating it.
4 H. Rept. No. 97-201, 97th Cong., 1st Sess., at 124 (1981); Treas. Reg. section 1.41-8(a)(4), example.
5 H. R. Rep. No. 144, 101st Cong., 1st Sess., at 1202 (1989).
6 See, e.g., Treas. Reg. section 1.368-(d)(4), where a remote continuity of business enterprise is permitted through a chain of controlled corporations despite the precise statutory language in section 368(a)(2)(C) that only permits a transfer of the assets acquired in a reorganization to "a corporation controlled by the corporation acquiring such assets."
7 We have been unable to locate such a description of the purpose of the proposed regulations either in the proposed regulations or in the preamble.
8 The amount of $5,105 is the sum of increments for Y and Z not reduced by X's decrement of $320. This amount must be used to insure that neither Y nor Z is allocated more than 100 percent of the XYZ group credit.
9 The amount of $10,105 is the sum of increments for Y and Z not reduced by X's decrement of $5,320. This amount must be used to insure that neither Y nor Z is allocated more than 100 percent of the XYZ group credit.
10 See, e.g., Treas. Reg. section 1.1502-80(f), which provides that section 1031 of the Code will not apply to any inter-company transactions within a consolidated return group.
11 I.R.C. section 7805(b)(3).
12 T.D. 8562, 1994-2 C.B. 30.
END OF FOOTNOTES
- AuthorsMoll, Charles J., IIIMacIntyre, Joy S.
- Institutional AuthorsMorrison & Foerster LLP
- Cross-Reference
- Code Sections
- Subject Area/Tax Topics
- Index Termsresearch credit
- Jurisdictions
- LanguageEnglish
- Tax Analysts Document NumberDoc 2000-23681 (19 original pages)
- Tax Analysts Electronic Citation2000 TNT 179-26