§ 1.861-17: Allocating & Apportioning R&E Expenditures
Understand the § 1.861-17 framework for sourcing R&E costs, including the key apportionment mechanics and binding elections that impact foreign tax credit calculations.
Treasury Regulation § 1.861-17 provides the rules for allocating and apportioning the amortization deduction for research and experimental (R&E) expenditures. This process affects the calculation of the foreign tax credit limitation under Internal Revenue Code (IRC) Section 904 by determining how these costs offset U.S.-source versus foreign-source income. Even when all research occurs in the U.S., a portion of the amortization deduction may be apportioned against foreign source income, potentially creating double taxation.
Under tax law changes effective for tax years after December 31, 2021, businesses must capitalize and amortize R&E costs. The amortization period is five years for U.S. research and 15 years for foreign research. This annual amortization deduction, not the total expenditure, is subject to these allocation and apportionment rules. Legislative proposals to repeal the amortization requirement remain uncertain.
Identifying Qualifying Research and Experimental Expenditures
Before allocation, a business must identify the expenditures that qualify as R&E under the tax code, relying on the definition in IRC Section 174. R&E expenditures are costs for research and development in the experimental or laboratory sense. This includes activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, or software. The costs of obtaining a patent, such as attorneys’ fees, and direct costs of labor and materials are also included.
Certain costs are explicitly excluded from the R&E definition. These include ordinary quality control testing, efficiency or consumer surveys, advertising, and promotions. The cost of acquiring another’s patent, model, or process is also excluded.
Allocation to Product Categories
The R&E amortization deduction is allocated to relevant product categories based on what the research is expected to benefit. Taxpayers must use the three-digit Standard Industrial Classification (SIC) code system to group these deductions.
The allocation requires connecting research activities to specific product lines. The income generated within a product category is expected to bear the costs of all research for that category, whether successful or not.
If research benefits more than one product category, the taxpayer must determine a reasonable basis for distributing the deduction among them. Some R&E may be “basic research,” not associated with any specific product category. In such instances, the amortization for these costs is allocated to all of the taxpayer’s product categories.
The Apportionment Process
After allocation, the deduction is apportioned between U.S. and foreign source income. This involves an exclusive geographic apportionment, then apportionment of the remainder by one of two methods.
The exclusive apportionment rule allows a taxpayer to apportion 50% of the R&E amortization to the geographic source where the research was performed. This is permitted only if more than 50% of the R&E activity for that product category occurred in that location and the taxpayer is using the sales method.
The remaining deduction is apportioned using either the sales method or the gross income method. The sales method, the default, apportions costs based on the ratio of foreign sales to total sales within the product category. The gross income method uses the same principle but with gross income figures. However, the amount apportioned to foreign sources under the gross income method cannot be less than 50% of the amount that would have been apportioned using the sales method.
Method Elections and Grouping Rules
The choice to use the gross income method is a binding election. Once a taxpayer elects this method, they must continue to use it for five consecutive years. A change from the gross income method back to the sales method within this period requires consent from the Internal Revenue Service (IRS), though one-time exceptions have been provided after major tax law changes.
The rules for allocating and apportioning R&E amortization are applied on a consolidated basis for affiliated groups of corporations, which are treated as a single taxpayer. This means the R&E deductions and sales or gross income of all members are aggregated for the calculations. All members of the group must use the same apportionment method.