Co-Authored By Tyler H. Ison, JD
Recent proposed regulations address the calculation of the Research and Experimentation (R&E) tax credit for a controlled group that includes one or more foreign corporations that derive foreign-source gross receipts. The proposed regulations impact some controlled groups with foreign sales that calculate the R&E credit using the ‘regular method’ (in which qualified research expenses (QREs) are referenced to gross receipts in the computation of the credit).
Currently, intra-group transactions and transactions of foreign corporate members of a controlled group are generally disregarded for the purpose of determining gross receipts and QREs for the R&E calculation. The IRS and Treasury believe, however, that completely excluding gross receipts associated with certain transactions is inconsistent with congressional intent.
Research Experimentation Credit – Foreign Corporations
For example, assume that a domestic corporation incurs research expenditures and sells a product that it produced to a foreign corporate member, and the foreign corporate member then sells the product to a customer in a transaction that does not give rise to gross receipts effectively connected with a trade or business within the United States.  Gross receipts from the intra-group sales transactions are excluded, and the foreign corporate member’s gross receipts are also excluded under the current R&E tax credit calculation rules. The aggregate amount of gross receipts for purposes of determining the research credit is distorted because the QREs of the domestic member are included, but its gross receipts from the sale to the foreign corporate member who ultimately sells to an unrelated third party are not. Accordingly, the IRS and the Treasury Department propose to revise the regulations to include the foreign gross receipts in this situation. The result is that the R&E credit may be reduced (QREs remain the same but the gross receipts to which they are referenced may increase). To further complicate matters, the gross receipts in question may be earned by the foreign corporate member in a different year than the intra-group sale.
Example: In Year 1, D sells Product to F for $8x. In Year 2, F sells Product to F’s unrelated customer for $10x. Because the Product that F sells outside the group is the same Product that was the subject of an internal transaction (i.e., the sale from D to F), and the $10x that F receives upon sale of Product outside the group is not effectively connected with a trade or business within the United States, the Commonwealth of Puerto Rico, or any possession of the United States, the $8x that D receives from F is included in D’s gross receipts for purposes of computing the amount of the group credit. The $8x of gross receipts is taken into account in Year 2, the year of the external transaction.
The result is that controlled groups are prevented from shifting gross receipts to foreign corporate members such that the resulting gross receipts are excluded from the R&E calculation (thus skewing the credit).
Controlled groups utilizing the regular method to calculate their R&E tax credit should be aware of intra-group and foreign company transactions that can impact the R&E tax credit calculation, as well as the additional record-keeping needed.