TAX FOUNDATION

SEMINAR

PROCEEDING S

Remarks by the Honorable Beryl F. Anthony, Jr.

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Outlining the Conflicts in R&D Tax Policyn

Conflict in R&D Tax Policy and the Need fo rChange

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Mapping Out Sound R&D Policies for the 1990 s

Hyatt Regency on Capito lWashington, DCMarch 22, 1990

©1990 Tax Foundation . All rights reserved .

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TABLE OF CONTENTS

FOREWORD

v

INTRODUCTION

vii

SEMINAR SPONSORS

ix

SEMINAR PARTICIPANTS

x

POLICY COUNCIL

xii

PROGRAM COMMITTEE

xiii

KEYNOTE ADDRESS

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The Honorable Beryl F. Anthony, Jr.United States Representative from ArkansasMember, Ways and Means Committee

OUTLINING THE CONFLICTS IN R&D TAX POLICY

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John Magee

8Partner, Miller & Chevalie r

CONFLICT IN R&D TAX POLICY AND THE NEED FOR CHANGE

17

Panel Chairman : Cyrus J . HalpernTax Vice President, Federal & International TaxesAT&T

Edmund K. Harding

1 8Manager of Tax Planning & Litigation, Xero x

Stuart E . Eizenstat

22PartnerPowell, Goldstein, Frazer & Murph y

Richard Grafmeyer

31Minority Tax Counsel, U .S. Senate Committee on Finance

Q&A

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MAPPING OUT SOUND R&D POLICIES FOR THE 1990s

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Panel Chairman : M.D. MenssenStaff Vice President, Taxes, 3M

B . Anthony Billings

38Associate Professor of Accounting, Wayne State University

Robert N. Mattson

42Assistant Treasurer, IBM

Michael J . Graetz

48Deputy Assistant Secretary for Tax Policy, Department of the Treasur y

Q&A

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FOREWORD

The last half of the 1980s was a great disappointment to Americans who see research an ddevelopment (R&D) as vital to the nation's economy . Real growth in R&D expenditures onlyaveraged 1 .3 percent from 1985 to 1988 . They are projected to be even slower from 1988 to 1990, wit han 0.9 percent decrease in real growth during 1989, the first such decline in 14 years . This stagnantperiod contrasts sharply with the first half of the decade when R&D expenditures increased a naverage of 8 .2 percent in constant dollars . The U.S. currently spends substantially less than eitherWest Germany or Japan on non-defense R&D .

What role has tax policy played in this nosedive? What provisions of our tax code provid ecorporations with positive incentives to invest in research and development? Which provisions o fthe code inhibit R&D expenditures? Everyone here in Washington seems to agree on the benefit sto our economy of more R&D. But despite this unanimity, the U.S. R&D tax credit has been sinc eits inception in 1981 a jumble of short-term extensions and technical changes to its calculation tha thas not provided substantial incentive for U .S. firms to increase R&D expenditures . On March 22,1990, the Tax Foundation held a seminar, "R&D Tax Policy : A Study in Conflict - Opportunity fo rChange" to examine this theme of conflict within the code and propose a variety of possibl eimprovements .

Instrumental in putting together the program were James Q . Riordan, co-chairman of the Ta xFoundation, along with Bob Hannon and Glenn White, co-chairmen of the Tax Foundation'sProgram Committee . The Foundation's special thanks go to Dr. Robert L. Black of Coopers &Lybrand for editing the proceedings and contributing the introduction .

A major accomplishment of the seminar was the lively exchange between the public an dprivate sectors on issues of vital importance to both government and industry . The publication ofthese proceedings will bring these important viewpoints to a wider audience, promotin gunderstanding of this critical issue .

Wayne GablePresident

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INTRODUCTIO N

Research and development is essential to the growth of the economy and the continue dcompetitiveness of American business . Investment in R&D creates new products and job oppor-tunities. Consequently, technological innovation is a cornerstone for building a better economicfuture .

Given the integral part R&D plays in our country's economic development, it is surprisin ghow uncertain and inconsistent its treatment in the tax code and by regulations has been durin gthe past decade . The rules governing application of the R&D incentives are quite complex an darguably more burdensome than necessary for an appropriate blend of tax policy and administra-tive practicality .

Allow me to illustrate this point with an example from my own experience with the taxatio nof R&D. For somewhat apparent reasons, when viewed from their single perspective, differen tauthoritative bodies, such as regulatory agencies, have created significantly different definition sas to what R&D activities and expenses constitute "research and development" for their purposes .So, for instance, there are GAAP rules for measuring R&D for accounting purposes, governmen tcontract accounting rules for eligible R&D on government contracts, specific industry guideline sfor R&D in certain industries, and a multiplicity of tax rules .

More specifically, however, once we focus on the tax rules, their construction seems to havebeen with limited reference to other definitional sources . Moreover, the tax rules rely on differentdefinitions for different statutory applications . For example, the deduction under Section 174 isfairly broad, but the "qualified research" definition for the R&D credit of Section 41 is much morerestrictive and only applicable to a subset of expenses. In addition, during the last decade thes edefinitions have been changed both statutorily and by regulation . Imagine then the plight of amanufacturer with some government contracts, for example, who must maintain exhaustiv erecords for distinguishing between the costs on a project-by-project basis that meet the varyin gdefinitions: GAAP for financial statements, government contracting regulations for governmen tcontracts, Reg. Section 1 .174 for R&D deductions, and Section 41 and the regulations thereunde rfor the R&D credit . Of course, I've not mentioned what is perhaps the most important researc hnumbers for this hypothetical manufacturer: the management reports used to properly administe rthe research project, which obviously could require an entirely different set of records .

While the objectives of having different defintions may make sense on a separate-purposebasis, the multiple definitions, when applied concurrently to the same projects, only createadministrative confusion and inefficiencies . This was one of the themes echoed by several of th espeakers . For instance, Edmund K. Harding of Xerox Corporation illustrated how these regula-tions and the present credit scheme created an accounting nightmare for Xerox, especially durin gthe IRS audit of Xerox's 1983 R&D credit .

This thought-provoking seminar had many excellent speakers, who with their wide-rangin gbackgrounds offered many excellent ideas for improving R&D tax policy . The two primar ysessions of the seminar were chaired by Cyrus J . Halpern, Tax Vice President — Federal &International Taxes for AT&T, and M. D. "Buck" Menssen, Staff Vice President for 3M Corporation ,both of whom provided stimulating sessions .

Stuart E . Eizenstat, former Assistant to the President for Domestic Policy and Affairs in th eCarter Administration, and John B . Magee of Miller & Chevalier each offered an excellent technica loverview of the status of R&D tax incentives and expressed a concern that the Japanese and man yEuropean countries are more committed to R&D than the U .S. — a trend that has accelerated overthe past decade . Robert N . Mattson of IBM Corporation presented a practical commentary on th e

vii

nature and importance of R&D from the business community's perspective .Even with all the confusion underlying the application of the R&D code provisions, the mos t

critical legislative problem that R&D faces today is the uncertainty surrounding the continue dexistence of these incentives. The Omnibus Budget Reconciliation Act of 1989 extended the R& Dcredit through September 1990. Whether or not it will be extended again is certainly not guaran-teed. Congressman Beryl F . Anthony, a member of the Ways and Means Committee, and Richar dGrafmeyer, minority tax counsel for the U .S. Senate Finance Committee, both discussed th eprospects for the credit and other R&D incentives in their presentations .

Awareness of relevant problems is only half the battle . The debate continues as to whichproposals would best advance the goal of increased R&D spending . Professor Anthony Billings o f

Wayne State University suggested that corporate integration may be at least part of the answer .Balanced against the need for incentives are the budget constraints that currently restrict th egovernment's willingness to commit to tax-reduction incentives . Michael J . Graetz, DeputyAssistant Secretary of the Treasury for Tax Policy, discussed this issue at length and reassure dthose engaged in R&D that the Administration is committed to assisting their efforts .

This Tax Foundation seminar was designed to illuminate the issues that companies fac eregarding research and development . R&D expenditures are more than corporate operatin gexpenses; they are an investment in future technological advances, in the competitiveness of U .S .industry, and ultimately in society as a whole. As you read through the presentations of theselawyers, scholars, businessmen and government representatives, you may be surprised to learnthat a company often reaps little direct or immediate benefit from its R&D spending, and that to ofrequently there may be no benefit at all . Combined with the fact that the credit percentage has bee neroded over the years and the allocation rules require a company to disgorge any benefit it receive sfrom the credit if it conducts any of its R&D overseas, it may seem surprising, from a tax standpoint ,that companies commit the level of resources to R&D that they do .

On a personal note, it has been a pleasure editing these proceedings . I was aided by DinaSchapiro and Mary Hansen, Associates at Coopers & Lybrand's National Tax office, to whom I amthankful for their attentiveness and able assistance . In addition, I am grateful to Paul Merski,William Ahern and the rest of the Tax Foundation's staff for attending to the details and makin git happen.

Robert L. Black, Ph.D., CPANational TaxCoopers & LybrandWashington, D .C.

Robert L. Black is a Director at Coopers & Lybrand's National Tax office in Washington, D .C., wherehe is responsible for R&D tax consulting and the tax aspects of high-technology businesses . Prior t ojoining C&L, he was a tax professor at The University of Texas at Austin . He received his Ph.D. in Account-ing/Taxation from the University of Minnesota, and is a certified public accountant . Dr . Black is the autho rof numerous publications on the taxation of R&D and technology, including both of the articles appearingin thejournal of Taxation following passage of the 1981 and 1986 tax acts, and the comprehensive analysisof the R&D credit in the 1983 New York University Institute on Federal Taxation .

SEMINAR SPONSOR S

AT&T

Allied-Signal Inc .

BellSouth Corporation

Campbell Soup Company

Chevron U.S.A., Inc.

Digital Equipment Corporation

The Dow Chemical Company

E .I . du Pont de Nemours and Compan y

Eli Lilly and Company

Ethyl Corporation

Ford Motor Company

Georgia-Pacific Corporation

The Goodyear Tire & Rubber Company

Johnson & Johnson

Phillips Petroleum Company

The Procter & Gamble Company

3M Company

Warner-Lamber t

ix

SEMINAR PARTICIPANT S

The Honorable Beryl F. Anthony has been theDemocratic Representative from Arkansas' sFourth District in the United States Congres ssince 1978. In 1981, during his second term,Congressman Anthony won a seat on theWays and Means Committee . The Congress-man has a keen interest in the Committee's ta xtreatment of capital gains, and with the devel-opment of international trade into the issue o fthe 1990s, Congressman Anthony will be turn -ing his legislative attention to a 1989 assign-ment to Ways and Means' Subcommittee o nTrade. He is the Chairman of the DemocraticCongressional Campaign Committee, and h ehas formed the Anthony Public Finance Com-mission, a coalition of mayors, governors, localgovernment officials, and members of th epublic finance community, who will stud yhow local governments can better finance in-frastructure improvements at the local level .B. Anthony Billings is Associate Professor o fAccounting at Wayne State University with hi sPh.D. from Texas A&M . Dr. Billings' articleshave appeared in journals such as AccountingHorizons, CPA Journal, Tax Adviser, Taxes, Busi-ness, Journal of Corporate Taxation, Journal of Rea lEstate Taxation, Tax Executive, Oil and Gas Quar-terly, and Best Review. He is the recipient of agrant from the Arthur Young Tax Researc hFoundation to study international tax prob-lems, and has completed internships wit hDow Corning Corporation in Midland, Michi -gan and with 3M Corporation in St . Paul, Min -nesota .

Stuart E. Eizenstat has been a partner in thelaw firm of Powell, Goldstein, Frazer &Murphy since 1981 . During that same periodhe has been an adjunct lecturer at the JF KSchool of Government, Harvard University . Agraduate of Harvard Law School, Mr. Eizen-stat has published articles in numerous publi cpolicy and legal periodicals . In 1976 and 198 0he was one of the principal authors of th eDemocratic Party platform, and from 1977 to

1981, he served President Carter as Assistant tothe President for Domestic Affairs and Policy,and Executive Director, Domestic Policy Staff .At the same time he was a member of theCouncil on Wage and Price Stability, and an ex -officio member of the Economic Policy Group ,The White House .

Michael J. Graetz, Deputy Assistant Secretar yof the Treasury for Tax Policy, is on leave fro mhis position as Justus S . Hotchkiss Professor o fLaw at Yale University. He oversees the activi -ties of the Offices of Tax Legislative Counsel,the International Tax Counsel, and the BenefitsTax Counsel . Mr. Graetz has taught law schoo lcourses in taxation since 1971 and before join-ing Yale was a professor of law at the Univer-sity of Virginia and the University of Souther nCalifornia law schools . His publications on th esubject of Federal taxation include a leadinglaw school text and more than 30 articles on awide range of tax policy issues in books andscholarly journals . He served previously in th eTreasury Department in the Office of Tax Leg -islative Counsel from 1969 to 1972.

Richard Grafmeyer is currently minority ta xcounsel for the U .S. Senate Committee on Fi-nance. He is responsible for tax legislation in avariety of subject areas including employeebenefits and pensions, child care, individua ltax items, savings incentives, and tax exemp torganizations. Before joining the FinanceCommittee, Mr . Grafmeyer was Federal ta xmanager and tax legislative counsel for MC ICommunications Corporation in Washington ,DC. Mr. Grafmeyer has an undergraduate de-gree in accounting from Walsh College i nOhio, a law degree from the University o fAkron School of Law, and an LL .M. in taxatio nfrom Georgetown University School of Law .Cyrus J . Halpern is Tax Vice President - Fed-eral & International Taxes for AT&T Corpora -tion. He has been with AT&T since 1967, hav -ing held positions as Tax Attorney and Direc-tor, Federal & International Taxes. He received

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his LL.B . in 1959 and his LL.M. in Tax in 1961 ,both from New York University Law School .He is a Certified Public Accountant and a Di -rector of the Tax Council. AT&T has been affili-ated with the Tax Foundation since 1960 .

Edmund K. Harding has since 1979 beenManager, Tax Planning & Litigation, for Xero xCorporation . He received his B .S. in Account-ing at the University of Detroit and his J .D. atWayne State University . Prior to joining Xerox ,he worked for General Motors Corporation i nDetroit in a variety of tax-related positions . Mr.Harding is a member of the Connecticut andMichigan Bar Associations and numerous tax-related organizations .John B . Magee is a Member of Miller & Cheva -lier, Chartered, in Washington, DC . Mr. Mageerepresents corporate clients and industr ytrade associations, primarily in the naturalresource, chemical, and insurance industries .His responsibilities have included IRS rulingsand regulation projects, audit and appeals con-troversies, Tax Court and refund litigation ,and legislation. In the legislative area, he hasrepresented clients before Treasury and Con-gressional tax staffs on technical and polic ymatters . Mr. Magee received his J .D. from theUniversity of Washington School of Law i n1972 and his LL.M. in Tax in 1977 from Geor-getown University Law Center in Washing-ton, DC .

Robert N. Mattson is currently AssistantTreasurer of IBM Corporation at Armonk,N.Y., and is responsible for all worldwide taxand customs valuation related affairs; all taxreturns; negotiations with tax authorities; andanalysis of tax effects of contemplated or com-pleted transactions . Previously, he held thepositions of director of taxes, corporate taxcounsel, and director of tax planning and de-velopment. He received a B .S. in Economicsfrom the University of Pennsylvania's Whar-ton School of Finance, an LL.B . and LL.M. intaxation from New York University School ofLaw and worked toward a Ph .D. in Interna-tional Economics at New York University . Mr .Mattson has published tax articles in numer-ous publications, including articles on re-search and development .M.D. (Buck) Menssen is Staff Vice Presidentfor 3M Corporation in St . Paul, Minnesota . Hehas worked for 3M since 1967 and held sevenpositions with the company during that time .These include serving as Area Controller,Europe from 1981 to 1983 and Sector Control -ler, Graphic Technologies Sector from 1983 t o1987 before becoming Executive Director ,Taxes. He received his B .A. in Accounting in1959 and his M.B.A. in 1973, both from theUniversity of Minnesota. In 1979 he received aC.M.A. from the Institute of Certified Manage -ment Accountants .

xi

POLICY COUNCIL

James Q. Riordan, Co-Chairman Richard J . Hiegel William E. SimonPresident & Chief Executive Partner President

Officer Cravath, Swaine & Moore John M. Olin FoundationBekaert Corporation Kenneth Iverson Richard L. SmithJames C. Miller III, Co-Chairman Chairman Senior Vice President & Chie fChairman Nucor Corporation Financial Office rCitizens for a Sound Economy M. Alanson Johnson II The Rosewood Corporation

Wayne Gable Executive Vice President, Steven C. StrykerPresident Treasurer & Chief Financial Vice President & General Ta xTax Foundation Officer Counse l

P. H. Glatfelter Company Shell Oil CompanyEdward L. AddisonPresident & Chief Executive William A. Liffers Dominic A. Tarantino

Officer Vice Chairman Co-Chairman & Managin gThe Southern Company American Cyanamid Company Partner

Price Waterhous eMichael Ambler John A. LoveDeputy General Tax Counsel Of Counsel W. Bruce ThomasTexaco, Inc . Davis, Graham & Stubbs Vice Chairman - Administration

Roland M. Bixler Paul W. McCracken & Chief Financial OfficerUSX CorporationPresident Edmund Ezra Day University

J-B-T Instruments, Inc . Professor of Business Hans W. Wanders

Robert T. Blakely Administration Vice Chairman - Retired

Senior Vice President The University of Michigan The Wachovia Corporatio n

Tenneco, Inc . Richard L. Measelle James W. Wirth

John C . Burton Managing Partner Senior Vice President & Chief

Arthur Young Professor of Arthur Andersen & Co . Financial Officer

Accounting & Finance Kendyl K. Monroe Aluminum Company o f

Graduate School of Business Partner America

Columbia University Sullivan & Cromwell David T. WrightVice Chairman, TaxesThe Hon. Harry F. Byrd, Jr. Stewart G . Nagler

Dennis D . Dammerman Senior Executive Vice President Coopers & Lybrand

Senior Vice President - Finance Metropolitan Life Insurance

General Electric Company Compan y

James W. Nethercot tJames M. DennySenior Vice President & Chief Senior Vice Presiden t

Financial Officer The Procter & Gamble Company

Sears, Roebuck and Co . Robert L. Plancher

Robert A. dePalma Senior Vice Presiden t

Senior Vice President & Chief American Brands, Inc .

Financial Officer Victor B. Nosches eRockwell International Vice Chairman, Tax Services

Corporation Ernst & Young

Gwain H. Gillespie John J . QuindlenExecutive Vice President - Finance Senior Vice President - Finance

& Administration & Chief Financial Office rUNUM Corporation E .I . du Pont de Nemours & Co .

C. Lowell Harriss Raymond J . SaulnierProfessor Professor Emeritus of Economic sColumbia University Barnard College - Columbia

University

xii

PROGRAM COMMITTEE

Robert F . Hannon, Co-Chairman Ernest S. Christian, Jr. Cyrus J . HalpernDirector, Government Relations Partner Director - Federal &

(ret .) Patton, Boggs & Blow International Taxe sArthur Young & Co. Ralph J. Coselli AT&T

Glenn White, Co-Chairman Assistant General Tax Counsel Michael A . HassDirector of Tax Department & Shell Oil Company Director of Taxe s

Assistant Secretary (ret .) Dennis J . Crispin Marsh & McLennan, Inc.The Dow Chemical Company Vice President, Employee Mark L . HazelwoodByrle M. Abbin Benefits, Insurance & Taxes Vice PresidentManaging Director, Federal Tax The Boeing Company Arco

Services William G . Dakin Michael J . HenryArthur Andersen & Co . Supervisory Tax Counsel Chief Counsel - Tax PolicyMichael Ambler Mobil Corporation Sun Company, Inc .Deputy General Tax Counsel Michael A . DeLuca Thomas A. HimesTexaco Inc . Vice President - Taxes Vice PresidentChristopher Baldwin Household International BASP CorporationDirector of Taxes Anthony R. DeSanto Martin HoffmanGannett Executive Director, Taxes Senior Vice President & TaxJames J . Baldwin Eli Lilly and Company CounselVice President - Taxes Manufacturers Hanover TrustThomas A. DowdCampbell Soup Co . Vice President, Corporate Tax CompanyFrank J. Bianca CNA Insurance Companies Dean HudsonVice President - Taxes John E. Easton Vice PresidentAmerican Brands, Inc . Partner Southern Company Services ,Alan M. Breitman Coopers & Lybrand Inc .

Director of Taxes & Assistant Haskell Edelstein J.P. LaCass eSecretary Senior Vice President & General Director of Taxes

American Cyanamid Company Tax Counsel American PresidentsBruce Brown Citicorp/Citibank Companies, Ltd .Vice President and Director, Stuart S . Flamberg Herbert J. Lerner

Taxes Senior Vice President &Director PartnerPhillip Morris Companies Inc . of Taxes Ernst & YoungJames P. Bryant Donaldson, Lufkin & Jenrette, Jeffrey D . LernerVice President & Director, Inc . Assistant Vice President - Taxes

Corporate Taxes Burlington Northern Railroa dRichard A. FrelingJ . C. Penney Company, Inc . Johnson & Gibbs, P.C . Daniel L. LundyAnthony H. Buckman August W. Frisch Senior Vice President & DirectorCorporate Tax Manager Vice President & General Tax of TaxesToyota Motor Sales, U.S.A . Counsel ITT CorporationPeter C . Canellos Westinghouse Electric Thomas P . MalettaPartner Corporation Vice President - TaxesWachtell, Lipton, Rosen & Katz Thomas V. Fritz Xerox Corporatio nAnthony J . Cetta Vice Chairman Michael E. MartelloDirector & Comptroller Ernst & Young Assistant Controller & Manage rFirst Boston Corporation Albert E . Germain of TaxesJohn E. Chap oton Vice President - Taxes & Tax Bechtel Group, Inc .Managing Partner Counsel Robert N. MattsonVinson & Elkins ALCOA Assistant Treasurer

Ralph A. Gerra IBM Corporation

Thomas McHugh William Resnick John S. StephanPresident Assistant Treasurer and Senior Vice President & Ta xIllinois Business Roundtable Director, Tax Division CounselD. Bradley McWilliams E. I . du Pont de Nemours & Co . Bank of America

Vice President, Taxes & Real Richard P. Roling Don J . SummaEstate Director of Taxes Professo r

Cooper Industries, Inc . Commonwealth Edison Monmouth CollegeDonald Meier Steven L . Rosner F. E . Well sVice President, Taxes Manager, Tax Accounting and Manager - Tax Divisio nSara Lee Corporation Analysis The Procter & Gamble CompanyJohn R. Mendenhall Pacific Telesis John WilkinsVice President - Taxes John J . Ross PartnerUnion Pacific Corporation General Tax Counsel Coopers & LybrandM.D. Menssen Chevron Corporation L. L. WilsonStaff Vice President, Taxes Robert F . Sama General Tax Counsel3M Vice President - Tax Counsel Unocal CorporationJoseph Mikelonis Gillette Company Richard A . WilsonDirector of Corporate Taxes David M. Schwartz Vice President, Ta xEaton Corporation Senior Vice President - Safeway StoresJohn T. Mills Corporate Taxes Neil P. Wissin gVice President - Taxes Crestar Bank Vice President & Director ofUSX Corporation Bernard M. Shapiro TaxesDavid R. Milton National Director, Tax Policy Weyerhaeuser CompanyRetired, formerly Vice President Price Waterhouse Arlo Woolery

& General Tax Counsel Arnold B . SidmanShell Oil Company Partne rR.L. Morris, Jr. Chamberlain, Hrdlicka, White ,Vice President - Tax Johnson & WilliamsOccidental Petroleum Robert Simpson

Corporation Vice President of TaxesTenneco, Inc .David P . Norum

Vice President - Taxes Burton B. SmoliarSears, Roebuck and Co . Associate General CounselLeif H. Olsen Ford Motor CompanyPresident Edward I. Sproull, Jr.Leif H. Olsen Associates, Inc . Vice President - TaxRichard Overton AdministrationVice President, Taxes PPG Industries, Inc.Monsanto Company Thomas L. StapletonJohn F. Palmer Senior Vice President & TaxVice President, Taxes DirectorWhitman Corporation Metropolitan Life Insurance

Company

xiv

KEYNOTE ADDRES S

The Honorable Beryl F. Anthony, Jr.United States Representative from ArkansasMember, Ways and Means Committee

Beryl F. Anthony, Jr., a sixth term congressman from Arkansas andmember of the Ways and Means Committee, emphasizes the need for th eUnited States to remain technologically competitive with the rest of th eworld. He believes the best way to accomplish this is to enact permanent ,comprehensive incentives to encourage research and developmen texpenditures . Congressman Anthony notes that the regulations under Cod eSection 861, governing the allocation and apportionment of expenses betwee ndomestic income and foreign income, do not provide sufficient incentives t opromote U.S.-based research activity . He indicates that the Ways and Mean sCommittee supports the effort to make the R&D credit permanent.

Congressman Anthony also makes the point that the tax code should no tdrive the worldwide marketplace . He notes that there should be some parityamong tax systems so that products can compete on a level playing field .While the congressman acknowledges federal budget constraints, he say sthose restrictions should be balanced against the country's need to hav estable laws and a permanent national policy regarding R&D .

Before I was introduced, I was talking t oJohn Magee, who has prepared this [outline] . Iwas very impressed . It looks so good, I wil lprobably steal a copy of it. He said, "Well, Pa tis really the one who put it together ." So I said,"Pat put it together, but you get to present it ."That reminds me of a story I heard once abou tthis particularly cranky rascal, an old Unite dStates Senator who used to give his speec hwriter hell . This Senator was making a com-mencement speech. He was about three-fourth sof the way into the speech, and he was knock -ing them out. He had them right in the palm o fhis hand. He flips the page over, and in big,bold letters it says, "You're on your own now,you S.O.B ." So, John, I hope you've lookedthrough the pages very closely before you ge tup here and try to present that detailed pack-age.

I must admit I feel some fear when I amamong such knowledgeable presenters andpeople in the audience. I don't know howmany of you know the tax consultant on m ypersonal staff, J . W. Rayder, who represent sme on the Ways and Means Committee. Whenit comes to the politics of it, I think I can handl eit, but when it comes to the technical aspects ofit, I think he can handle it . Every time someoneasks a difficult question, I always tell them m yfavorite story ; so forgive me if you have al -ready heard this .

This college professor is going aroundmaking very detailed technical presentationson research and development and how it helpsthe country's productivity and growth . Hischauffeur has heard this speech about a halfdozen times, and on their way to the next col-lege, he says, "Professor, I think you're losin g

1

R&D Tax Policy

your enthusiasm. Now, I've got that speechmemorized, and I believe I could do it with a lo tmore enthusiasm than you." So the professo rsays, "All right, just pull over and we'll switchclothes." Sure enough, they switch clothes—the chauffeur's uniform for the professor' sbusiness suit. At the next stop, the would-beprofessor gets up there and just hits a hom erun. He gives the speech non-stop—doesn' tmiss a beat—with great enthusiasm . Thencomes the time for Q&A. A little fellow in thefront row with big, thick glasses looks up an dasks him the hardest question that's been aske don the entire tour. He looks at this little fellowand says, "Son, that's such an elementary ques-tion, I'll let my chauffeur there in the bac kanswer it ." So, don't you dare ask me any har dquestions, because J.W. is not here, and I'mafraid we cannot refer them to my chauffeur .

C. Katherine Porter, a long-time friend o fmine and my wife had the privilege of watch-ing Sheila go to law school. Sheila is finishednow and in her fifth year of practice, but durin gher first year she did what I guess all freshma nlaw students do . She would call me at the offic eand start asking me about all of the old, archaic ,non-utilized definitions out of Black's LawDictionary . I finally got exasperated durin gher third call in one day. I said, "Sheila, I usedto be a lawyer, but I'm in a new profession now.I know what the law ought to be." So, I gues sI'm here, ladies and gentlemen, to talk to youfrom that perspective . Probably what I oughtto do is take my four-page speech, flip throug hthe pages, just read the final paragraph, then sitdown. I think that final paragraph really sum-marizes how I feel about the topic .

What I want to say is that the curren tallocation regulations do not provide suffi-cient incentives for United States-based re -search activities, and that we must find a per-manent solution to this problem . I guess if Icould only say one thing, that would be mymessage .

Taxpayers have had ten years of instabil-ity. Temporary rules for allocating R&D ex-penditures were passed in 1981, 1984, 1985,1986, and 1988 . United States firms need per-

manent rules so they can be certain of the long-term tax ramifications of their R&D expenses .Stable tax laws are needed to encourage th egrowth of United States research activity, al -lowing us to maintain our lead in technologica ldevelopment. That, ladies and gentlemen, iswhere I am coming from .

How did I get there? When I got on th e[Ways and Means] Committee in 1981, ther ewas a gentleman from Hawaii, C .F. Trunta,who was the lead sponsor of the research an ddevelopment issue .

When he became involved in an automo-bile accident, he called me and asked if I wouldsubstitute for him in one of the OversightSubcommittee hearings because the chairma nwas taking some pot shots at the R&D ta xcredit . Trunta alleged that companies like IBM ,rather than mom and pop operations, were th eones that utilized it, and it therefore benefittedbig companies and not others .

I said I would try to brief myself. So, I readup on it very quickly and went into the hear-ing. We were able to deflect some adversecriticism that day . Then, I got more interestedin that particular technical issue in the tax code,and I began to study it in more detail . I guess Istarted to realize that if there is any one thin gyou have to do, it's that we have to treat ourresearch and development as favorably a sforeign countries treat their companies . We arethe only country in the world that acts likeresearch and development is all done some -where else . I am personally convinced—and Iknow you have all made these statementsbefore—that if we don't find a rational, perma-nent solution to this problem that your compa -nies will take more and more research off -shore, and it would be a proper managemen tdecision because you can get better treatmen tunder international tax laws .

I am totally convinced that a lot of ou rfuture economic prosperity will depend upo nhow many dollars—both from the federa lgovernment and private companies—get in -vested in research and development .

History is very clear. There are manyspin-offs from research and development—

2

The Honorable Beryl F. Anthony, jr.

many times accidental, sometimes not discov-ered at the time—and an enormous amount o ffuture growth and a better way of life arealways the result .

You can stack what we are doing in th eUnited States up with any of your foreig ncompetitors, and you can see that we are fall-ing behind. A favorite illustration is to look a twhat japan does versus what we do . Many ofour foreign competitors are slowly but surel ytaking away our technological advantage. In1986, we actually went into a deficit positio nwhen it comes to high-tech exports versu simports. This is an indictment in itself, bu teven knowing the trade numbers, we still can' tfind a permanent solution to Section 861 .

The title of your program is "R&D an dTax Policy: A Study in Conflict — Opportunityfor Change." Let me tell you what your prob-lem is, pure and simple . The conflict is not overwhether or not people believe in research an ddevelopment, or over the proper allocation o fforeign research versus domestic research. Theconflict is between the need to balance th ebudget and the need to have a permanent,national policy on research and development .I guess that is where I come into play. You cansit and talk about all the technicalities that yo uwant, and you can find all the conflicts in thetax code that you want, but until the wills of theCongress and the Administration combine toput this tax policy on the books permanently ,you are always going to have this conflict outthere.

I had your coalition come by to see m eearlier this year . I told them that I was no treally sure I wanted to lead the fight in 1990 forresearch and development allocation, yourSection 861 . Why?

I have passed it three times, ladies an dgentlemen. I have passed your amendmen tthree times in the Ways and Means Commit -tee. I have passed it three times in the House .Two of those three times, I think, it passed theSenate, but it has been dropped in conferencethree times in a row. For three years it has bee nin the President's budget . We have accommo-dated the President by passing it, but this

industrial policy runs into conflict with budge tconstraints, because it costs a lot of money as atax expenditure calculated out over a five-yearperiod of time.

We have turned the corner this year .Chairman Rostenkowski and the staff are say -ing "enough is enough—let's make it perma-nent—so we won't have to go through the figh tagain this year." We will try to get it passed ona permanent basis, and the fight will see measy. You may think you have won somethin gwhen it is passed through the House and Sen -ate, but don't take a vacation and think tha tyour part is done . Let me tell you why. Youbetter come circle the conferees and not le tthem out of the room until they agree to somepermanent rational allocation . If you are frus-trated with the inability of Congress to find apermanent solution, let me tell you I, too, a mfrustrated with being asked to do somethingfour years in a row. As far as I, personally, a mconcerned, this is an indictment of how lacka-daisical we are about what is happening i ninternational trade .

I hope your Tax Foundation seminar findssome good arguments to give to Bentsen,Rostenkowski, Brady, Darman, and Bush, andthat those arguments sink in . Maybe you canget them to agree that if they really care aboutit, they will follow through this year and won' tcome back and talk about another temporarysolution to it .

I would say to John and others, "if youfind conflicts in the tax code that are workingat odds with what we are trying to do, brin gthem to our attention and I think this is the yearto try to do something about it . "

It will come about because of anotherpolitical force that is out there . We had Com-missioner Goldberg testify before our Over-sight Subcommittee, and I just walked out o fthat Subcommittee to come here for this pres-entation. I asked him whether he was allocat-ing any personnel, time, or effort, or had anyinitiative to make sure that foreign companie swith United States subsidiaries are paying thei rfair taxes, since you are required to pay you rfair share of taxes . He said he was, but didn't go

3

R&D Tax Policy

into it in detail, and we are going to follow upon it .

As a result of imbalances in the dollar an dour trade deficit, foreign companies come her eand can then take advantage of our tax code . Inthe automobile industry alone, they make $7 . 7billion and only pay tax on $12 million worth o fincome. Our domestic companies have to pa y585 percent more tax than they do . There ha sgot to be some type of rational balance in ou rtax code, vis-a-vis here and other countries, s othat everyone is competing as they ought to be :if you have the best product, the marketplac ewill accept it as such . If you don't have the bestproduct you will come in second or third place .

Basically, I think that is where we ar etrying to go . We are not trying to say to foreign-ers "don't invest your money here," becaus ewe need that investment. At the same time,John, I hope you can find and make some goodrecommendations, and that others on the pane lcan make some recommendations in terms o fhow we can find a permanent solution to allo wus to continue to pursue research and develop -

rnent. It will, in the final analysis, change wha thas occurred over the last ten years . The 1990shas to be the decade of investment in America .If not, then we are on a rocky road with aslippery slope downward.

I thank you for letting me come by andvisit with you . You have a great task ahead o fyou. I guess I will be willing to put on th euniform and go back into the game one mor etime. But, ladies and gentlemen, if the WhiteHouse and Congress can't get their acts to-gether this year, maybe we have to conside rthis the fourth quarter, and the game is abou tover. Then, maybe you will have to make tha tfinal decision about where you are going t oplay the next game . I hope that we will have alegislative success, and I hope that the pro-posal I have offered, and the Administratio nhas accepted in its budget, will eventually b eadopted, because it is good, sound researc hand development tax policy. It is good polic yfor the country in terms of the economics .

Good luck, and you have a big challengeahead of you .

Q& A

Q: What other incentives is Congressthinking about putting into the tax code be-sides the traditional tax credit and other rule sthat already exist? What other bills are ou tthere to further encourage R&D investment?

A: I don't know of any that are beingtaken seriously by the Ways and Means Com-mittee, other than just your standard researc hand development extension. The current R&Dprovision goes through September 30th, a sdoes Section 861 . I can't foresee anything otherthan those two items being implemente dthrough the tax and budget compromise thi syear. With reference to my comment aboutmaking sure that everybody is paying their fairshare, I think that might be the one added in -gredient that is out there . We have not taken alook at overall international taxation of indus-tries in a long time. I think it will get some

examination this year . I can't foresee that therewill be a host of recommended changes thi syear, but I think you are going to see the star tof the learning process—a lot of questions arebeing asked .

Then, maybe in the next two to three year swe will see if there need to be any policychanges .

Q: Just a general budget question abou tyour predictions for the budget process an dthe chances of the tax bill and where the Ros -tenkowski proposal fits in .

A: I think the Budget Committee will rec -ommend a $13 .9 billion increase in revenue tothe Ways and Means Committee . That is thePresident's number . We had to do $5 .2 billionlast year. It took us until October. We abou tkilled each other just trying to get a $5 .2 billion .Now we have to get to almost 14 . It won't be

4

The Honorable Beryl F. Anthony, jr.

easy in an election year . The Rostenkowsk iproposal is getting a lot of play for two reasons .There are a lot of people who perceive a void inleadership who are coming forward and say-ing we have to do something about the deficit .So, there have been a lot of comments sayin g"We appreciate the chairman moving forwardand laying out a proposal." Then, each groupsays what they do and do not like, but overal lthey all like the thrust of where he wants to go ,which is, "let's be serious and do somethin gmeaningful this year . "

What is the reality? You will not get tha ttype of a budget compromise passed in th eUnited States until George Bush, George Mitch -ell, Lloyd Bentsen, Tom Foley, and Dan Ros-tenkowski sit down together with their handsup on the table—they have to be holding handswith one another—and say to every mediaperson who is present, "We have agreed jointl ythat this is the tonic that is needed to get thi sdeficit straightened out so that this country cancontinue to survive economically ."

Until that happens, I think you will jus tcontinue to have what Leon Panetta called las tyear a "slide-by budget ." Why? Democrats areconcerned about being relabeled "tax andspend." The Republicans remember wha thappened in 1982 when the Senate passed abudget resolution and Ronald Reagan cut thei rknees out from under them with a chain saw .In the next election they lost the Senate, an dthey lost 22 members in the House of Repre-sentatives .

You are not going to see the necessarykind of bravery occur on a one-party basis; itwill have to happen jointly . To some extent Ithink that Bush should be given credit . Hebasically said what these other groups hav edone. I applaud the Chairman for throwing hi splan on the table . There are parts of it I don' tlike, but I like the whole. It keeps hope alive ,and that is what is important .

Q: Congressman, to follow up on a ques-tion just asked: the summit we are talkingabout here, do you see that earlier or later, orwhat?

A: Later.

Q: What time approximately? After th eHouse approves the budget or before?

A: I think when the House hammers ou ta budget, we'll pass it . I don't think the Senat ewill pass a budget, and I think we will be force dto go to a summit in October. Since we willwant to get out early in October to go cam-paign, each passing day in October means tha tthere is more pressure . The greatest amount o fpressure will come around the 15th of October .I think the only reason we would have a lam educk session is for the Senators to get their payraise. There may be a call for a lame ducksession, but I just don't think anybody willshow up. I personally don't think it will have tohappen. I think we will hammer out all of ou rdifferences, but, unfortunately, it is lookin gmore and more like it is going to be the end o fthe year before we actually resolve this budge tsituation . As sick and tired as I am of bigbudget reconciliation bills and summitry . . .You know why I am opposed to summitry,don't you? Because I am not in the summit . Ihave to go home and defend it, but I don't getto shape it . There are only about 15-20 peoplein the summit, but everyone has to go homeand defend it .

There is a growing resentment of sum-mitry because we feel like we should be equal .We are sworn in together, we all draw the sam epay check, and we all have to defend the pol-icy, so you would think that we would all havean opportunity, through the regular commit -tee structure, to offer amendments and to debateit . However, my personal political judgmentsays by the end of the year we will be in sometype of a summit .

Q: Very few people would argue withyour comment that United States subsidiariesof foreign companies should pay their fai rshare of taxes. From my understanding, thereis a recent proposal by Congressman Gephard tand Chairman Rostenkowski that would in asense implement some double taxation ; theseUnited States subsidiaries are often payin gtheir capital gains, for instance in the countrywhere they are incorporated, just as UnitedStates companies and subsidiaries overseas

5

R&D Tax Polic y

pay their capital gains here. To what exten thave you looked into that issue, and do you se eany ways that the tax laws need to be changed?

A: I personally have not done an exten-sive study of this, and I don't think the Com-mittee has either. I think the bill was put out t obe a lightning rod, to create discussion, and tostart holding the hearings. I don't think youwill see the Chairman pursue a piece of legis-lation if, in fact, it is proven clearly through th erecord that it is double taxation . If anything, Ithink the Chairman's attitude in 1990 is to tryto find ways to simplify the tax code, with th erepeal of Section 89 he has eventually comearound and I think there has been a change i nattitudes, both of the Chairman and a lot of thestaff. I think they are looking for more ways t osimplify the code .

To that extent, do you realize that in 198 9we did not pass one single tax provision tha thad an effective date retroactive to 1989 . This isthe first time this has happened since I have

been on the Committee. Just maybe we hav elearned our lesson . Maybe we are going to tr yto write solid, progressive, prospective legisla-tion and not get into some of the traps that w egot into last time .

I do a tax conference back home with myCPAs and with my tax attorneys . I thought Iwas going to be strung up in 1989 because ofSection 89 . This year, you would have thoughtwe were at a love-fest. There has been anenormous change in attitude between last yea rand this year in terms of the problems that havedeveloped in the tax code.

So, based on that, I just do not think tha tyou are going to see the Chairman shepher dthrough something that is ill-conceived . I thinkthis is an area he wants to look into .

Moderator: There is a vote on the Hill, sowe have to get the Congressman out . But wewould like to thank him very much .

6

ISSUE OVERVIEW

Outlining the Conflicts in R&D Tax Polic y

John Mage ePartnerMiller & Chevalier

John Magee, a Member of the law firm of Miller & Chevalier, Chartered,focuses on the increased globalization of the world's markets and the roleR&D plays in this expanded market. He gives an overview of the decision-making process involved in making R&D expenditures. Through hypothetica lscenarios, he sets out a summary of the impact of Code Section 174 (th ededuction for R&D expenditures) and Code Section 41 (the credit for increasin gresearch activities) on R&D expenditures . He, as did Congressman Anthony,notes throughout his presentation the importance of Regulation Sectio n1.861-8 on domestic R&D . He discusses the inverse relationship of creditsallocated to foreign-source income to the foreign tax credit limitations an dthe negative impact this relationship has on domestic R&D expenditures .

Mr. Magee talks at length about Code Section 174 and the regulation sthereunder . He notes that in the past there has been a tendency to try tonarrow the availability of the deduction . In 1989, the temporary regulation sclarified that the deduction for R&D expenditures would not be disqualifie dmerely because the expenditures were made with respect to an existin gproduct. Mr. Magee still sees some problems in the area of computer software ,however, and he cautions that a proposal to require capitalization of R& Dexpenditures conducted overseas, which was dropped in conference last year,may resurface .

Mr. Magee also discusses the importance of making the credit permanent.He notes that it is impossible for companies to plan for the long-run withou tthe benefit of a permanent policy in place .

Mr. Magee concludes his presentation with a discussion of foreign join tventures. He talks at length about Sections 367(d) and 1491, which impose sa 35 percent excise tax on the transfer of technology to a foreign partnership .This excise tax causes whatMr . Magee refers to as a "transactional meltdown"because it makes contributions of technology to a foreign partnershipseemingly prohibitive . Alternatively, a partnership can elect to have Sectio n367(d) apply and be treated as a corporation . Under that section, the propert yis treated as sold and the deemed sale generates deemed royalty paymentsover the life of the asset.

Unlike a real sale of an intangible, which would produce foreign sourceincome if the asset were to be used overseas, this deemed sale create s

7

R&D Tax Policy

domestic source income which will not generate a foreign tax credit . Thisprovision essentially requires the restructuring of a joint venture transactio nas an actual sale if the parties want to avoid pricing and payingthese deeme droyalties .

(A copy ofthe paper Mr. Magee and Ms. Patricia M. Lacey prepared for theconference is available from the Foundation .)

Thank you Dan. Pat Lacey really wrot ethe technical outline, so if you have technicalquestions I may call on her to help me out . Iwrote the speech, and that was an experiencein technology all by itself because last night a t11 :00 p .m. my screen went dead, I got an errorsignal that the disk drive was down, and I ha dto call one of the young associates at home a t11 :15, put him on the conference speaker phone ,and have him walk me through the retrieval o fthis document .

It is a sign of progress in this country tha tI have a computer on my desk at my age, an dthat I am actually learning to use it . In fact, theUnited States is a major leader in the develop-ment of new technologies and new products ,and as Congressman Anthony said, it is the ke yto our economic prosperity in the future .

But our tax laws have not kept pace wit hthe advances of technology, nor with change sin the global market . I am going to be talkin gnot only about some of the domestic issues tha taffect R&D directly, but some of the issues tha taffect the deployment of R&D as we enter aglobal market .

I don't know if you saw the Wall Stree tJournal this morning, but there was an articleabout annual reports being more global i ntheir presentation . It is a trend now that firmsare beginning to talk about being part of th eglobal market and of global competition . Globalcompetition is becoming increasingly impor-tant, and we have some provisions in our taxlaws that make it difficult for United Statescompanies with major technology to compet eabroad in deploying that technology .

I am a practicing tax lawyer, and since Ipromised Paul Merski that I would not readdirectly from the Code today, the easiest wa yfor me to make clear some of these problems is

to illustrate them by examples that show ho wdifficult it is to explain this area to corporat emanagement that may be considering R& Dprojects or foreign joint ventures.

Assume that you are a tax lawyer sittin gat your desk reading Commissioner Goldberg' slatest attempt at tax simplification . The phonerings. It is the international business develop-ment people in your company and they hav etwo proposals. Naturally, they are going t opresent them to management tomorrow andthey want your quick review and blessing .

The first proposal involves spending $100million for research and development relate dto new technology for the manufacturing proc-ess for an existing consumer product thecompany already markets in Europe . Theybelieve that with the new technology th ecompany will be able to be more competitive inthat market, and to begin to penetrate wha tappears to be an opening Eastern Europeanmarket .

The second proposal is to enter a join tventure with a German company — a 50/50deal. Your company has existing technology inthe fertilizer business, and it would like to putthis technology and some of its capital into a50/50 equity enterprise with a German com-pany, which is going to put in some of its owntechnology and capital . Together the join tventure would manufacture fertilizer in Eu-rope for the European markets . The existingmanufacturing technology has a value of $100million, so it is valuable technology . The com-pany probably does not have much of a cos tbasis on this technology, however, because ithas deducted most of its expenditures underSection 174 .

So, let us examine the tax provisions tha tcome into play for the first proposal, the expen-

8

Outlining the Conflicts

diture of $100 million to develop a new manu -facturing process for an existing consumerproduct . Section 174 provides a deduction fo rresearch and development expenditures . Whenit was adopted in 1954, it cleared up ambigui -ties about whether or not certain R&D had t obe capitalized and amortized, or, in the case o fproperty that had no useful life, was neve rwritten off at all . So, it was a liberalization anda provision that Congress believed at the tim e

would serve as an incentive to encourage tax -payers to conduct more R&D .

The problems with Section 174 have prin-cipally involved the scope of coverage . In 1983 ,regulations were proposed that would hav enarrowed the scope of the deduction . Particu-larly, they might have affected the "manufac-turing modification" type of research that weare talking about here, because they disal-lowed the deduction for activities related to"routine, periodic, or cosmetic alteration orimprovement" of existing products or com-mercial production lines. This was a troublingproposal because in today's technologicalworld it is frequently the case that improve-ments which build upon existing things are th ekey to future development . These are often th eareas where there are the most significan tdevelopments in technology .

Another controversial aspect of the pro-posed regulations was their treatment of com-puter software. They narrowed the scope ofthe deduction available under Rev . Proc . 69-2 1for computer software development costs . Afterpublication of the regulations, however, theIRS said that the restrictions on eligible soft-ware development costs would not apply fo rSection 174 purposes, but only for purposes ofthe research credit . Ultimately as things devel-oped in the 1989 version of the proposed regu-lations, the treatment of software was clarifie dto some extent, as was the proposed disquali -fication for improvements in existing product sor product lines .

The concern about the restrictions on"routine alterations" was largely alleviated b ythe 1989 proposal . It excludes from Section 174coverage only those "activities not directed at

the functional aspects of a product includingexpenses relating to style, taste, cosmetic o rseasonal design factors ." However, routine orperiodic research and development expendi-tures will not be disqualified if they satisfy th ebasic tests for qualification, including a ne w"significantly enhanced function or perform-ance level" standard .

The proposed regulations came out i n

May of last year. They eliminated most of theproblems with computer software and made i tclear that computer would be governed by thesame standards that apply to other products . Itis not clear from the regulations themselves ,however, how to treat the costs of computersoftware developed for management function sor internal use of the company . Conversationswith National Office personnel at the IRS wh odrafted the regulations indicate that when theregulations are finalized, they will clarify tha tthis is not intended to be a restrictionand thatsuch expenditures may qualify under Sectio n174. So, if our proposed research expendituresfor improvements to a manufacturing proces sinclude management software, presumablythey would be covered.

In 1989 the Ways and Means Committeepassed a provision that would have disalloweda deduction under 174 for foreign-conductedR&D. If, in our example, there was considera -tion of conducting the company's research anddevelopment overseas, one would want to beaware that there have been proposals to re-quire the capitalization of such expendituresinstead of allowing the deduction. While theprovision did not become law in 1989, it i slikely to resurface, particularly in the currentbudget climate, and also because there is ageneral concern about keeping R&D in th eUnited States . As Congressman Anthony indi -cated, there are other pressures that may driveR&D out of the United States, and we are goin gto talk about 861 in more detail in a few min-utes .

The research credit was originally enactedin 1981 as a 25 percent incremental credit . Thatmeans you get the credit for incremental ex-penditures over the expenditures incurred

9

R&D Tax Polic y

during a base period. The credit was reducedto 20 percent in 1986 in conjunction with thereduction in tax rates overall. The credit isobviously intended to be an incentive fordomestic research. Its availability is limited t oresearch that is conducted in the United States .So, the credit would be available for our projec tif we conduct the research here .

A tax credit can be a powerful incentive ,because every dollar of eligible expenditur eoffsets a full dollar of tax liability . The value o fthe R&D credit has eroded over time, both b yuncertainty and direct limitations, many ofwhich were attributable to the budget revenu eproblems to which Congressman Anthonyalluded .

In 1989, the base used to determine theincremental R&D credit was changed from arolling base period to a fixed period . Even so ,the incremental nature of the credit means, a tleast from what I can ascertain in talking withclients, that for large multinational companie sin the United States the credit is really a ninsignificant piece of the R&D picture . Onecompany told me recently it estimates that th ecredit represents less than two percent of itsannual R&D expenditures . In a 1989 report o nthe credit, the Government Accounting Offic eestimated that the average effective rate for th ecredit in the period 1981 to 1983 was 3 .5 percentto 5 percent . So, the incremental nature of thecredit has a significant dampening effect, eventhough the base period has been modified an dpresumably liberalized .

To make matters worse, now your Sectio n174 deduction is disallowed to the extent youclaim the credit . This started in 1988 with a 50percent disallowance and increased to a 100percent disallowance in 1989. So, if you spend$100 for R&D and you have a credit (let's say i tis an incremental expenditure and you have acredit of $20), you are going to reduce your$100 deduction under Section 174 by the $2 0credit and claim a deduction of only $80 . Whatthis does effectively in a 34 percent tax rateenvironment is reduce the value of the creditfrom 20 percent to about 13 .2 percent .

In the 1986 Act, Congress did a number of

other things that reduced the incentive valueof the credit . Eligible expenditures were re-stricted, but the restrictions did not permit asimilar redifinition of the base period expendi -tures. The credit was also brought under th elimitations that apply to the business credit .Finally, when adopting the Alternative Mini-mum Tax, Congress refused to permit the R& Dcredit to offset AMT liability . That means thatindustries like the U.S. chemical industry ,which is capital intensive, and has minimumtax exposure because depreciation is one of it smajor considerations, may lose the benefit o fthe R&D credit . As research-intensive andcyclical in nature as the chemical industry is, i ttends to have both good times and bad . Acompany may lose any benefit of the R& Dcredit during the down-turn periods in itseconomic cycle, because it can't use the creditto offset its alternative minimum tax liability .

Perhaps the most common complaint ,though, concerning the credit is that it has no tbeen made permanent . Here we have a credi tthat was enacted in 1981 . Initially, it was goo dthrough 1985 . Then it was extended through1988. Then it was extended for 1989 . Then i twas extended through the first nine months o f1990. Again, the Administration has propose dmaking the credit permanent . But the revenu eestimate associated with this provision is $5 . 5billion for the period 1990 through 1995 . Giventhe extent to which revenue considerationshave driven tax policy in recent years, it isdifficult to believe that a figure of this magni-tude will permit the adoption of a permanen tR&D credit provision in the absence of som efairly important coalescence of policy in th eR&D area — some comprehensive policy thatputs everything together and makes all the .incentives work in the same direction .

Can I promise my product developmentpeople who want to spend $100 million o ntheir R&D project that if they do, and if it i sincremental, they will be eligible for the re -search credit to the extent that the expendi-tures are made after September? I think that issomewhat difficult, but it demonstrates theproblem with this sort of episodic extension .

10

Outlining the Conflicts

Particularly in the modern environment, thes eprojects get bigger and bigger, more expensiv eand complex, and require longer and longe rlead times for planning . As a tax advisor, it isdifficult to predict with any kind of certaintywhat is going to happen one, two, or thre eyears from now as these projects move along .You can't advise management about the availa -bility of the credit even if you are otherwise i na position to utilize it .

I think Congressman Anthony is correc tin focussing most of his attention on the 861-8allocation. It is perhaps the most difficult as-pect of analyzing United States tax benefitsassociated with R&D . As he said, these regula-tions allocate R&D expense between Unite dStates source income and foreign source in -come. In the game here the stakes are yourforeign tax credit . Since the 1986 Act with itslower tax rates and multiple 904 foreign ta xcredit limitation baskets, many more taxpay-ers are in an excess foreign tax credit limitatio nsituation . Any time these taxpayers allocate adollar of R&D expense against foreign sourc eincome under these rules, they reduce theirforeign tax credit limitation by one dollar andin effect, deprive the company of the foreig ntaxes paid and nullify the benefit of the R& Ddeduction .

It is also important to recall that foreigncountries frequently do not permit deduction sto United States taxpayers for this allocation o fexpenses. Thus, if under 861-8 $100 of R& Dexpense is allocable to foreign source income ,and the foreign country does not permit you t otake a deduction against your foreign sourc eincome for that R&D, you will have a corre-spondingly higher foreign tax liability .

To give you a flavor of the magnitude o fthis problem, one client recently told me tha tfor his company the 861-8 issue was worthbetween $50 and $100 million a year under th e1977 regulations . Under the 64 percent solu-tion that we now have temporarily in effect, Ithink this figure has dropped to something lik e$15 or $20 million. So, we are talking abou tvery large sums of money .

As Congressman Anthony said, a pru-

dent tax advisor is going to begin considerin gwhether or not R&D should be performe doverseas in a foreign subsidiary . A foreigntechnology subsidiary company can performR&D and then use reciprocal licensing, cos tsharing, and other techniques to the extent it isnecessary to bring the fruits of that researc hback into the United States . But, as long as th eresearch is performed overseas, a deductio nagainst foreign source income will be avail -able .

The National Science Foundation hasconfirmed that this may be a growing trend .They noted that in 1988, industrial R&D spend -ing overseas in current dollars increased b y17.4 percent, while domestic spending in-creased by only 5 .8 percent. The Foundatio nattributed this differential in part to the 861- 8regulations .

Congress, the Treasury, and taxpayer sare aware of this problem and have worked o nsolutions. Congress has acted on six separateoccasions, starting in 1981, to either suspend ormodify temporarily the 861-8 regulations . In1987 a consensus was reached among all of th eparticipants to provide a permanent 67 percentsolution. It was never permanently enacted ,and as the pressures of the budget operated onit, it became a temporary 64 percent solution .The effect of this episodic treatment has bee nthat there was no moratorium on the 1977regulations for eight months of 1988, all o f1989, and for three months of 1990. TheAdministration's current budget proposa lwould make the 64 percent solution perma-nent. The estimated price tag by the Admini-stration is $2.8 billion from 1991 to 1995 .

If our business development people spend$100 million on research during 1990, can w ebe sure how the deduction is going to be allo-cated under 861-8? We can't . The temporary 64percent solution applies through September o f1990 and we don't know what will happe nafter that. We don't know whether there will b ea permanent solution. It could be, if the futureis consistent with the past, that there will be atemporary extension that will not pick up th elast three months of 1990 . Thus, we could end

11

R&D Tax Polic y

up in a situation where we have a large portionof the R&D expenditures (9/ 12ths of the amoun tspent during the year) treated under the 6 4percent solution, and the remainder treatedunder the 1977 regulations. You can imaginewhat this uncertainty does to business plan-ning .

On that optimistic note, let's move on t othe more difficult problems that are presentedby the German joint venture. I think we allknow about the domestic problems with R&D .But one area that has not received much atten -tion involves the problems that I am going topoint out with respect to the German join tventure.

When we talk about joint ventures today ,we are talking about either partnerships orcorporations . Joint ventures are becoming amore commonplace method of operating inthe global market . You have countries tha trestrict foreign ownership, so you have to join tventure . You have governments that are inter-ested in government participation, so you havejoint ventures . And you have other companiesthat have technology, knowledge, processes ,employees and know-how that make it advan-tageous to have joint ventures.

The German joint venture we are talkingabout here is to manufacture fertilizer in Eu-rope and Eastern Europe . So, it is going to be aforeign joint venture . It is not going to bepractical to make it a United States company .We are talking about a foreign corporation oraforeign partnership. Ordinarily, putting asideissues with respect to intangibles, you woul danalyze the choice between corporation an dpartnership form by comparing the benefit sfrom income deferral in a corporation, subjec tto certain non-deferral rules, to the benefits o floss pass through from a partnership . In addi-tion to these tax considerations, you wouldalso factor in other considerations from a busi-ness standpoint, including the climate in th eforeign country and whether they have part-nership forms of business, limitations of liabil -ity, and all sorts of other things .

In our hypothetical, 50-50 joint venture ,we have $100 million worth of technology to

transfer to the joint venture, and the other sid ewants the transfer to be an equity investment .They will transfer their technology as an equityinvestment . It doesn't really matter whethe rwe choose a corporate or partnership formbecause both will be a disaster from a UnitedStates tax standpoint .

Section 367(d) covers equity transfers toforeign corporations, and Section 1491 coversequity transfers to foreign partnerships . Let'sstart with 1491 . It imposes a 35 percent excis etax on the value of the technology contribute dto a foreign partnership to the extent that i texceeds our cost basis — in other words, th etaxable gain that is inherent in this technologyasset. In our case, it is all gain because all of thedevelopment costs were deducted . We have$100 million in technology and a zero basis . Wehave a 35 percent excise tax liability on this . I tdoesn't take an economist to tell you that thedeal makes no sense on this basis . We had oneof these situations recently in the office, an done of my partners labeled it "transactionalmeltdown" after confronting this provision.

Assuming that I don't abuse the partner-ship rules of 704(b)(c) allocations, which basi -cally require that the way partners split u pincome and deductions has substantial eco-nomic effect . Under these provisions the gov-ernment has the authority to write regulation sthat require you to essentially realize the gain sattributable to contributed property . I under -stand there are some technical glitches there .But if those could be cured, what is the policyreason for requiring an excise tax on this kindof a transfer when we are talking about a pass-through entity where the United States con-tributor is going to get 50 percent of the incomecoming out of this venture? If this technologyis disposed of in some way, the company wil lpresumably get a proper allocation of the in -come attributable to the disposition of th eproperty that it has contributed .

There are a couple of elections to help youavoid this "transactional meltdown," excep tthey don't really help . The first one allows youto elect, under Section 1057, to treat the prop-erty as though it had been sold . So, if you have

12

Outlining the Conflicts

$100 million of taxable income at a 34 percen trate, you save yourself one million dollars . Istill don't think you are going to do the trans-action on that basis .

Alternatively, you may elect under Sec-tion 1492, to apply the principles of Section 367 .This brings us around again to our corporat ealternative, because 367 governs contribution sof intangibles to corporations. Because youhave the option of applying those principles tothe partnership, you come out basically in thesame place.

Under Section 367, you can ordinarilytransfer tangible trade and business assets fro mUnited States source to a foreign source with -out too much expense. Section 367(d) is theprovision that governs intangibles and it cre-ates insurmountable barriers . In our case, theequity contribution of $100 million of intan-gibles to the foreign corporation or the foreig npartnership, if we elect the principles of 367(d) ,is treated as a deemed sale of intangibles i nreturn for a deemed periodic payment or roy-alty—an imaginary royalty over the useful lifeof the asset . If we really sold this technology tothe joint venture on a license basis for an arms-length royalty, the royalty paid would be for-eign source because the property would b eused abroad and therefore would generat eforeign source income, at least for a foreign ta xcredit analysis . Unlike a real royalty, however,the deemed royalty under 367(d) is character-ized as domestic source income . No one willever make a contribution of intangibles likethis and take the 367(d) consequences — a tleast not under circumstances of which I amaware.

You can only avoid these rules by trans-ferring the intangibles to the joint venture in alicensing transaction for a real royalty . That isnot what those on the German side of the join tventure are contemplating . They never though tthat you would put your intangibles into th eenterprise and then take money off the top a san expense for this royalty to you, instead o fputting your technology in as an equity, at riskwith their technology . The German partnerswill probably call other potential partners in

Europe and Japan . The fact is that the situatio nin the U .S. for the deployment of research i sdisadvantageous in a lot of respects . There ar eother countries that don't have these restric-tions and problems .

The Federal Reserve published a study i nthe summer of 1989 that quantified the cost o fcapital rates for the United States, Japan, Ger-many and the U.K. for 1988 on a ten year pay-out investment for R&D. The cost of capitalrate for the United States was 20 .3 percent . Thecost of capital rate for Japan was 8 .7 percent.The cost of capital rate for Germany was 14 . 8percent; and for the U .K., 23.7 percent Thestudy is a very detailed economic piece whichdoes conclude that the income tax is not th eprimary effect here . Putting that conclusionaside, however, we are talking about a tremen-dous differential in burdens in different coun-tries . Now, adding to that as a toll-gate Sec-tions 367(d) or 1491, we are prevented fromentering into international joint ventures with-out insisting that the deal be restructured t osatisfy concerns about our tax law.

Let's assume for a minute that the Ger-man entity is willing to go along with us an dhave some dialogue about how we might pricethe royalty on the transfer of our fertilizertechnology . We are going to be dealing withSection 482 which requires arms-length pric-ing between related parties and applies to th elicensing of technology. The standard ought t obe fairly straightforward, but it isn't . Like mostof the things under the Internal Revenue Code ,it has been further complicated by the 1986 Act ,which adopted in the case of transfers o fintangibles a standard that the amount ofincome under Section 482 must be commensu-rate with the income from the intangible ,whatever that means . This provision is nowreferred to as the "super-royalty" provision . Itresulted from government concerns that in -come derived from intangible assets that ha dbeen transferred outside the U.S. was slippingaway from the Treasury through transfers totax-haven jurisdictions, or where extraordi-nary intangibles were transferred for ordinarylevel royalties . The problem is that the ne w

13

R&D Tax Polic y

standard applies as written to all transfers o fintangibles whether it is your normal ongoin gbusiness technology or a super drug of som ekind with the potential to go off the charts interms of its capacity to earn income.

Treasury published a white paper in theFall of 1988 on inter-company pricing for in -tangibles — a lengthy and very difficult piece .It was a valiant effort, but to comply with th ekinds of concepts that Treasury must hav eenvisioned will be virtually impossible, par-ticularly in the area of cost-sharing, and even inthe more mundane types of transfers . Thoseconcepts now are under reconsideration andTreasury is still struggling to figure out wha tthe super royalty provision means in the con -text of the old arms-length standard, the stan-dard that the U .S. sold in the international taxcommunity as the proper standard for related-party transactions .

The difficulty with the super royalt yprovision is that it requires you to look bac kretroactively in the future and see how muc hincome has been earned . If you have a majorchange from what was anticipated at the be-ginning, you may need an adjustment to th eroyalty. I still fail to see how this can be consis-tent with what I consider to be arms-length —what unrelated parties would do . It remains t obe seen .

How do you respond to your busines speople when they ask you what kind of royalt ywe need to ask the Germans for in order t omake this joint venture fly? What is the leveland what must we do to determine a prope ramount? I think a cautious tax advisor willadvise you to hire an economist, and have hi mlook at all the comparables that are availabl efor this type of technology . You also bette rhave him look at all the economic functionsthat you are going to be performing, that th ejoint venture is going to be performing, and the

Germans are going to be performing . You bette rlook carefully at what the anticipated incom estream is and then approximate the prope rroyalty amount . This will not eliminate futureIRS challenges. You cannot predict with an yconfidence what will happen in the future .Your estimates of the income may be made ingood faith, but they may not turn out to bewhat actually happens and then you may endup facing the look-back requirement .

If you haven't heard enough about theseconflicts in tax policy from me, I know that thebusiness people we're talking about have . Itmakes you wonder what they are going to telltheir management committee when they go i ntomorrow to talk about the two proposals, an dare asked what the tax consequences are fro mthe United States standpoint? They can say, "I fwe do research in the United States, it is de-ductible, but that is about all we can tell you ,except that the deduction will cut back signifi -cantly on our foreign tax credit if we are in anexcess credit situation and we have to restruc -ture the deal with the Germans because wecan't do a joint-venture equity contribution ."

You might think that after this presenta-tion management would decide to get involvedin an effort to develop a coherent tax polic ytoward R&D that would provide strong incen -tives for conducting R&D and facilitate the us eby United States companies of that R&D a sthey compete outside the United States . TheTax Foundation has, today, taken an importan tstep in developing a dialogue on the develop-ment of a coherent policy for R&D . We alsoneed to be mindful of Congressman Anthony' swarning that these R&D issues involve budge tconsiderations . I think it is time for tax policiesto be based on long-range economic concerns .It is time to do something about the budget, o rat least to put it in its proper place when itcomes to policy planning .

Q& A

Q: I know you are not an economist, butif we look at a time-line situation and the rulesstarted to stiffen and get very tough, could you

almost pinpoint the time of the more difficultR&D rules and the impediments to R&D withthe decline in the R&D picture we have seen in

14

Outlining the Conflicts

the United States. This hasn't always been thecase. In the early '70s and '60s, R&D had amuch more favorable position . What are yourcomments?

A: I haven't seen any data that would al -low me to say anything intelligent in response ,but there could well be a connection. Since westarted in the '80s enacting and modifyingthese tax acts and temporary provisions, par-tial provisions and partial extensions, etc ., therehas been a tremendous amount of confusion .Even though the credit originated in 1981, i thas had a difficult life . It has had a lot of cut-backs, modifications, tinkering, and it has beentemporary. So, you may well be right that i nthe old days we were doing better when ther ewas less interference.

Q: [Note: This question has ben short-ened considerably because of the transcriber' sinability to hear the questioner .] The wholeconcept of 861-8 as it impacts R&D, seems to b eheavily affected by concerns of the Treasurywith respect to 482, whether 482 is really doin gits job of properly charging subsidiaries . Ifsome of that income is being realized by aforeign subsidiary, then there is a possibility o fdeferrals . Do you think these considerationsapply differently when you are dealing with ajoint venture company versus a wholly ownedsubsidiary?

A: I think those considerations are proba-bly the important ones and I am hoping Mr .Graetz this afternoon may expand on some ofthe other considerations . Obviously, there issome thinking that while the expenditure maytake place here, it may benefit the company a tlarge and the production of its income world -wide. To the extent you are doing thing sthrough joint ventures where you have theactual pressure of opposition from your busi-ness partner, you are going to keep things i nline.

Q: Isn't it true that no 861-8 allocation is

required where there's a bona fide cost-shar-ing agreement? Have they changed that ?

A: I am going to ask Neala Brown toanswer that .

Comment: My company operated withcost-sharing . We were effectively exemptedfrom 861-8 allocations with respect to R&D ,which shows that there was a great deal o fconfusion between where 482 stopped an dwhere 861-8 started .

A: Part of that, I think, may be that th enormal treatment is to reduce the R&D ex-penses by the amount of the contribution, andtherefore your deduction goes down and your861-8 problem goes away, at least to the exten tof the contribution. Presumably those in a truecost-sharing arrangement are all doing thi stogether anyway . While you may be spendingyour money here together, they are taking th etechnology and owning it, if you will, as a nundivided piece abroad or wherever they ar edeploying it .

Q: What is the revenue cost of the credit ,and who does the major benefit inure to?

A: I am not sure who gets the major benefi tfrom it . My feeling is that the large UnitedStates multinationals don't get a large benefi tfrom it because their ongoing R&D expendi-tures are so large and they have such larg eprograms and you are looking at an incre-mental credit.

Q: Do we have a feel for what the tota lrevenue cost is? How much additional reve-nue might there be if there was no credit at all ?

A: I guess that is quantified in the pric-ing of the extension, making it permanent .What did I say about that? — $5 .5 billion .

Q: That is not just the credit .A: That is making the credit permanen t

and that is the cost '90 through '95, I think —'9 0meaning from October 1, of 1990 because weare covered . It is the three month gap in 199 0plus the other .

15

SESSION ONE

Conflict in R&D Tax Policy and the Need for Chang e

Panel Chairman : Cyrus J. HalpernTax Vice President, Federal & Internationa l

TaxesAT&T

Edmund K. HardingManager of Tax Planning & LitigationXerox

Stuart E. EizenstatPartnerPowell, Goldstein, Frazer & Murphy

Richard Grafineye rMinority Tax CounselU.S. Senate Committee on Financ e

Edmund K . Harding

Edmund Harding, Manager of Tax Planning and Litigation for Xero xCorporation, offers the tax practitioner's perception of current R&D policy.He expresses a concern — shared by his fellow speakers —that the Japanes eand Europeans are spending considerably more on non-defense R&D tha nthe U.S. and he offers statistics to support this assertion . He also notes thatthe nature of U.S. R&D expenditures has changed . While once concentrate din the physical sciences, R&D expenditures are now focused more on software,an area which generates more immediate economic return .

Mr. Harding criticizes the series of temporary extensions the availabilit yof the credit has been contingent upon . He notes that in choosing a site t oconduct R&D a company must now weigh tax considerations. By way ofexample, Mr. Harding suggests that a company might be inclined to choos eCanada over the U.S. because an R&D credit is already a permanent fixturein Canada's tax system .

Having been through an R&D credit audit, Mr . Harding adds some insigh tinto the Internal Revenue Service's R&D audit procedures .

He explains that, like most firms, Xerox's accounting system was not setup with specific accounts that delineated direct R&D expenditures . As aresult, the IRS agent initially allowed or disallowed expenditures for credi tpurposes based solely on the account title . The company then had the burde nof showing that an expenditure charged to a particular account was directlyrelated to R&D and should qualify for the credit. He also explains ho wapplication of the 1983 proposed regulations to the early years under audi tdisadvantaged the company. For instance, the results might have differed i fthe 1989 final regulations, which permit some R&D expenditures afte rsuccessful testing of a prototype, could have provided Xerox their mor eequitable results at the time of its audit.

17

RFD Tax Policy

My objective today is to give you the taxpractitioner's view on current United State sR&D tax policy . I have no unique qualifica-tions to perform this role, but have had theresponsibility of interpreting the law and regu-lations and to implement the requirements inour procedures . I have also been involved in a nIRS audit of the R&D credit, the appellatereview of the same, and participated in corpo-rate planning and strategy activities .

In preparing for today's meeting, I re-viewed some of the National Science Founda-tion data, finding much of it alarming . Forexample, I was surprised that both Japaneseand West German non-defense R&D spendin ghas outpaced that of the United States as a per-cent of GNP for nearly two decades . Whetherthere is a direct corollary between spendingand technological output or not, I will leave tothe experts . However, on the surface, the fol-lowing statistics make a pretty good case ofthat proposition to me.

From 1970 to 1986, United States produc-ers of high-tech goods decreased their share ofglobal markets for such goods from 50 percentto 40 percent. Almost all of the loss was due t oa reduced share of domestic United State smarkets for high-tech goods. The share of worl dnon-United States markets for United State shigh- technology goods actually increase dslightly during that period . The share of UnitedStates patents granted to foreigners rose to 48percent in 1988 . The Japanese share was 2 1percent and is growing rapidly . It was only 10percent in 1978. Japanese patenting in th eUnited States emphasizes certain specific tech-nical fields that are commercially important .They are photocopying—one that is importan tto us—information storage. and retrieval, pho-tography, motor vehicles, and typewriters .

I also reviewed the Xerox Corporation' srecent activities and found that our R&D spend-ing increased steadily and significantly fro m1983 to 1988, both in terms of absolute dollar sand as a percentage of business equipmentrevenue. We went from $529 million and 6 .6percent in 1983 to $794 million and 7 .1 percent,in 1988. In 1989, however, our R&D spending

increased only to $809 million and actuall ydeclined as a percentage of revenue, falling t o6.9 percent .

In the last few years, the nature of ourspending has also changed significantly fro mbasic research in the physical sciences, to workin systems and software areas that are morelikely to have an immediate product pay-off .

There are several reasons for this change,including, for example, the frustration of de-veloping significant advances in persona lcomputers, only to see such development sbrought to the market by others before wecould establish a foothold in the industry . Ofequal or greater importance was to meet th echallenge of our Japanese copier competitor swho have been so effective at rapidly translat-ing R&D into successful commercial products .

Has the credit actually helped to increaseour R&D spending? I believe that with th ecompetition for corporate funds by all thevarious activities, whatever you can bring t othe table to support a request has got to help .Moreover, if the debate is whether to place aresearch facility in the United States or, say ,Canada, tax benefits obviously play a muc hmore significant role. Is there any correlationbetween the fall-off in R&D growth and theunsettled state of the reduced R&D credit? Idon't know for sure, but this situation certainl ydoesn't help . Similarly, I wouldn't want t oargue the United States versus Canadian sit elocation case and have to explain that we hav ea credit through 1989, based on nine monthsactivity, with the shot at an extension, whil emy Canadian counterpart can point to a nongoing 20 percent credit on all R&D spend-ing, including capital acquisitions on top of a100 percent first-year write-off of all depre-ciable property . The requirement to allocateUnited States R&D spending to foreign sourceincome is also a negative in a site selectiondebate .

I then looked as best I could at what othercountries offer in terms of R&D incentives .Foreign taxes aren't my field and our librarydidn't offer a whole lot . So, my research wasseverely limited . However, I did get the dis-

18

The Need for Change

tinct impression that most economically com-petitive countries offer incentives equal to o rgreater than ours . I also understand, throughmy Xerox colleagues abroad, that the admini-stration of such incentives is fairly simple an dstraightforward. For example, in Japan thesystem of finance and tax incentives operate sto stimulate R&D by the private sector . Spend-ing on specific projects for the commercializa-tion of new technology is encouraged throug hJapanese development bank loans, made atfavorable interests rates or as conditional inter-est free loans . Since 1961, Japan has also mad eavailable a 20 percent tax credit for corporat eincremental R&D spending . An additiona lcredit, equivalent to 7 percent of the purchas eprice of equipment related to basic researchand materials, electronics, robotics, and manu-facturing is also provided .

On the other hand, I did not run acrossany country which required R&D spending t obe allocated to foreign source income as is th ecase under our law.

With that background, let me now turn t othe IRS audit process as it relates to the R& Dcredit . We have, to date, completed audit sthrough 1983. The R&D years included twodifferent audit segments with the same IR Steam on both . At the outset, I should note tha tthe Treasury engineer who handled the R& Dcredit audit was both professional and intelli-gent. As further background you should beaware that at Xerox the R&D functions arethoroughly self-sufficient and generally com-pletely separated from other operations . Thereare two major R&D locations in the UnitedStates: one in Webster, New York, and th eother in Palo Alto, California .

Neither the Xerox organization nor its ac-counting R&D was changed during the yearsunder audit, including the pre-R&D audit bas eperiod. Accordingly, there was no controvers yover whether or not changes were made to op-timize the credit .

The R&D effort employs around 7,50 0people in literally hundreds of budget center sutilizing Xerox's standard chart of accounts inaccounting for these functions . The use of a

standard chart of accounts limits the level o fdetail, but is necessary in order to allow for anymeaningful consolidation of corporate-wid edata. The engineer agent took a three-ste papproach in performing his review. First, heasked for and was given a listing of all th eaccount titles claimed as performing or in di-rect support of our R&D. Based solely on th eaccount title, he made a decision as to whetherthe charges qualified for the credit. For ex-ample, based on this review, he threw out al lcharges to an account entitled "General Cleri-cal," no matter what budget center the sam efell under . Remember, we didn't change an yaccounting to accommodate the R&D credit s othe account descriptions were not designed t oprecisely delineate between activities whichare in direct support versus those which mayindirectly support our R&D .

In checking the number of budget centers ,however, we were able to determine that thi saccount was used to accumulate costs for avariety of job classifications directly support-ing R&D, such as engineering records, docu-ment control, and scheduling. We also foundthat because R&D functions were operated ona stand-alone basis, some non-direct R&D cleri -cal functions were also charged to this account .To examine all the charges to this account fo rall the R&D budget centers would have been ahorrendous task, so we recommended thebudget center approach. That is, if the budge tcenter performed direct R&D, all charges underthat account for that budget center qualify . If i tdidn't, none would qualify. The engineer agentwouldn't buy that approach and insisted tha twe prove it or lose it .

The second prong of this audit approac hwas to review the budget center titles for whic hwe claimed qualifying R&D expenditures .Again, strictly by the title he allowed or disal-lowed expenditures to such budget centers a squalifying for the credit . To the extent theentire budget center was disallowed, he firs tadjusted for the accounts previously disallowedin the first step so there was no doubling up inthat regard .

This approach, though, fell prey to the

19

R&D Tax Policy

same deficiency as the first, because the budge tcenter titles were not designed with qualifyi nor not qualifying for the credit in mind, antherefore could be — and in some instance swere —misleading. We had a slew of these andworked out most of them, all but about 14, to amutually satisfactory solution. The ones wewere left with generally had titles indicatin gtest or design functions which, for the mos tpart, actually were R&D. For example, we hadone entitled the mid-volume test budget cen-ter, which was actually performing analytica land measurement techniques in support of themid-size copier development activities . Thiswould stand to reason given the R&D facilitie soperating on a stand-alone basis with produc ttesting falling under manufacturing .

You may also recall that I said the engi-neer agent was both professional and intelli-gent and also that we had not changed any ofthe accounting practices or procedures to try t omaximize the credit . Further, because the creditis incremental, the base period should self -police any undue advantage or disadvantag etaking place. Moreover, in the course of thesediscussions, neither the agent nor Xerox paid awhole lot of attention to the amounts involved .Thus it was more a matter of principle, or eve nperhaps, stubbornness on both our parts tha twe could not come to an agreement after wehad both put so much time and effort into theprocess. Unfortunately, we also consumed agood bit of time of those who would have beenmore productive in the R&D functions tha tthey were hired to perform .

At any rate, we took the unsettled accountand budget center issues to the appellate level .The appellate looked at purely the factual is-sues and in fact threw up their hands, sendin gthem back to the agent level where they werecompromised to nobody's satisfaction .

The third step in the audit process was theagent's request for a complete description o fall R&D projects worked on during the period :who did what, when, how, and what was th eresult. The volume was incredible and his ownteam even convinced him to back off a bit.Further, at the time in 1988 when we were

looking for records on 1981 through 1983 activ -ity, non-accounting detailed records were no teasy to come by. It was very difficult to com eup with information . Moreover, the enginee ragent used regulations proposed in 1983 inmaking his decisions as to what did or didn' tconstitute R&D. Those proposed regulation swere more restrictive in several respects perti-nent to the years at issue, than the presentlypublished final regulations . For example, theengineer agent relied on 1983 rates to disallowthe R&D costs incurred with respect to an ycopier model after construction and testing o fthe original prototype for that model had bee ncompleted . In fact, he pretty much disallowedall product development costs after comple-tion of a prototype. The new final regulations,while creating their own set of time-line prob-lems, at least cleared up this issue by permit-ting the cost of all subsequent prototypes an ddisqualifying only the cost of duplicates use dfor market testing or held for sale .

Similarly, use of the 1983 regulations re-sulted in an out-of-hand denial of all interna lsoftware development costs . Prior to the 1986Act, there was absolutely no authority for suchan adjustment in either the credit or deductio nfor R&D. Moreover, the 1986 Act does no tcompletely exclude an R&D credit for internal -use management software . In fact, the Com-mittee Reports direct that regulations shoul dmake clear that research on software which isinnovative, risky and not commercially avail -able, should be eligible for the credit. Withregard to both the prototype and internal-us esoftware issues, however, we were forced t ocompromise before issuance of the new regu-lations .

The agent also disallowed any salariesabove the first-line supervisory position on th ebasis that involvement above that level woul dnot constitute the conduct of hands-on R&D . Inan organization of 7,500 people totally devotedto R&D, such a position seems totally absurd ,and we were able to prove that in a number o fbudget centers . However, again, it was diffi-cult to come up with organization charts an djob descriptions, and I heard this morning that

20

The Need for Change

in other audits they even requested job evalu-ations on each individual, which sounds ratherextreme five years after the fact . We, quitefrankly, wound up compromising much mor ethan we should have had to .

Enough of that. I don't want to get to ocarried away with war stories about the com-plexity of administering the credit . In point offact, I believe the audit process is fairly admini -stered by those charged with the responsibil-ity. This is just another case where the law's re -quirement for precision is not reasonably ob-tainable without undue and sometimes impos-sible complexity .

In concluding, I would like to say that Ibelieve that the Administration and Congresson both sides of the aisle are sincere when theystate we must continue our prominence inworld markets and that a strong R&D effort i sthe key to that performance . However, if ta xpolicy is to play a role in that performance, a sI think it should, I also think we are kiddingourselves that it does so under the current law .Let's face it, in 1981 we started off with a 2 5percent credit based on incremental spendingwithout any limitation on deductions, and no

requirement to allocate R&D to foreign earn-ings. In 1990, we have effectively a 10 percen tcredit after the elimination of a deductio nequivalent to the credit, and the restriction t onine-months activity, the bottom line of whic his further reduced on audit . Coupled with theallocation requirements, this doesn't leav emuch in the way of an incentive .

With the Administration, Congress, andeven the man on the street in favor of increas-ing R&D, it is hard to figure just why taxincentives to accomplish that goal are drasti-cally reduced and in danger of elimination . I tbrings to mind the story of the fighter return-ing to his corner bleeding profusely, telling hi strainer that his opponent never laid a hand o nhim. His trainer's reply, "If that's the case, yo ubetter keep an eye on the referee, becausesomeone is killing you." Unfortunately, thesame might be said to those of us in the R& Dtax policy battle, but I am not sure who weshould be keeping our eye on . Maybe we wil lfind out today .

21

R&D Tax Policy

Stuart E . Eizenstat

Stuart Eizenstat, former Assistant to the President for Domestic Affair sand Policy in the Carter Administration, and currently a partner in the la wfirm of Powell, Goldstein, Frazer & Murphy, expresses concern over the factthat the U.S. spends considerably less on civilian R&D than its competitors .He notes that as a percentage of gross national product, R&D expenditureshave dropped from 9 percent in 1970 to just over 6 percent in 1990 whil ecountries like Japan are rapidly increasing their expenditures . He says thatwhile the United States struggles with brief extensions of the R&D credit an da solution to Section 861, the rest of the world is passing the United State sby.

Mr. Eizenstat says the solution is to foster R&D efforts by private secto rprofit and non-profit institutions. He indicates that the financial rewardsfor investment in R&D are high, higher in fact than the return on physica lcapital, provided the product is eventually viable . Mr. Eizenstat indicate sthat feasible technology is the result of only 20 percent of all R&D efforts. Headds that the benefit to society as a whole is twice what it is for the companyconducting the research. Therefore, the stagnation of the average U.S. family'sincome over the last 15 years could be related to the decline in R& Dexpenditures over the same period .

Eizenstat states that CORETECH, a coalition dedicated to a reformingR&D public policy, has a three-fold set of goals : (1) to assist in developingpermanent tax policies which encourage R&D in the U .S.; (2) to help developa technical and scientific workforce; and, (3) to aid in rebuilding the U.S .'sresearch infrastructure by encouraging the renovation and modernization o funiversity and non- profit research facilities . One area CORETECH focuseson is modification of the credit's base period . Mr. Eizenstat is concernedabout prior years' efforts to increase the base limitation . He notes that achange of this nature would further reduce the incentive to invest in R&D fo rmany taxpayers .

He further expresses his concern over Section 861's allocation requirements .He says the effect of that provision is to drive U.S. R&D overseas. Heconcludes by indicating that tax policy is not the only consideration indeveloping a solid R&D policy, CORETECH's other two goals are equallyimportant.

I. R&D is central to America's ability to corn-

fied as a major source of economic growth . Itpete in a fiercely competitive world environ-

results in new processes that produce morement .

output with less input, it creates innovativ eA. As President Bush noted in his Budget

products to perform old tasks more effectively ,Message this year: "R&D has long been identi-

and it opens up previously unimagined mar-

22

The Need for Change

kets. In today's international marketplace, th eUnited States can remain competitive only if i tstays at the forefront of technological innova-tion . "

B. Despite the fact the United States spent$132 billion on R&D in calendar year 1988 an dgovernment R&D outlays totaled $61 billion o fthat figure—one-half of the total figure—wedo not do nearly as much R&D as we must .

1. While we spent roughly the sameamount on total R&D as France, West Ger-many, the United Kingdom, and Japan relativ eto GNP—about 2-1/2 percent—we spent con-siderably less than our competitors on civilianR&D. During the 1980s, 65 percent of all fed-eral R&D went to defense .

2.While federal R&D expenditures hav eremained roughly constant as a percentage o fGNP for the past two decades—while that o four competitors has increased—their share ofthe overall federal budget has dropped pre-cipitously—from 9 percent of all federal spend -ing in 1970 to 6 .7 percent in 1990.

3. A recent study by the National Sci-ence Foundation (NSF) shows that a widevariety of American companies are leveling of ftheir R&D spending at the very time Japanes efirms are increasing theirs . The NSF reportshowed that adjusted for inflation, corporateR&D fell .9 of 1 percent, the first drop since1975 .

4. Last November, the National Advi-sory Committee on Semiconductors reportedto President Bush that research spending b ythe five biggest Japanese chip makers wa snearly double that spent by the five top Unite dStates merchant suppliers . The report con-cluded that we were gaining in no technologi-cal area .

5. Japan's Science and Technolog yAgency said in a report at the end of 1989 tha tR&D budgets are virtually sacrosanct and tha ttwo-thirds of Japanese corporate mergers iden-tify "strengthening R&D" as their number on eobjective, up from a little over half only thre eyears ago .

6. While R&D rose 20 percent between1982 and 1987 in the United States, the Science

and Technology Agency in Japan found it ros eby 60 percent for Japanese companies . Figuresfrom the OECD (Organization of Economi cCooperation and Development) confirm thes efigures, showing that as of 1987 the growth o fR&D spending among Japanese companieswas more than three times that for UnitedStates companies .

7. While United States Memories, aUnited States consortium designed to create acompetitive chip supply in the United Statesdied aborning; while we debate whether ourantitrust laws should permit cooperative jointventures needed given the huge costs of mod -ern plants — $200 to $400 million for a singlesemiconductor fabricator plant; while westruggle to get brief extensions of the R&Dcredit, the rest of the world is passing us by .The Japanese government is coordinating aproject called Sortec formed by all 13 of Japan' sbiggest electronic and semiconductor makers ,in which the companies direct scientists andequipment to develop x-ray lithography . Is i tany wonder our competitiveness is laggingwhen our R&D necessary to produce ne wproducts and processes is falling so far behind .

C. The direct and indirect effects of R& Dmake it imperative that the United States gov-ernment foster more of it in the private sector .

1. While federal spending constitutesabout 50 percent of the total nationwide invest-ment in R&D, the federal government is not th eprinciple performer of R&D. Industry performs72 percent of all R&D, and universities, non -profit institutions, and colleges another 1 7percent. Therefore, the federal governmen tmust encourage more R&D by the private profi tand non-profit sector . The direct rate of returnfor R&D is around 30 percent—three time shigher than the return on physical capital (OMBData) .

2. But the indirect effect on our econ-omy is even greater because a given innova-tion does not stay with the innovator but i sused in other industries to improve their in-dustrial processes . The Office of Managemen tand Budget estimated this year that over 4 0percent of the R&D used in a typical manufac -

23

R&D Tax Policy

turing industry was developed in anotherindustry .

3. By conservative estimates, R&D' scontribution to productivity growth is at leas t.4 per year—nearly 20 percent of the tota lproductivity rise since World War II . Thiswould mean, using OMB's own calculations, acontribution of $350 billion of additional GN Pover 20 years or over $1200 for every person i nthe United States .

D. There are compelling public policyreasons—which economists call "externali-ties"—for a stronger federal role in R&D pol-icy. In short, this is one area where the market-place sends imperfect signals .

1. There are enormous risks to privat eR&D. One expert, Professor Mansfield, esti-mated that less than 20 percent of all R& Dspending by the private sector results in acommercially viable product .

2. The company producing the innova-tion cannot capture the full economic value o fits own innovation because of imperfect paten tprotection, back-engineering by competitors,and copying, both legal and illegal .

3. Society gets much higher benefitsfrom R&D than those which accrue to th ecompany or industry whose R&D producesthe new product—by a factor of two or three toone. Because of this, OMB itself has stated tha t"not enough resources from the point of vie wof society would be devoted to R&D . "

One expert, quoted approvingly by th eBush Administration, has estimated that whil eprivate R&D investment yields a private rat eof return of 25 percent, the rate of return t osociety and the economy as a whole is 5 6percent—more than twice as much .

II. Signs of our problems in the new worl deconomy are palpable.

— Our rate of productivity growth ha sbeen markedly reduced since the 1960s and isfar outstripped by our competitors .

— Household incomes adjusted for in-flation have been stagnant since 1973. As arecent study indicated) Frank Levy and Rich-ard Michael, Washington Post, Cl, February 4,

1990), from the end of World War II throug h1973, the average family's income more tha ndoubled from $16,000 to $33,000 in today' sdollar. Poverty dropped from 32 percent (1949 )to 15 percent (1970) . The OPEC oil shock and asudden drop in the growth of labor productiv-ity stunted this growth so that the averag efamily's income in 1987 was $33,500-onl y$500 more than 15 years ago . Even this masksthe magnitude of our income problem as w ehave far more two-earner households than w edid 15 years ago. In effect, for many families ittakes two earners to make in inflation-adjustedterms what one could make a decade-and-a-half ago. Adjusted for inflation, the averag eweekly earnings of private non-farm workersare 3 percent lower now than 4 years ago .

— A study just released in January 1990by the Bureau of Labor Statistics showed thatthe real earnings of most Americans fell durin gthe 1980s—the second consecutive decade ofloss—as the economy shifts from manufactur-ing to services . Thus, despite a steady expan-sion, real pay has not risen due to the restruc-turing of the economy. Since 1969, the 80 per-cent of United States private sector employee swho are non-farm workers in production andnon-supervisory jobs fell by 12 percent in realterms and by 9 percent since 1979 .

— Hourly pay for production workersin our country was twice that of Japan asrecently as 1985 and far above that of any othe rEuropean country. Now after the decline of th edollar, it is lower in United States dollars tha nJapan's, West Germany's, France's, and eve nItaly's .

— We are spending at a rate of 3 percen tmore than we are producing each year, creat-ing the illusion of prosperity by borrowing an dimporting the difference .

A country cannot continue to run a chronictrade deficit without real consequences :

— The Tokyo Stock Exchange is nowthe biggest by far in the world, dwarfing theNew York Exchange.

— Japan for the first time spent moremoney on foreign aid last year than the Unite dStates with all the foreign policy implication s

24

The Need for Change

this has . It is they who are putting in money t oEastern Europe and the Philippines. It is theywho are the leaders in pushing debt relief.

— Nine of the 10 largest banks in th eworld are Japanese, almost a complete reversa lfrom only a decade ago .

— The United States semiconductorindustry is on its way to dependency for itsbasic infrastructure on Japanese and otherforeign suppliers—from silicon, to etchingequipment and quartz plates to wafer step -pers. If the United States companies whic hsupply components necessary for United Statessemiconductors die, efforts to revive the semi-conductor industry itself, a vital part of ou rdefense posture, will suffer. This concern wasunderscored by a United States firm's recen tsale of its silicon wafer operation to a Wes tGerman firm—leaving the United States with -out a major domestic vendor of wafers . Japa-nese firms in 1988 held the top three spots in th esemiconductor equipment industry. If foreigncorporations dominate the semiconductorequipment and materials industry, they will b epositioned to make more sophisticated chip sthan their American competition.

— Japan makes 9 of the 10 TV sets, 3 o fthe 4 telephones used in the United States, andalmost 1 in 4 cars driven here.

At the same time as Japan is developin gnew x-ray technology, called x-ray lithogra-phy, using ultra-fine x-ray beams to make chipsmore densely packed with electronic circuit sthan current state of the art, United Statesefforts are lagging .

While we still lead in microprocessors, w eare losing our edge in computer chips .

III. CORETECH Polic yOur coalition—CORETECH—brough t

together for the first time industry and univer-sities to work more closely together to enlis tpositive government cooperation for the de-velopment of a public policy agenda to pro-mote research and development . We did so inrecognition of the fact that countries like Japa nhave the ability to bring an R&D concept t ocommercialization in the marketplace faster

than the United States, in part because of bette rcorporate-university cooperation than we en-joy here .

We did have a three-fold set of goals i nour agenda .

— Develop permanent tax policieswhich encourage R&D in the United States—particularly the R&D credit and the basic re-search credit for universities and non-profi tinstitutions—and which remove tax barriersto R&D here—especially Section 861 .8 and it spunitive provisions on the allocation of do-mestic R&D expenditures to foreign sourceincome .

— Help develop a technical and scien-tific workforce which can compete i ntomorrow's even more complex internationa leconomy .

— Rebuild our research infrastructureby encouraging the renovation and moderni-zation of university- and non-profit researchinstitute-based research facilities at which th ebulk of our nation's basic research is conducted .

A . Our tax policy toward R&D is a meta-phor for the difficulty our political system ha swith coming to grips with the competitivechallenge we face .

1 . The incremental R&D credit initiallypassed in 1981 has been under constant pres -sure and clouded by uncertainty, at the ver ytime we need certainty and a stronger incen-tive for corporate R&D .

It was initially passed in 1981 but expiredat the end of 1985 . Although it was extended bythe 1986 Tax Reform Act through the end of1988—and a basic research credit was added—the credit's rate was cut from 25 percent to 2 0percent. With the cooperation of industry, wenarrowed and clarified the definition of quali-fied research so the credit could only be use dfor research undertaken to discover informa-tion that is "technological in nature," useful indeveloping a new or improved product, not t oimprove style or taste .

The 1988 Tax Act—TAMRA (Technicaland Miscellaneous Revenue Act)— extendedthe R&D credit for one additional year, throug hthe end of 1989, but the value of the credit was

25

R&D Tax Polic y

significantly reduced . Prior to the Act, a firmcould fully deduct R&D expenditures and claimthe R&D credit. But the 1988 Act limited theamount of R&D a firm could deduct by anamount equal to 50 percent of the R&D credi tclaimed that year.

As of this time, the credit's value had bee nreduced an incredible 34 percent—from a 25percent rate to an effective 16 .6 percent rate (2 0percent with a 50 percent deduction disallow-ance) .

In 1989, the Omnibus Budget Reconcili-ation Act again extended the credit temporar-ily—in effect until the end of 1990 but for 9months value. CORETECH worked with Treas-ury, the Hill, and Chairman Rostenkowski andSenators Danforth and Baucus on a new baseperiod for the credit .

We agree with the academic and jointCommittee critique of the original base period ,in which a firm could take only the R&D creditfor expenditures above a rolling three-yearaverage. This reduced the value of the credit ,as the Congressional Research Service note d(CRS Issue Brief, February 7, 1990) for firm swith moderate growth to the 3 percent to 4percent range dramatically below the statu-tory 20 percent rate . This was true not onlybecause the credit was only incremental bu talso because credits were linked in the curren tyear to increases in the preceding three years.As CRS explained, this "meant that each dollarof R&D investment in one particular year in-creased base period R&D for future years an dhence reduced the amount of future credit sthat could be claimed."

The new base period, which we supported ,will limit this negative impact by a new bas eperiod based on an R&D to gross receiptsformula. (The new base is computed by multi -plying a fixed base percentage—which is th eratio of a firm's R&D expenses to its grossreceipts from 1984 through 1988—by a firm' saverage gross receipts over the preceding 4years .) As CRS concluded in its analysis of th enew base, "the most severe dampening effectsof prior law's base period calculation has bee nremedied." (CRS-4)

But the value of the credit was furtherreduced by passage of a fu11100 percent deduc-tion disallowance—increasing to 100 percentthe amount of R&D which cannot be expensedif it is taken as an R&D tax credit .

We also had to fight off proposals to re -quire the capitalization of R&D expenses ex-pended abroad .

I truly believe that at last there is a consen-sus to make the R&D credit permanent . We a tCORETECH were greatly heartened by th esupport last year for a permanent credit fromChairman Rostenkowski, a two-thirds major-ity of his Ways and Means Committee and alarge majority of the House, together withChairman Bentsen and a majority of his Fi-nance Committee with strong encouragemen tfrom the Bush Administration, favoring apermanent extension of the R&D and basicresearch credits . This was a significant break-through. Indeed, for a few short days, a perma -nent credit had passed the House of Represen -tatives, with the new Rostenkowski base pe-riod, and the Senate Finance Committee . But i twas the "shortest permanent credit" in Ameri-can history as the permanent feature wa sremoved when the Senate passed a strippeddown tax bill given the fight with the Admini-stration over capital gains .

The case for a permanent credit has bee nbolstered by several studies . Two Brookingseconomists, Martin Baily and Robert Lawrence,did an extensive study in 1985 which con-cluded that the R&D credit increased indus-trial R&D by 7 percent above what otherwisewould have been expected and increase dannual real GNP levels from $1 .2 billion to $7 . 5billion by 1986 and in a range from $2 .9 billionto $17.7 billion in 1991 . R&D, in part due to th ecredit, increased for the first time during arecessionary period .

In 1987, these same two scholars di danother study which concluded that "the rati oof R&D spending to output" during the perio dwhen the R&D tax credit was in effect, gre wmore than twice as rapidly as it did in th ecomparable period prior to enactment of th ecredit .

26

The Need for Change

In 1989, the United States General Ac-counting Office (GAO/GGD-89-114) con -firmed that the R&D tax credit had stimulate dup to $2 .5 billion in additional research spend-ing between 1981 and 1985 and stressed it sadditional social value . It suggested additionalR&D would be stimulated by changing th emoving base to a fixed base—just as Treasury ,Congress, and the industry worked out in th e1989 Omnibus Reconciliation Act .

I believe it is not coincidental that R& Dspending is leveling off in the past year or twoas the value of the credit has been reduced andshort-term extensions create uncertainty aboutfederal tax policy .

But even with the consensus emerging fora permanent R&D credit, yet another provi-sion can further reduce its incentive effort .Under current law, a taxpayer's base perio damount cannot be less than 50 percent of itscurrent research expenditures, meaning th ecredit can only be taken on the remaining 5 0percent. But under the permanent credit whichpassed the House and Senate Finance Commit -tees last year, this base limitation is increased 5percentage points each year until it reaches 75percent in 1995. Thus, only the increment of 2 5percent of current R&D spending is eligible fo rthe credit.

While the initial base limitation was passedto both limit the cost of the credit and to assurethe credit was given on the basis of real incre-mental R&D effort, the idea of raising the baselimitation of 75 percent would significantl yreduce the incentive effort for a substantialnumber of taxpayers. For example, for taxpay-ers subject to the limitation at 50 percent, themarginal credit incentive of the 20 percentcredit, including the full deduction disallow-ance, is 6 .6 percent . If the limitation is raised t o75 percent, the marginal credit incentive dropsin half to 3.3 percent .

The General Accounting Office (GAO) i nits positive 1989 report on the R&D credit ,strongly criticizes this increase in the bas elimitation. As GAO put it, we "would no trecommend raising the 50 percent limit fur-ther—to 75 percent for example—since this is

likely to reduce the marginal incentive to les sthan 5 percent for a large number of firms . "

2. The continued struggle over a solu-tion to 861 is yet again an indication of th eperseverance of our R&D tax policies . At theend of the Ford Administration, Treasury is-sued Regulation 1.861-8 under which a UnitedStates corporation must allocate a percentag eof their domestic R&D expenditures to incom eearned abroad . This prevents companies in a nexcess foreign tax credit position—paying moreon foreign taxes than can be claimed as a credi tin the United States—from fully deductingtheir United States R&D expenditures .

This is a direct penalty on United StatesR&D. Treating these domestic expenses as i fthe R&D were conducted abroad—on the ta xtheory that products marketed abroad resul tfrom domestic R&D efforts—invites compa-nies to move their R&D abroad where they canreceive the fully deductible benefit of the ex-penditures . Obviously, West Germany will no tpermit a deduction for United 'States R&Dexpenditures disallowed for United State sincome and allocated to German income whenthe R&D was not performed in Germany.

By treating American domestic R&Dexpenses as if they were incurred abroad, th e861 regulations encourage companies to actu-ally move R&D abroad . Simply, if the tax codetells you that a portion of your domestic R& Dwill be treated as though it were performedabroad—where labor is cheaper and whereforeign governments often offer economi cincentives for relocation—then it might as wel lbe! If the United States wants to maintain or ,better yet, increase its research force in thiscountry, the government should clearly trea tsalaries for American Ph .D.s and engineers, forexample, as American expenditures—becausethey are .

Domestic R&D primarily benefits th eUnited States, so there is little reason to treat i tas if it were conducted abroad :

— U.S.-based R&D develops productsthat are predominantly used by Americans ;

— Domestic R&D also produces Ameri-can jobs, encourages collaboration between

27

R&D Tax Policy

corporations and United States universitie s(which often results in corporate contribution sto American schools), and trains United State sscientists; and

— Because there is a close link betweenbasic research and eventual product develop-ment, domestic R&D results in more manufac-turing of new and improved products withi nthe United States.

A book could be written about the histor yof 861 . Congress from the start recognized th enegative effective of the 861 regulations .

— In the Economic Recovery Tax Act o f1981, Congress adopted a two- year morato-rium on Section 861's application ;

— Another two-year moratorium wasadopted in the Deficit Reduction Act of 1984,after Treasury reported that a reduction indomestic R&D could adversely affect Unite dStates competitiveness ;

— This moratorium was fully extendedfor an additional year by the Comprehensiv eOmnibus Reconciliation Act of 1985 ;

— A partial moratorium was adoptedfor 1987 by the Tax Reform Act of 1986 ; and

— In 1988, Congress extended the mora-torium for four months—to May 1, 1988, fo rmost taxpayers—as part of tax technical cor-rections legislation .

Responding to a specific congressionalrequest, the Reagan Administration, then ledby Treasury Secretary Jim Baker and Deput ySecretary Richard Darman, negotiated an agree-ment with congressional leaders, to which th eUnited States high-tech industry acceded as away of getting this decade-long issue behindus, called the "67 percent" compromise . Underthis compromise, at least 67 percent of acompany's United States R&D expenditure scannot be recharacterized as foreign and canbe set aside against domestic income. This wa slater reduced to 64 percent and this compro-mise was also incorporated for a one-yea rperiod in the 1989 Omnibus Reconciliatio nAct .

It is long since time to put this issue to res tpermanently and to remove the cloud 861 cast sover United States R&D . The Bush Admini-

stration has proposed in its FY 1991 budget apermanent solution along the lines of th ecompromise already agreed to . We hope Con-gress will follow suit .

B. CORETECH also believes that prope rR&D policy must encourage a well trainedscientific and technical workforce . We pub-lished a CORETECH report late last year o nthis topic. We found that the education of ou rcurrent and future scientists, engineers, andtechnicians was inadequate . We already hav ea shortage of scientists and engineers . As ourworkforce in the next century will increasingl ybe Black and Hispanic—groups severely under -represented in sciences—this shortage wil lbecome even more acute . We cannot stay o ntop of the world's technological ladder with -out the trained personnel to run our R& Dfacilities.

The number of science and engineeringundergraduate and graduate students is de -creasing. The proportion of American under -graduate students majoring in the natural sci-ences has been decreasing steadily since the1970s. Only 9 percent of entering freshmen in1987 showed an interest in majoring in engi-neering, compared to 12 percent in 1982. Ofevery 100,000 high school sophomores nation-wide, only 850 will earn a bachelor's degree inthe natural sciences or engineering .

More than half of the new Ph .D.s in engi-neering and nearly one-third in the physica lsciences are awarded to foreign nationals .

At the same time, we face a serious short -age of faculty in key scientific and technica lfields. There are currently 1,400 engineeringfaculty positions vacant—between 7 and 1 0percent .

While this is occurring, there has beendrastic decrease in federal financial supportfor doctoral students . From 1970 to 1986, thenumber of federally-funded fellowships andtraineeships fell from 60,000 to less than 13,000 .Is there any wonder that we have a competi-tion problem when we are decimating ou rscientific and technological workforce?! Thishas occurred while Pell grants for undergradu -

28

The Need for Change

ates have dropped dramatically (from cover-ing 59 percent of total college expenses in 1979to only 29 percent now) as have other college -level programs like TRIO grant programs .

We welcomed warmly the ReaganAdministration's and the Bus hAdministration's commitment to begin t oaddress these problems by doubling the budge tof the National Science Foundation over 5 years .In the 1988 NSF Authorization bill, a 5-yearauthorization was passed which provides for adoubling by 1993. This is appropriate sinc eonly 3 percent of the $64 billion in the federa lR&D budget went to NSF in 1988 . But congres-sional appropriations have not kept pace wit ha 5-year goal of doubling .

The Bush budget for FY 1991 is one of th estrongest in history for encouraging a stron gNSF and a better trained scientific workforce .It provides over $1 billion for science an dengineering education activities for five agen-cies .

CORETECH made five recommendation sto remedy the scientific workforce crisis :

1. Focus appropriate attention and re-sources on federal mechanisms to bolster ele-mentary and secondary science and mathe-matics education, recognizing that the founda-tion laid by early education is critical to th eentire scientific and technical pipeline and tha tthe primary responsibility for the United States 'elementary and secondary education syste mlies with state and local government .

2. Substantially increase support fo rundergraduate and graduate education in th esciences and engineering and for moderniza-tion of university research facilities .

3. Expand programs to raise the per-centage of women and minorities in our scien-tific and technical workforce.

4. Support, and stimulate, career-lon gcontinuing education programs .

5. Foster communication and collabo-ration among government industrial, andeducational partners to maintain the excel-lence of our scientific and technical workforce .

C. The third leg of our R&D policy triad is

modernizing R&D facilities . Our goal is toimprove the physical infrastructure in whic hbasic research is conducted on our universitiesand non-profit research institutes .

United States academic research facili-ties, in CORETECH's opinion, are in alarmin gcondition. The world class research we need t ostay competitive cannot be done in antiquate dfacilities, inadequate space, and outdate dequipment .

The serious deterioration in United Statesuniversity research facilities has been recog-nized by both the White House and the Con-gress.

In 1986, President Reagan's White HouseScience Council completed a major study andcalled for a 10-year, $10 billion program "as thenecessary minimum" to renovate and mod-ernize scientific facilities and instrumentation .

CORETECH worked hard with Chair-man Bob Roe and Senators Dodd, Kennedy,and Hatch to pass a bipartisan plan to take th efirst steps to deal with this R&D facilities chal -lenge. The result was that in 1988 Congresscreated a matching grant NSF university/non-profit research institute modernization pro -gram as part of the NSF reauthorization bill .This program authorizes $125 million for fa-cilities modernization in 1990, $187.5 million i n1991, and $250 million in 1992 and 1993 . Las tyear Congress appropriated $20 million forthis program and the Bush Administrationsought $20 million in the President's budge tfor FY 1991 .

The challenge is indeed daunting. As thePresident's budget itself recognized : "Withou tthe specialized R&D facilities such as the par -ticle accelerator telescopes, research ships an dplanes, the process of gathering new knowl-edge would be greatly diminished . Genera lpurpose laboratories and research supportfacilities are also important, particularly wher esuch facilities are used for the training of futur escientists and engineers ."

A NSF study showed it would cost ap-proximately $3 .6 billion to undertake all th erepairs and renovations needed in universit yresearch facilities for 1988 and 1989 alone . Bu t

29

R&D Tax Policy

universities can only budget a fraction of thi sneed. They are repairing and renovating only9 percent of their current space even though 3 9percent is in need of attention—thereby defer -ring $3.60 in needed repairs and renovation forevery $1 planned .

We believe Congress should fully fundthe new NSF research modernization progra mand that it can do so while continuing to sub-stantially increase the other important NS Fprograms.

Stimulate more industrial sector anduniversity R&D by tax incentives to give theprivate sector the maximum flexibility on whereto target their research. Invest in a stronger

scientific and technical workforce for Americ aso it can help do the additional R&D the taxincentives will provide . Modernize our researchfacilities so this added R&D can be done i nstate-of-the-art conditions . These together area coherent R&D policy for America . Thesetogether can and will improve United Statescompetitiveness and add to our national wealth .

30

Richard Grafmeye r

Richard Grafmeyer, Minority Tax Counsel for the Senate Financ eCommittee, offers an overview of tax legislation in Congress and the prospectsfor the success of any specific R&D modifications .

He states that he doubts the tax-writing committees will revisit the issueof the credit's redesign in the near future . He says the committees would liketo wait until there is more statistical data on the effectiveness of the creditas an incentive to invest in R&D . Mr. Grafmeyer does reassure his audiencethat the Committee is listening to taxpayers who have specific problemswith the current credit structure, but he reminds those present that everythin gis subject to budgetary constraints .

He says that Congress understands that planning for future R& Dexpenditures is difficult while there is uncertainty about the future of thecredit and the allocation rules . He thinks this is why a permanent extensio nof both these items passed the tax-writing committees last year . Both werestripped out of the final bill, however.

Mr. Grafmeyer notes that Congress is operating under the assumption thatthere will be some kind of revenue package this year . He does indicate thatany revenue bill will be required to raise five times the revenue raised b y1989's Omnibus Budget Reconciliation Act .

Ending on an encouraging note, Mr . Grafmeyer says that R&D issues arehigh on most members'"A" list.

I was sitting here listening to Xerox's audi tproblems earlier, and I will bet that none of youin this room can figure out why I left corporat etax departments to come work on the Hill .How I used to enjoy that .

I am here to tell you a little bit about th eoutlook for general tax legislation in Congres sthis year — specifically, what the prospects ar efor R&D. The best way to start is to look at las tyear's tax bill . Prior to last year's tax bill, weheard a lot of debate over whether R&D ta xcredits provide companies with the prope rincentive to increase their R&D expenditures .We heard a lot of debate about the tax credi tand allocation rules that were in effect prior tothe 1989 Act — whether they favored fas tgrowers, slow growers — it just went on andon.

I guess it is our belief, from a committe eperspective, that the redesign of the credit tha twas agreed to in the conference agreement inlast year's Budget Reconciliation Act, has fi-nally put to rest, at least for a while, thesedebates of whether the credit is properly de-signed, who it benefits, and things like that .

Whether you disagree or not with ho wthe credit was designed in the conference agree-ment in 1989, I believe that both committeestaffs will be a little hesitant to revisit the issu eof whether the credit really works again . Ithink from Congress' perspective we wouldlike to wait a couple of years, get some mor estatistics in on how the new base period works ,how it affects companies, and who is affected ,who is gaining by it — just see how it is work -ing .

31

R&D Tax Polic y

If it looks like it is providing an incentive ,obviously there is no reason to revisit it again .I think we want to wait a little bit and step backand take another look at it in a few years . I thinkwe would like to let it lay and rest for a while .

Now having said that, there are probabl ysome nervous people in the room thinking ,"Well, I have some real issues with the designproblem," " and I don't want to preclude the fac tthat we are having people come in through th edoors asking for some minor changes to th ecredit's design. As usual, there are alway speople who want changes in the tax laws, someof them very well deserved. For instance, weare hearing from companies who come in andsay, "We have extraordinarily large down -swings in income in those base period year sthat we have to work off of. This is obviouslygoing to be a large detriment on the amount o fcredit we can take in future years." Othercompanies have said, as Stu was mentioning,that they have a real problem with the increasein the minimum base period from 50 percent to75 percent . Again, we are listening to thosethings. The problem with those and othersimilar items is that they are all going to b esubject to — as I am sure you have all heardbefore — revenue constraints.

In reality the extension of the credit itselfand the extension of the allocation rules, as Ithink we have been beating to death here to -day, are all subject to the same thing . There areso many items competing for a very limitedamount of federal tax dollars . Again, 1989 wa sthe best example I can think of .

As we mentioned, the permanent exten-sion of the credit and the allocation rules tha twere out there for a week or so are the bes texamples. The nine-month proration that endedup occurring was, again, a result of revenueconstraints in conference. It is interesting t onote that when the nine-month extension wa sbeing negotiated, as usual it was one of thos elate-night negotiations that is always jokedabout in publications and elsewhere . But I gota lot of calls both from without and withinCongress assuming there was some sinisterplot going on and that this really was another

way to lower the credit rate down from 20percent to 15 percent . So I was busy the whol enext day trying to reassure people that tha twasn't the case . Again, that proration strictl yinvolved revenue constraints, but I am sur ethere are some people out there who still be-lieve Congress and its staff, especially in Join tTax, had something to do with trying the lowerthe credit rate . Again, it was just a compromise .

As I am sure Congressman Anthon ymentioned today — I missed his discussion —the staff up on the Hill and many of the mem -bers of both the House and the Senate fullyunderstand the fact that to be really effectiv ethe credit and the allocation rules need to b emade permanent . We understand that regard-less of the studies that say how the credit worksor how the allocation works and how it affect sdifferent companies, I think there is finally —and I won't say this is always the case, anunderstanding on the Hill that corporate taxdepartments and corporate finance depart-ments really can't take the credit and how th eallocation is going to work into account whenthey are trying to figure out financing and th ebudgets for long-term R&D projects if the ydon't know what the law is going to be in th enext year or two. Believe it or not, I thinkCongress finally has gotten that through ourheads, and we understand it. I think that i swhy we at least momentarily saw a permanen textension of both of those items .

There was a lot of discussion about thatwhen it happened, but again, it was just one o fthose kinds of compromises that came out .

I don't think anyone felt very good aboutit . I do think that everyone understood th eimportance of permanently extending the creditand trying to do something permanent withthe allocation rules .

Obviously, I have been talking a lot abou trevenue concerns and things like that, and Ithink it is appropriate at this point in time to g ointo a little bit of the big picture of where w emay be this year.

The way I always like to start this is to lookat what we did last year . Last year's bill raise d$5.6 billion for the fiscal year and $24.6 billion

32

The Need for Change

over the five years . If you have been followin git in the newspapers and tax journals, we don' thave a budget resolution yet, and I can't seeone coming in the near future . But if we assum ethat eventually the tax committees will be givena target, approximating what the President ha sin his budget, which is around $1344 billion ,that would be around $60 billion over fiveyears . Now, let's add to that the approximatel y$11 .3 billion over five years that capital gainswould cost . I mention the fact that th ePresident's budget targets exclude any capita lgains for corporations which would obviousl yincrease it even further . Then you have to addto that the approximately $22 billion that i twould cost over five years to extend perma-nently many of the expiring provisions, an dthe approximately $5-10 billion that IRAs orFamily Savings Accounts or other savings -type incentives will cost . If you add all of thosetogether they come up to approximately $10 0billion over five years. That would be the siz eof the tax bill we would need to do if all thos eitems I have mentioned that have gotten a lot ofpress are included .

That is a mere five times the size of las tyear's tax bill . I will tell you right now, tha tCongress takes a lot of hits for finding smallitems throughout the Code to try to raise reve-nue. There are not enough small items in theCode to raise that kind of revenue this year .That is why I think you see a lot of starts andstops going on right now, and basically every -one is unsure where we are going to go thisyear with these kinds of tax bills . I think it is notclear to all the members exactly what kind o ftax bill there will be and, obviously, as it looksright now, even any kind of timing of a revenu ebill this year .

I think, from our perspective, we ar eworking under the assumption that we wil lhave some type of revenue package this yea r— be it in the context of Reconciliation or,potentially, outside the Reconciliation process ,which has been talked about a little this year .But the exact make-up of that and where we areall going, that is really up in the air right now,which of course the members just love, par -

ticularly because it adds confusion to every -thing that is going on throughout Congress,and makes them unsure of what we are goin gto be doing .

I want to mention a couple other topics . Itseems like, at least from the last few speaker sthat I was able to hear, they spoke a lot aboutthe importance of R&D in keeping Americastrong in the competitive worldwide market -place. Again, the problem the staff, and th eSenators and Congressman have is that wedon't get the luxury of tunnel vision . We haveto look at the broad perspective .

When we look at capital gains, we look a tsavings incentives; we look at things like edu-cational assistance . And yet we hear fro meveryone who comes in to lobby those issuesthat those are the things that are absolutely,positively necessary to keep America competi-tive in the worldwide marketplace. Withoutthose items, America is going to go right dow nthe tubes .

Obviously, the problem we have is bal-ancing all of these very equitable argumentsand trying to come up with a solution . That iswhy I think in the last couple of years you keepseeing these short-term extensions. Again, it i snot something everyone is pleased with, bu twe are just juggling these balls and trying tocome up with the best types of tax policy wecan. Obviously, when I describe a potential taxbill five times the size of last year's tax bill, i tcalls into question whether we are going to beable to do that size of bill this year .

Who is going to win out? It is probably tooearly to tell . I would say the R&D-type issuesare way up there on the "A" list of mos tmembers, based on the discussions we've hadwithin the committee. My personal opinion isthat there will be at least a temporary extensio nof those credits and the allocation rules . But Istill think that a lot of people, such as SenatorsDanforth and Baucus and the Finance Com-mittee, will push as hard as they can to get apermanent extension, and I can imagine w ewill be looking at that .

Other changes to those types of rules aregoing to be totally revenue driven. It probably

33

R&D Tax Policy

will have nothing to do with whether peoplehave equitable arguments for some of th echanges they may want to have made . I guess

we would be less inclined to make any changesright now until we see where we are going .That is as brief as I can be .

Q& A

Q: Is the nine-month proration somethingthat will be picked up in a new bill so thatpeople get the remaining quarter, or is thatspecifically going to be cut off?

Grafmeyer: No. It is intended that wewill pick that up at some point . Obviously, thebig concern for folks here in this room is wha thappens if we don't do a bill until sometime inmiddle or late September when that prorationis already gone . We went through this type ofprocess before with educational assistanc ewhere we retroactively extended it . But from acorporate tax perspective, it made all you rlives miserable. Again, we are aware of that .

A lot of this is involved in mega-politicsway beyond the small issues of R&D, but Iwould say right now I can't imagine that w ewouldn't pick up the other quarter .

Q: [Editor's note : There were difficultiesin transcribing this question, which has thusbeen rephrased.] It is clear that revenue con-straints will affect decisions regarding change sin the tax law. It is also clear, however, that staffor CBO or Treasury estimates are inaccurate .None of those organizations use a dynamicmethod of estimating revenues . Is it true thatwhat you are telling us is we can't move ahea don new legislation without considering budge tconstraints, but the revenue estimates we hav eto rely on are inaccurate and may price the costof the R&D credit and some of these other in-centives much higher than they should be be-cause the estimates do not take into account thereturn the economy gets from the investmen tin R&D?

Grafmeyer: All I can say is that is some-thing that — more so in the last couple of year s— we have heard more about and I think yo uhave read more in publications about the reve-nue estimating process and how it works . I

think that is good for the system . I understandthe dynamic part. The problem is dependingon whose estimates of GNP and inflation ratesyou use, it really skews the numbers tremen-dously . It is just very difficult to do . I under-stand your concern . It is tough for me to sit hereand try to address that and I appreciate it.

The other comment I probably didn't mak ewhen I spoke is that it is just not the R& Dnumbers we are concerned with when we tal kabout extending expiring provisions becausethose seem rather small when you comparethem to items like capital gains . Capital gains ,according to Joint Tax, is a larger revenue lose rthan the R&D extension. I think what happensis all the extenders — 13 or 14 of them — arealmost hooked together as a package . Thatmay be unfortunate for this group here, but alot of the other people whose extenders maynot be as popular as R&D is, obviously try t ofoster putting the extenders as a group . Eventhough the two R&D provisions may only cost$1 .4 billion or so in the upcoming fiscal year ,when you put them all together with the othe rones, it starts to be two or three when we get t othe $22 billion. That is also a dynamic thatenters into it .

Eizenstat: I would just like to say evenmore broadly that having put budgets togethermyself, they are difficult and you do have t omake very tough decisions . You have to be ableto find the money .

We found $167 billion for the S&L indus -try. We are finding $800 million right now fo remerging democracies . We are going to fin d$400 million for housing in Israel for Sovie tJews. The money is there if the priority is there .I think what is needed is a sense of urgencyabout this priority and we will find the money .

Q: Stu, I would like to ask if you can tell

34

The Need for Change

us the flavor on the Hill now that the Ta xReform Act of 1986 has molded the corporat etax environment. Now that the corporate rat ehas been lowered is Congress less willing t oprovide tax incentives like the R&D credit ?

Eizenstat: No. I really haven't found tha tan argument at all .

I don't think that is our major problem . Ido think that Rick is right. The major problemis that there are a lot of other things competingfor the limited tax expenditure budget . But weare not faced with an argument that we havealready lowered corporate rates, because I thinkit is recognized that this is a specific incentivegeared toward research and development, an dthat general corporate rate reductions don' tnecessarily help that particular national prior-ity .

Grafmeyer: One other thing I will justthrow out to address that, too, is that there is adifference between the marginal rate and theeffective rate . I think the Finance Committee i sgoing to be having a hearing on this next week ,which is especially important in that the TaxReform Act — even though the rates may hav egone down — because of a lot of other broad -based changes that were made — the effectivetax rates for a lot of people in this room ma yactually have gone up . So, from a staff perspec-tive that is why I don't think you hear that kindof bargain .

Moderator: I would like to thank the panel .We will have a short break, and then we willreconvene for our second session .

35

SESSION TWO

Mapping Out Sound R&D Policies for the 1990 s

Panel Chairman : M.D. MenssenVice President, Taxes3M

Anthony BillingsAssociate Professor of AccountingWayne State University

Robert N. MattsonAssistant TreasurerIBM

Michael J . GraetzDeputy Assistant Secretary for Tax PolicyDepartment of the Treasury

M.D. Mensse n

Why would they take a controller andmove him into tax for a company the size o f3M? There is really only one major reason fo rthat, and I think it pertains to what we aretalking about today . 3M wanted to get theoperational part of the company closer to thetax division, or, as the tax people thought, i twas to get the tax division closer to the operat-ing people. As I listen to the discussion that i staking place on R&D, perhaps we need to d omore of that on the R&D issue .

Now, we have a very well-known pane lwith a lot of knowledge, and we have a lot o fpeople in the room with a lot of knowledge . Itis very interesting to note on the subject of R&Dhow little research has been done on the ta xside, and how few creative solutions we hav ecome up with . I really challenge the panel hereto think of some creative ways that we cansolve the dilemma of the United States R& Dproblem in the '90s, because I do believe it i svery acute .

War Story number one, and I promise thisis the only one I will tell . I came into an operat-ing unit in 1966. It was the electrical unit, andI am sure many of you have used electrical tap efor various things around the home . This wasa product that had its maturity. We have a fewother electrical tapes, but for a three-year pe-riod, this product line had been going down -hill in both sales and profits. 3M reorganized it ,and they took a bunch of young Turks —young at the time — and put six new people in

charge of this operating unit . I happened to bethe controller at the age of 32 . We had decreas-ing sales and profits for three years . We had anR&D budget that was about 4 percent of sale s— very low by 3M standards . We met, and a tthe first meeting the general manager of thedivision said to me, "Buck, your job is to fin dsome way of getting the budget of R&D up t oeight percent . We want to double our R& Dbudget and get some new products ." So, I tro tover to my boss, the corporate controller, an dI say, "we would like to have another drop inour profit of about four percentage points be-cause we want to put that money into R&D." Imust remind you that this person was a P-5 1pilot during World War II and he knew a lot offour-letter words, and I learned all of them thatday .

The next trip was to go down to themanufacturing group because 50 percent o four costs were in manufacturing, and to mee twith the manufacturing director and his plan tmanagers. They were all either infantry, artil-lery, or marine officers during WWII, and Ilearned a few more four-letter words fro mthem.

So, this thing about the Treasury comin gup and saying every time we want somethin gfor R&D or some other issue, we simply hav eto raise taxes — I just don't believe it .

I went down to the factory during the nex tyear and I was not the most popular person inNew Ulm, Minnesota . We turned over rock s

37

R&D Tax Policy

and we looked under rocks. We came up in thatfirst year with a decrease in our manufacturin gcosts from 50 percent down to 45 percent . It canbe done. I think if Congress and Treasury haveto take a course in turning over rocks, then Ithink they should take a course in turning ove rrocks. Now they can say, "Buck, we have thevoters to face, and you simply could tell yourpeople down there what to do at New Ulm ,Minnesota ." Those World War II officers werenot too gentle either on a person who had just

gotten out of the Korean War, but we did ou rjob and I think they simply have to get on wit hthat .

What was the result of this increase in ou rbudget, in the doubling of it? That divisio ntripled sales and profits in six years . Is R&Dlong term? Not necessarily. Some of it is . Butwe can get this country rolling again, I think, i nshort order if we simply start putting som emoney into the R&D line . I think there shouldbe a creative approach .

B . Anthony Billing s

Professor Billings of Wayne State University, conducted a study ofcorporations and their R&D expenditures . He attempted to pinpoint th especific economic factors that motivate or restrain R&D spending. ProfessorBillings feels that in order to turn the current trend in R&D investmentaround, some degree of corporate integration is necessary . He says theincremental credit formula is not the answer .

Professor Billings' study indicates that those companies with considerabl espending on R&D had higher profits than comparable companies that di dnot. He notes that industry spending generally determines the range o fspending by particular firms. Professor Billings claims that as the R&Dintensity of a firm increased, its debt-to-equity ratio decreased . Thus, heconcludes that R&D spending has a positive effect on equity financing.

Billings presents the methodology used for his study . He explains in detailthe variables he considered in setting up his three models, which represen tthree different time periods. On the basis of his study he ultimately conclude sthat while changes in the credit formula and the allocation of R&D have aneffect on R&D intensity, the fundamental variable is the company's capita lstructure. He recommends corporate integration and says the billions itwould cost would be a small price to pay for the benefits it would yield .

[Professor Billings' paper is available from the Foundation .]

I should tell you that my undergraduat etaxation professor sits in the front row and I'msomewhat worried about the prospect of get-ting a grade on my paper . However, I shouldremind him that I got an "A" in his class by afew points . Hopefully, he will keep this i nmind .

For the next twenty minutes or so I wil ltalk to you about the study I conducted . I

started this at 3M and continued until abouttwo weeks ago . The results concern the R& Dintensity of a firm and what I consider to be thespecific economic factors that motivate or, onthe other hand, constrain R&D spending . I willconclude by saying that, based on my results ,corporate tax integration may be needed tosomehow turn the tide with respect to R&D .

We heard a lot today about tinkering wit h

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Mapping Out Sound Policies for the 1990s

the incremental R&D credit formula, and I lik eto think of that as being tantamount to puttin ga patient on a respirator when there is little o rno chance of survival . I will tell you why . Afterthe law that passed, I went to the data basehaving financial statements . I pulled 100 firm sat random. I pulled data from 1984 throug h1988, and I got estimates for 1989 through 1992 .I set up a Lotus spreadsheet and looked at th eavailable credit under the old law and unde rthe new law. In each case, when sales remaine dconstant for a number of years or when sale sdeclined, the R&D credit disappeared .

Having a little bit of distaste for reality, Isought to construct my own numbers . What Idid is for five years I kept sales constant . Inanother five years I caused sales to increase byfive percent, and then for the subsequent fiv eyears I caused the sales to decline by fiv epercent per year. The results were once againconfirmed.

What can you gather from this? Maybethe incremental credit formula is not the an-swer. Some other approach is needed .

Let's talk briefly about how the UnitedStates stacks up with respect to the other in-dustrialized nations, such as Japan and Wes tGermany; then we will look at what has beendone in the R&D area. I will talk briefly aboutthe method I used to investigate, some of thequestions I considered, and some of the result s— particularly with respect to corporate ta xintegration. Let's discuss R&D with respect tohow the United States compares .

National Science Foundation data showsthat in 1965 the United States had 27 .5 percentof global sales of technology in terms of prod-ucts, as compared to 7 .2 percent for Japan . Butby 1986, the United States share had decline dto 20.9 percent and the Japanese climbed to19.8 percent. Over this same period, if weconsider non-defense R&D spending as a per-centage of GNP, the United States ranks sig-nificantly behind Japan and West Germany.

Countries such as the U.K. and Francehave traditionally spent well below the UnitedStates level . But by 1986 they were on the sam elevel as the United States. How do we explain

this? I am not saying here that there is a nassociation between exports of technology interms of products and R&D spending . What Ican say is that the economic literature dis-cusses the theory called the product life cycletheory. What it suggests is this . In the earl ystages of production countries are able to expor ta significant amount of goods . In the laterstages, production moves overseas. This iswhen saturation takes place. If we look at thesales of technology in terms of products andR&D spending, what can you conclude? Ther eis some information there .

I next considered the literature on R& Dand looked over the last 20 years at what hadtaken place . There are three basic lines of re -search. One line looks at R&D spending as apercentage of sales . These researchers dividedR&D spending into two groups : one groupwith the lower spenders, the other group wit hthe high spenders. The profitability of the hig hspenders and low spenders was compared .Studies differed as to whether or not R&Dspending made a difference . By and large, thelater studies confirmed that high R&D spend-ers generally enjoyed higher profits .

The second line of research tried to iden-tify what I would call industry effects in ex-plaining R&D. They found that the level ofprofit and liquid resources from operationspretty much explained the level of R&D. Forexample, measures such as gross profits, oper-ating income for depreciation, and incom ebefore extraordinary items all explain R& Dwith a lag of up to four years .

Some studies have found that liquidity —that is cash flow from operations — has little o rno effect on the R&D intensity of the firm .Studies have looked at industry facts, and o neach occasion spending in the industry prett ymuch determines the spending by particula rfirms .

When one considers all these studies ove r20 years, no study to date has considered th eeffect on the capital structure or federal taxesand how these variables affect R&D spending .So, during my time at 3M I collected data fo r1987 for the top 100 firms . I ran a regression

39

R&D Tax Policy

model, and included a variable which is de -fined as follows : the long-term debt of the fir mdivided by total capital; then I included all theother variables included by prior research .What did I find? As the R&D intensity of thefirm increases, the debt declines. The debt-to-total capital declines . Stated differently, R&Dfunding is a positive function of equity financ-ing .

What I sought to do at that stage was t olook at the broader, longer period of time . So,I went back to the year 1970 and I got a database from the Compustat Industrial Manual . Icollected data for all non-financial firms overthe 1970s through the 1988 year. I came up with2,700 firms with usable data. I then went bac kand dropped all firms with incomplete histo-ries, meaning that for a few years they did no treport or that they were involved in a merger .I was left with 700 firms. I then eliminatedfirms with missing data, and from the finalsample I had 385 films over 18 years withcomplete data .

I then sought to look at the debt positionof the firm, profitability and liquidity as pointedout by earlier studies . After developing mymodels I noticed a paper published in 1988 ,which I missed in my first review of the litera -ture, suggesting that for new debt and equit yissues, for example, outside funding giveninsufficient cash flow from operations mayalso be significant in explaining R&D inten-sity. So, I included both variables in my model .I developed models over the 18-year period . Ithen sought to determine, given the variou schanges in the tax laws over these 18 years ,how the results changed from one period toanother. I referred to changes in Section 11 ofthe Code for differences in rates at the high an dlow end. I considered that criterion. I alsoconsidered changes in the law. For example,those changes that affected the tax base and no tthe nominal rate, per se. That was anothe rcriterion I could use. The third variable I con-sidered was periods having homogeneous taxrates.

So, I had three possible factors to use i ndividing my data over these 18 years . After

about one month of struggling with this data,I decided I would develop three separatemodels and I would test the phenomena thre edifferent times . That is what I did .

The results — much like I expected ove rthe 18-year period for all three models — Ipretty much confirmed what prior researchhad said about profitability. However, threenovel results emerged . One, outside fundin gfrom operations — for example, funds fro mnew equity issues — did not play a significan trole in funding R&D in the 1970s, but by 198 1new equity issues provided significant sourcesof funding for R&D. What would you expect o fdebt financing? The debt variable had no effec tat all on R&D. This means that new debt wa sraised each year because cash flow was insuf -ficient . The third result, much like we found inthe earlier study, was that as the debt relativeto total capital increases, the R&D spending ofthe firm declines .

What does this mean with respect to R& Dfunding? It means that changes in the incre-mental credit formula and issues surroundin gallocation of R&D may be quite important . Butthere is a more fundamental problem ; the rolethat capital structure plays in explaining R&D .This has been ignored totally for the 20 to 25years that we have been studying R&D.

So, what do we do? I think, in concluding ,I would suggest that, all things being equal ,corporate tax integration may be the mostimportant change that could ever be made t oremedy the problem. A lot of commentatorsare quite worried about the cost of tax integra -tion. I have seen figures suggesting that a smuch as $38 billion in revenues could be lostdue to corporate tax integration .

If we consider the export sales that are los tand the revenue potential of the United State sTreasury, I think it is a very small price to pay .In real terms, if we look to 1965, if we tabulatethe lost sales in today's dollars, if we should fo rsome reason be able to recapture the lost salessince 1965, we would be able to pay for corpo-rate tax integration and many other measuresthat we are now concerned about. It is a boldapproach and runs counter to what we hav e

40

Mapping Out Sound Policies for the 1990 s

heard from many of the speakers today, but Ithink if we look at the problem more closely,

we will all conclude that it is the way to go .Thank you .

M .D. Menssen

I would like to reinforce that last poin tand that we doing further study on that withTony at 3M and that is that export market, an dit doesn't take a whole lot of brainpower andyou can ask any controller of any major corpo-ration that does R&D; it isn't the same paper i nthe tape that we send overseas out of the United

States. It is the post-it notes and the memorytechnology stuff; the high-tech stuff that run sabout 10 percent to sales that we ship overseas .I think we must remember that when it come sto whether or not we solve this problem ofR&D.

41

RFD Tax Policy

Robert N. Mattson

Robert Mattson, Assistant Treasurer of IBM Corporation, provides th ebusinessman's approach to R&D policy decision-making. He says that tounderstand the businessman's approach to mapping out R&D policies fo rthe nineties, you have to examine trends in technology as well as th eeconomic atmosphere in which these decisions will be made . He notes tha tR&D is an ongoing process . He says once you develop technology, you haveto begin developing new technology so that you and not your competito rmakes your old technology obsolete. Mr. Mattson also notes that R&D isincremental, which is why he disagrees with a time-line approach to th ecredit.

Mr. Mattson sees the climate for R&D development in the U .S. changingin recent years. He says that companies that once viewed each other a scompetitors for R&D innovation now pool their resources . He notes that thetrend is to cooperatively develop technology on a worldwide scale . He alsosays that the U.S. joint venture provisions have not kept pace with this trend .Mr. Mattson explains how the companies involved in these partnership sreap the direct benefits of the technology, and how they reap indirect benefitsas well .

Mr. Mattson makes several recommendations . Like Ed Harding, he saysthat R&D should be defined using a functional approach to determine wha ttypes of research qualify for the credit. He states that future R&D projectswill have to be worldwide efforts to achieve success ; thus, he sees Section 86 1as counter-productive .

He also says that the cost of capital must be reduced, and believesintegration could be one step toward accomplishing that .

John Akers, IBM's CEO, has said tha t"You can't manage an IBM for 90 days — i fwe're not investing with a longer term in mind,investors will be very unhappy four to seve nyears from now." IBM continues its heav yinvestment in research and development grow-ing from $5 1 /2 billion in 1987 to nearly $7billion last year — a year when short-ter mperformance was difficult due to restructurin gthe business .

A rational and sound R&D tax polic yshould be supportive of and encourage ournation's R&D efforts . The businessman's ap-proach to mapping out sound policies for the1990s and beyond starts with an inquiry of

how today's R&D activities will be changing i nthe future. For this we have to look at trends ,not only in the technical nature of R&D activi-ties themselves, but also in the economic ar-rangements which make these activities pos-sible.

For our purposes today I have brokenthese trends down into three themes : First, tha tR&D today is and must be evolutionary andnot revolutionary in nature . Secondly, thatR&D has become global in effort, cooperationand funding; and lastly, that R&D benefits ar edispersed beyond the business performing theactivity. These are realities that must be recog-nized and from which appropriate tax policy

42

Mapping Out Sound Policies for the 1990 s

must be formulated .For Corporate America, R&D is an ongo -

ing and continuous activity with dedicate dresearch scientists, engineers and technica lpeople of all kinds working usually at researc hsites and laboratories .

However, R&D is not just scientists work-ing on laboratory experiments and attemptin gby experimentation to make radical new dis-coveries or develop innovative processes o rcome up with a "super" invention never beforeheard of. Ralph Gornory, formerly IBM's Chie fScientist and now President of the Alfred P .Sloan Foundation, refers to an R&D "ladder"process. It is a process of building on knowl-edge step by step until the top of the ladder isreached and you have your radical discovery,innovative process or new invention . But oncethat is achieved, rivals begin to climb yourladder and exploit your knowledge and ideas .Then, in order for you to maintain your com-petitive advantage, you have to start buildin ga costly new ladder .

"Innovation by Japanese companies is 1 5percent faster and costs up to 20 percent les sthan that of U .S. firms — an unbeatable combi-nation for winning market share and profits,"says Fortune . It goes on to say that, "A fewAmerican companies are beginning to fashio nthemselves into tinkerer organizations .

Hewlett Packard, for example, is tying itsresearch engineers more closely to the engi-neers who supervise the production lines an dexploiting scores of small breakthroughs . H-Plast year introduced its market-beating DeskJetprinter, which it developed in just 22 months— less than half the time it used to take to ge ta complete new product to customers . "

Peter Drucker in a Wall Street Journal ar-ticle on "The 10 Rules of Effective Research "commented that every new product, proces sor service begins to become obsolete on the'dayit first breaks even, and your being the one wh omakes it obsolete is the only way to preven tyour competitor from doing so. Thus, while asuccessful product is in manufacturing, a re -search and development team must be work-ing on the next improved version. Take for

example the dramatic advances in the semi-conductor industry . While 256K memory chipswere being manufactured, development teamswere working on the design and manufactur-ing process for a 1 megabit chip . When that wa sready it went into manufacturing and the 256 Kchip was phased out . At the same time thedevelopment people were starting over agai non the 4 megabit chip, and the process contin-ues today. The same cycle of manufacturing ,product improvement and new manufactur-ing is followed in many other industries . Andthe Japanese have mastered the cycle approac hto technology .

Obviously, the process of incrementalimprovement to existing products require steamwork on the part of scientists, produc tengineers and manufacturing technicians . Eachmember of the team must be well informed i nthe relevant sciences and technologies and kee pup to date on what is happening not only i nuniversity laboratories but in other companie sas well . Interdepartmental communicationwhich permits a steady exchange of ideas be-tween the basic research laboratory, the prod-uct development labs and the manufacturingfunction is essential for product and proces sinnovation. Today, R&D must be an evolution -ary-step-process to succeed in the competitiv eworld !

The concept of teamwork in the R&Dprocess goes beyond the confines of one's ow ncompany or any country's border . This bringsme to the next point I want to make on thechanging nature of R&D.

In the past, United States companie sgenerally did not engage in cooperative re -search efforts . Research and development ac-tivities were treated as proprietary informa-tion and the results were not shared withanyone, not even with potential suppliers o fequipment and material and especially no twith competitors. This resulted in inefficiency ,duplication of effort, and slow transfer of tech -nology from development to manufacturing .Research projects were limited by the financia lresources of individual companies .

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RFD Tax Policy

Since the late 1970s there have been dras-tic changes in the position of the United State sin the world economy and global technology .American companies are facing intense for-eign competition at home and abroad and th epace of research has to be accelerated in orde rto keep up. The cost of research is rapidl yincreasing while at the same time United Statesgovernment funding is being cut back . Andinvestment spending in the United States istoday the lowest of the major industrial na-tions .

In order to meet the foreign competition ,cope with the high cost of capital, work withreduced R&D budgets and spread the inherentrisks of R&D, U.S. companies are joining to-gether in research consortiums, universit ypartnerships and joint ventures . Scientific Ameri-can, in its May 1989 issue noted that there ar emore than 75 research consortiums scatteredacross the country investigating everythin gfrom cement to semiconductors . Many compa-nies confine their in-house R&D activities t oapplied research but obtain the results of basicresearch through networks of agreements wit hhundreds of universities . Many others areovercoming their past resistance to coopera-tive research and forming joint ventures t odevelop manufacturing processes, produc timprovements and new technologies .

This trend toward R&D alliances is mov-ing quickly to a worldwide scale . Just last weekit was announced that the National ScienceFoundation Network, the partnership that run sthis country's biggest research and educatio ncomputer network, has established a fiber opticcable link with the European Academic SuperComputer Initiative Network, its Europeancounterpart . Now researchers on both sides o fthe Atlantic will be able to collaborate on proj -ects and share information in the form of text,charts and graphics with greater clarity and a ttransmission speeds much faster then existin gsatellite links. Incidentally, IBM is a partner inboth the United States and European networks .

Joint ventures are being formed betwee nUnited States and foreign companies to de-velop new products and processes . Some

United States companies are funding researchat universities overseas, and conversely, someJapanese and European companies are fund-ing research activities at American universi-ties . The advantages derived from these ar-rangements are indispensable to firms thatcompete in the global marketplace . By expand-ing research activities overseas, U.S. compa-nies gain access to customers and the rapidl yevolving technologies needed to meet th ecustomers' needs . It enables them to under-stand and meet local standards and compl ywith legal, financial and regulatory require-ments. A local presence gives them the abilit yto attract and recruit foreign talent particularl yskills which are not available at home . R&Dhas clearly become global in its deployment !

What about the dispersion of benefits !The commitment of resources to research an ddevelopment is a high risk, long-term invest-ment and a company that makes such an in-vestment rightfully expects to reap the benefitsin the form of increased markets and profita-bility. There is no doubt that successful R&Dcan be highly profitable, but the question is ,who realizes the profits?

According to the conclusions of manyeconomic studies on the subject, a firm willnever be fully compensated for its develop-ment of a new product or process. The benefitswill spill over outside the company to others i nthe same or different industries . R&D invest-ments may lower a firm's costs or increase it sproduction, but as a result of spillovers, th ecost, productivity and demand for the prod-ucts of other firms will also be benefitted . Forexample, improvements in semiconducto rchips enhance the performance of such divers eproducts as computers, TVs, anti-lock brakesand telephone systems . Fortune in December1989 quoted Ed Mansfield, Director of th eCenter for Economics and Technology at th eUniversity of Pennsylvania . Mansfield esti-mates that the return on R&D investment tothe company making the investment averageda healthy 25 percent . But as imitators reengi-neer and refine the pioneer's breakthrough

44

Mapping Out Sound Policies for the 1990s

they and their customers reap returns averag-ing 56 percent .

Thus, it is necessary to recognize tha tthere are additional social and economic rate sof return on R&D, that is, benefits to the na-tional economy and society in general which i ntotal are far greater than just the rate of returnto the investor in R&D .

These then are the realities that should b ethe starting point for the development of soundtax policies . Let's look at each of these threetrends again but this time overlay what theappropriate tax policy should be to ensure tha tthe technological innovations necessary for ahealthy expanding economy are encouraged .

First, by recognizing the incremental na-ture of most R&D, a sound policy should en -sure that when the tax code and regulation sdefine R&D, whether for credit, deduction orother incentive purposes, a functional approachis the only sensible definition to use . R&D isR&D whenever, wherever and however per-formed! To use any other nonfunctional crite-ria such as a time-line or "significance" test, a swas recently proposed in regulations, not onl yproduces a technically incorrect result bu tbecomes administratively difficult and is cer-tain to lead to endless disputes and bickerin gbetween taxpayers and the Internal Revenu eService. And it defeats the tax provision's in-tended purpose to encourage R&D .

The Internal Revenue Service's decisio nin 1983 to revise the long-standing definition o f"research and experimental expenditures" fo rpurposes of Section 174 was undoubtedl ydriven by the newly enacted tax credit fo rincremental research and development expen-ditures .

However, in the Tax Reform Act of 1986 ,Congress adopted more restrictive rules .fordetermining which research expenditures meri ta tax credit, and in so doing removed much o fthe reason for revising the Section 174 defini-tion in the first place. The tax credit rulesspecify, far more concretely than an ambigu-ous standard of "significance," which types o fresearch qualify for a tax credit, and which do

not. There is no longer a reason, if ever ther ewas, to introduce the uncertainty of a "signifi-cance" test into Section 174 where neither statu -tory language, the legislative history, nor th eexisting regulations supports such a test . In-deed, the broadly remedial purpose of Section174 would be best served by a liberal reading o fthe statute that decreases rather than increasesuncertainty of taxpayers engaging in R&D, a swell as the Internal Revenue Service's admin-istrative burden.

Secondly, the trend toward globalizationmeans a more competitive marketplace, and t obe a player in that market, a company must b eable to cooperate and share resources with avariety of new United States and non-U .S .partners to achieve success. R&D for worldclass products in a world market will have t obe undertaken anywhere in the world wherethe people, resources and knowledge exist andit will need to be done in the most efficient ,least duplicative way . Our policy should be t ostrengthen the international competitivenessof U.S. companies by removing tax barriers t othe movement of technology, eliminatingcomplexity and inequity from the tax code andensuring that foreign earnings will not be di-rectly or indirectly subject to double taxation .In this connection, proposals such as the 198 9House provision to capitalize foreign-basedR&D are economically counterproductive aswell as discriminatory. Lookbacks and recom-putations as in the uncertain "super royalty"provisions are not the real world and not th eway most technical licensing arrangements aremade. To apply such rules unilaterally will putUnited States companies at a major competi-tive disadvantage compared to their non-U.S .competitors .

And there has been a turn back to doubl etaxation of foreign earnings. The most egre-gious examples of this anti-competitive posi-tion are the limitation on the use of foreign taxcredits against the alternative minimum taxand unfair allocation of U.S. incurred expense sagainst foreign source income . When such al -locations are made, the expenses incurred inthe United States in effect are not deductible

45

R&D Tax Policy

anywhere . From the standpoint of U.S. com-petitiveness in global technology, the idea lresolution of the issue would be complete repea lof the regulations which require the allocatio nof U.S.-based R&D expenditures, but recog-nizing the current budgeting constraints, w eshould at least have the 1989 (64 percent) direc tallocation method enacted on a permanen tbasis.

Finally, in formulating a sound R&D ta xpolicy for the future, the government musttake into account the high cost of capital andrecognize that those who take on the risks andcommit the resources seldom realize fully th ebenefits and profits of successful research .Sound policy should encourage the necessarylong-term investments by offering incentive swhich lower the cost of capital used for re-search and development. Recent temporaryextensions of the R&D credit have considera-bly watered down its incentive effect by lower-ing the rate from 25 percent to 20 percent anddenying deductions for part of the qualifiedR&D expenditures . The credit should be im-proved and made permanent . It should be

expanded to include start-up companies . As-sets used in research are now depreciated overtheir approximate economic lives . Under nocircumstances should those lives be length-ened, and indeed, consideration should begiven to shortening them as an incentive toinvest in them .

It should be recognized that the social rat eof return on R&D investments, that is, th ebenefits to the national economy and society i ngeneral, is much greater than the rate of returnto the investor in R&D . Economic benefits i nthe form of new jobs, increased productivityand enhanced competitive position in worldmarkets will more than offset the tax revenu eforegone by way of incentives. Let me con-clude by saying that encouraging R&D activi-ties is essential if our economy is to stay robus tand America is to be competitive in the worldmarketplace . Future R&D tax policy should bedeveloped to meet the specific goal of encour-aging such activities. To do anything less, wouldin the long run cost jobs, impact productivityand further erode America's competitive posi-tion in the world of the twenty-first century .

M.D. Menssen

I would like to reinforce some of the thing sthat Bob is saying from a controller's point ofview. Treasury thinks that you ring the belland all of a sudden at the laboratories at 3M o rIBM, the R&D and the manufacturing begins .We have what we call "pilot plants," and I amsure every company in this world has pilo tplants and that is where you do the transitio nfrom the laboratories out into the factories . It i sa tug-of-war between the manufacturing per-son who is telling the R&D department, "Woul dyou let go of that damn thing —I want to haveit because I want to do my own R&D downhere in the factory to get that thing to work."That simply does not work and the time-lineapproach doesn't work .

The second point on that I think Bob high -lighted a little bit, but I would like to draw ou ta bit more, we all know the success story of 3M

and the Post-it note, and the supposed inven-tor of that was my tennis partner many year sago by the name of Art Fry. He would be thefirst person that would tell everybody in thi sroom, "I was not the only inventor of Post-i tnotes." The R&D took place in engineering;they designed the equipment to strip-coat a nadhesive .

R&D took place in manufacturing wher ethey learned how to make something that w ehad never made before and strip on the adhe-sive .

R&D certainly took place in the market-ing area when the marketing person asked th eCEO's secretary, "Would you mind writing aletter to the CEO's secretary of the 500 majorcorporations in the United States and givethem a sample and ask them if they wouldmind using it ." I was in Europe and we did the

46

Mapping Out Sound Policies for the 1990s

same thing and our sales skyrocketed .It is rather interesting . If it wasn't for the

secretaries of the CEO's of the 500 largest cor-porations in America and Europe, we woul dnot be exporting the millions and millions o fdollars that we export of Post-it notes today . Ithink Bob and I have discussed this, and obvi-ously this has been the situation for a long time .

I hope you get your point across on tha tissue because it is irking the hell out of myfellow controllers back at 3M . Here is wherethe problem lies . We, as controllers, develo pthe problems for the tax people, because whenyou read the annual report there is a line ther ethat says, "R&D" and they say you must kno wwhat R&D is . We had that definition accordingto 3M. The biggest problem I had in electrica lwas an AMP was spending 10 percent to sales

for R&D and we are spending 4 percent . Whenyou cut through the difference in accountin gon the thing, we were both spending about 7-8 percent ; they just handled it differently.

Well, how does a controller handle theR&D line? We have a very simple solutionbecause we don't have to deal with the voters .We simply say, "if you work in the laboratory— and those are very defined departments i n3M — you are R&D. If you don't work in th elaboratory, you are not R&D ." That is verysimple. But, you can't translate that into regu-lations . It is simply impossible.

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R&D Tax Policy

Michael J. Graetz

Michael Graetz, Deputy Assistant Secretary of the Treasury for Ta xPolicy, agrees with other panelists that R&D has historically promote deconomic growth and productivity . He says it is important for the governmentto be supportive of R&D because companies that spend on R&D rarelycapture the full returns of those expenditures .

Secretary Graetz also agrees with Stuart Eizenstat that tax policy is onlypart of the picture . He notes the Administration's commitment to R&D asillustrated by the significant portion of tax items devoted to R&D in thePresident's budget.

Secretary Graetz notes the budget estimates for all the R&D provisions ar ehigher than were previously mentioned . He says the $5.5 billion quotedearlier in the program is the cost for making the credit permanent and doe snot include making the 64 percent allocation solution permanent . He believesthe 64-percent solution is the best approach available with respect to theSection 861 allocation issue .

The Administration is aware of the need for permanence with respect t oR&D incentives, and Secretary Graetz reiterates the Administration' scommitment to making both the credit and the allocation solution permanent .Rather than tinkering with the way that the deduction for R&D relates to th ecredit, he recommends concentrating on efforts to make permanent th eprovisions already in the Code. He personally thinks this should be th enumber one R&D priority .

With respect to the international issues related to R&D, Secretary Graetznotes the goal of the tax system in this area is to make U .S. business genuinelycompetitive in expanding world markets . At the same time, the U.S. has tobe sure that it is getting its fair share of taxes paid by multinationa lcorporations. International tax provisions must take into account both ofthese goals .

I will avoid repeating much of what hasbeen said here, since much of what I was goingto say has been said at least once, and in som ecases several times. So, it is probably not worthrepeating, although I will say I did learn a goo dbit today from the presentations that I hav elistened to. I am grateful for that . I think this isan important conference and I appreciate thisgroup sponsoring this conference .

I do think it is worth emphasizing, and Ithink when Stuart Eizenstat is here quotin gPresident Bush's budget, we know that R&D is

truly a bipartisan issue. I can quote StuartEizenstat and tell you that I agree completelywith what he says about economic growth andthe role of R&D historically in promoting pro-ductivity and promoting economic growth . I tis genuinely important . I don't think there isany disagreement about what he described asexternalities, which is the economists' term fo rthe inability of those people who spend moneyon R&D to capture the full returns from thos eexpenditures. I think it is universally agreedthat there are spill-over effects from R&D, an d

48

Mapping Out Sound Policies for the 1990 s

that those spill-over effects make it importan tfor the government to be supportive of R& Dand to spend money on R&D .

I would like to underline another thingthat Stuart said, which is that the tax story i sonly part of the story. I commend to you forreading the chapter on R&D in the President' sBudget and in the Economic Report of th ePresident. President Bush has produced abudget which would reverse the trend of adecline of federal spending for civilian andnon-defense R&D. There is about $31 billionthat has been requested for spending in thecurrent budget on civilian R&D so that thecommitment to R&D is there . Stuart mentione dthe doubling of the NSF budget by 1993, whic his another commitment that the Bush budge thas made. So, I think that government supportof R&D is something that we take seriously ,and there is money being dedicated to it, de -spite all the talk about budget difficulties.

I want to remind you that there is a budge tissue here. The revenue estimate that was give nearlier in the day is not the one that I woul dhave given for the President's proposals fo rR&D. The proposal to make the R&D credi tpermanent is estimated to cost $5.5 billionduring the budget period . That was the num-ber that was given . But that number does no tinclude making permanent the 64 percent so-lution — the 861 allocation rules — which is a nadditional $6 .3 billion estimate during tha tperiod. So, you are talking about a $9 .8 billionreduction in taxes in the President's budget. Itis a serious amount of money in the curren tbudgetary climate. It demonstrates the highpriority that is being given by the Administra-tion to having an effective R&D credit .

There has been a lot of talk — and I dowant to say one thing about it today — abou tthe decline in the value of the R&D credit .Again, Stuart Eizenstat mentioned the oppo-site piece of this, and I just think it is worthemphasizing that the history since 1981 is no tall one of decline, because the redesign of th ecredit in the last year is extremely important .The estimates of the GAO were that the credi twas producing three to four percent as an

effective tax credit rate because of the moving-average provisions .

Today, I guess John Magee was the firstone to use a 13 .2 percent number as the numberunder current law, and that is a quadrupling i fone believes the GAO report . So, while therehas been some restructuring of the credit interms of both its amount and in terms of theoffset for the deduction, there also has beensome restructuring of the credit to make itwork better, to make it more effective and t omake it more generally available . I think that isan important point.

On the allocation issue, I just want to saythat the one unmistakable thing that has hap-pened since I have been at the Treasury, and Ihave mentioned this elsewhere, is that th einternational area represents the single biggestchange from my prior tenure at the Treasury 2 0years ago. The problems that we are facing i nthe international area are genuinely new,whereas most of the other tax problems tha tare being talked about are genuinely old . Thetaxation of capital gains, for example, has bee nup and down throughout the history of theincome tax. That is true of most of the otherissues that we are seeing . But the internationalissues have taken on both a new significanc eand a new sense of priorities, and allocation o fR&D expenses is only one of the allocatio nissues I have seen in the last few weeks since Ihave been here . If I mentioned interest deduc -tions, you would all nod your heads . If I men-tioned state taxes and charitable contributions ,these would also ring some familiar sounds fo ryou. It is the case that we are struggling, and Iam the first to admit it is a struggle, wit hproblems about how to allocate expenses thatproduce income and are productive on a world -wide basis between foreign and domesti csources .

I think Section 861 and the 64 percentsolution are about as good a solution as we aregoing to come to in that area . It is a fairly liberalsolution. It is certainly liberal compared to th e1977 solution, and we have urged that it bemade permanent .

Here I think that the most pressing ques -

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R&D Tax Policy

tion before us regarding research and develop -ment in the 1990s is the need for some stability— the need to make both the credit and th eallocation rules permanent. The Administra-tion is committed to that and, as you haveheard, there is a bipartisan sentiment for that ,although Stuart's description of the shortestpermanent tax credit that he has ever seenrings a familiar note because of the budgetaryproblems.

It is extremely important that we use ou refforts to try to create stability and permanenc ewith respect to the credit and with respect t othe allocation rules — at least the structura lproblems that people have identified with thecredit, including the relationship to the deduc -tion. The relationship of deductions and cred-its is also an old issue . Those of you who hav efollowed the history of the investment tax credi tand the relationship of that credit to basis arefamiliar with the question of how one interre-lates tax credits and tax deductions. Regard-less of what you think of the merits of the 10 0percent offset, it does create parity betwee ndirect government expenditures for researchand development and the tax credit . So, it hassome sound reasons to commend it . But, in anyevent, the structural changes that were re-cently made in the R&D credit create an oppor-tunity for some stability in the area and I wouldurge everyone to work together toward per-manence and towards stability as our numbe rone priority in this area, rather than trying t ocome up with a perfect tinkering on the sub-stance of the provision . I don't think that shouldbe the priority .

I do want to make a comment about th einternational area, because it is interesting t ohave listened to John and others talk about thejoint venture problem and so forth, which isnot a problem that has been talked about . It isthe 861 problem that has been talked about themost . We are in a widely developing interna-tional climate, and arrangements among multi-national companies are being created in th ebusiness community faster than the tax systemis capable of dealing with them, or at least ha sseemed to be capable of dealing with them .

I want to repeat for you a comment I mad erecently at an International Fiscal Associatio nmeeting so that you understand the dilemm aof the Treasury Department and th egovernment's dilemma, therefore, with respec tto international taxation . Simply put, there aretwo cornerstones to U.S. international tax pol-icy. The first cornerstone is that U .S. citizensshould be taxed the same whether their incom eis earned here or is earned abroad. The secondcornerstone is that income in the United State sshould be taxed the same regardless of whetherit is earned by a U.S. citizen or by a foreigner .Those two have long been cornerstones of th eU.S. tax policy. The third cornerstone which Iwould add is that governments are entitled t oset their own tax rates, which is simply a de-scription of sovereignty. Other people hav esuggested that one should add reciprocity, s othat bilateral negotiations can take place an dthat one country can make concessions t oanother country based on the concessions tha tit makes to us. Those are all important taxconsiderations .

It turns out that the first two principlescan be satisfied only when taxes are equalthroughout the world. You are not able to getboth of those principles in operation unles staxes are equal throughout the world. I amreminded here of testimony that Eddie Cohe nand I gave in 1971 before the Ways and Mean sCommittee . We were discussing the proble mof the taxation of married people and singlepeople in the United States . We discoveredthat you could take three fairly non-controver-sial principles and in a progressive tax syste m— if you kept progressive rates — you coul dnot satisfy all three . What that meant was youhad to make some compromise in the taxationof married couples and single persons . What-ever compromise you made, you were criti-cized for. Prior to 1969, the compromise fa-vored married couples in all circumstances .After the 1969 Act, there were situation swhereby going to Haiti over Christmas andobtaining a divorce and coming home andremarrying in January, a married couple withrelatively the same incomes could save taxes . I

50

Mapping Out Sound Policies for the 1990 s

remember writing a letter to an irate taxpaye rsaying that at least we had given single peoplea reason for not marrying that their parent scould understand .

The reason that I mention this analogy i sthat there are genuine difficulties and genuinecomplaints that can be made regardless o fwhich compromise the Treasury Departmen tand the U.S. Congress make with regard tointernational taxation at any moment. Thatmeans that there will be genuine problems o finternational competitiveness and that one canpoint to some treatment of either some expen-diture or some form of income abroad andrightfully suggest that U .S. companies are bein gdisadvantaged by comparison . That is an ar-gument that is always available to U .S. busi-nesses. Therefore, the challenge to us — an dthe R&D example is a good instance of it — i sto design a tax system which enables Americanbusinesses to be genuinely competitive in worldmarkets and in the world economy. At thesame time, we have to make sure that the taxpie is divided among those countries wheremulti-national entities are doing business in afair or appropriate way so that the U .S. gets it sfair share of those taxes .

I really think that we need to be creativeabout this, and I urge all of you to think crea-tively about it . I think in the future we are goin gto need multi-lateral solutions that we havenot yet begun to think about . Bilateral solu-

tions are not going to work as well in the future

as they have in the past and we really do nee d

to try and put our heads together to come upwith appropriate compromises .

The only other comment I would make i s

that I was interested in Professor Billings' find -ings about the role of new equity in fundin gresearch and development, because I had no tseen that result anywhere in the discussions o fcorporate tax integration or of the Americantax system's favoring or disfavoring of equity .It is timely because we at the Treasury, as manyof you know, are studying the integration issue

and are trying to understand it better, andthere is no question that the U .S. tax systemdoes have a bias against new equity as a sourceof corporate finance . To the extent that Profes-sor Billings' finding is correct, I think it is a nimportant finding because it suggests that thereare other aspects of federal corporate incometaxation less directly connected to researc hand development that are inhibiting our abil-ity to have the appropriate level of spending o nresearch and development. To the extent thatwe are thinking long term about tax policy forthe '90s this is an important new insight. I amalso grateful, as I would be under any circum-stances, for 3M's hiring any professor duringthe summer. It will keep a few professors in theprofessing business, which in the tax are abecomes more and more difficult each year .

Q& A

Moderator : Thank you, Michael . I knowthere are a lot of burning questions out there ,and the man in the back, please speak .

[Note: Some inaudible comments hav ebeen excluded below . ]

Q: I wanted to make a couple of com-ments, and the speakers can respond in an yway they want. First of all, on Bob's poin tabout the idea of research being incremental, i tcertainly is, and anything that tries to cut yo uoff at a point in time is out of touch with reality .I would recommend anyone interested in thisto look at the article by Michael Porter in the

current Harvard Business Review entitled"Comparative Advantage of Nations," wher ehe discussed what brings it about . He talksabout the nature of technological innovationand makes this same point .

Secondly, on the point about internationa ltaxation raised by many, I am afraid that a sother nations have posed a competitive gapthat, given the present U .S. tax rules for multi -national operations, we may be very near th epoint where the mere fact of being headquar-tered in the U.S. is sufficient under our rules toraise your cost of capital beyond competitiv e

51

R&D Tax Policy

levels . The first principle you mentioned, tha tall U.S. citizens should be taxed the same re-gardless of the source of income, might havebeen true in a prior day . I think that is whatthey call capital export neutrality . Today, whereyour leading industries are global, companie slike our own and Bob's could not succeed orexist on a one-country basis or on an only U.S .basis . If we do not succeed in Europe and th eFar East, as well as in the U.S., we will notsurvive at home.

I think there is going to have to be somegive, and one of the main places that there isgoing to have to be give if we are to survive i sgoing to be on that first point . I think we aregoing to have to move into multi-lateral nego -tiations. Another way to formulate this that Ithink has to be considered is that we are now s oglobally integrated and have such a large pro-portion of our income from overseas sources i nkey industries that it is time to consider care-fully what the effective implications of that i sfor limitations on our U.S. tax sovereignty. Inother words, we can decide to do what wewant for our own political reasons on CapitalHill or we can decide we are going to create anenvironment in which our economy can suc-ceed. Those two are becoming ever more in-consistent .

Comment: I think the point on stability isone that would be shared by perhaps every -body in the room, but you do get to the point o f"stable as from when." I think on the foreignside if you were talking about stable as fro mthe time when you were last here, it would beone thing, but I think if we mean stability as o ftoday, if that means that Bob Mattson canno ttake a full deduction for charitable contribu-tions he makes to the American Red Cross, o rcannot take the full contribution for taxes h epays to the State of California, or the full con -tribution for money that he pays to scientist sworking in a lab in the U .S., or can't take the fulldeduction of hiring Dr . Billings to do a study,whereas a company that is a U .S. subsidiary o fa foreign multinational headquartered in an-other country could, in fact, take a full deduc-tion for all those expenses — then I hope we

don't try to freeze that situation and think wehave done something that is very good .

Comment [Graetz] : I will comment onthat. I did not mean to suggest that we needstability when we have gotten somethingwrong, if that is the case you are describing . Ithink that the problem of taxing twice incom ethat is earned multinationally is a serious prob-lem, and I agree with you that we should try t oavoid it. We need to try to tax at least U .S .source income once, and I think that is also agoal . What I was really referring to was th eR&D credit in particular where I do think tha tour first priority ought to be stability on tha tissue. And that is why we have supported andwill continue to support both making the creditpermanent and coming up with a permanen tsolution to the 861 problem, which are the tw oproblems that have been most pressing in tha tcontext .

Comment: There has been an issue tha thasn't even been raised today . Secretary Baker,when he was Secretary of the Treasury, in aninteresting book, Tax Policy of the 21st Century(Wiley & Sons), asks who would want to live o rinvest or run a business in the next century i na country that has very high tax rates . Whatthey were really talking about in this confer-ence was that the U.K., or maybe it was theU.S., began a tax revolution in the world . Theybegan with the concept that marginal tax ratesmatter more than a lot; they matter most . Asmarginal rates came down, the tax rates o fcorporations and individuals came down . Thisresulted in an explosion of competitive analy -sis throughout the world, and as anyone whodeals in the international arena knows, ta xrates everywhere have come down . In Swedenthis year they have come down from 50 percen tto 30 percent . What scares me most about whatis happening in the U .S. is that this year w emay reverse the trend, because what good is atax credit if it raises the corporate tax rate ?What good are research and developmen tincentives if they take it all away from you andpenalize you with higher taxes on your cost o fcapital, because raising the corporate tax rat ewill certainly increase the cost of capital? I

52

think the scariest scenario that is coming in thiscountry right now, and we have already begu nto see it, is that there will be a general increas ein the marginal rate of taxation in this nation—a reverse of a lesson I thought we had learned .The budget hysteria will cause that problem,and I think we may see a serious reversal o rtake-back of a lot of sensible stuff and ourforeign competitors will attract investment ou tof the United States very rapidly as that occurs .

I think that is something we have talke dabout today, and I think that is something w ehave to watch . I see it as the most serious stormcloud in this legislative session .

Comment [Menssen] : One of the thingsthat I think I get asked most commonly by Con -gressmen, being an ex-controller on this thing ,is "Does taxation really come into play in thedecision-making of where you put your plan tand equipment?" You have to realize, I als owrote the book in conjunction with the Univer -sity of Minnesota on capital budgeting for 3M .It was my specialty for all the time I was acontroller . This question is always coming up .Do taxes really count in the decision? Th eanswer to that is that at 3M taxes are the secon dlargest expense . As a matter of fact, on a pre-taxbasis, we spend more on taxes worldwide thanwe spend on raw materials in the United States .With that kind of expense, you have to takeinto account your taxation costs . It does makea difference where you put that plant and soforth .

Comment: If I may add one thing abou tthe credit with respect to what he said [inau-dible comment] . We may want to reexamin ethe credit formula before we embrace it . Theformula does not work well for companieswith declining sales . In fact, if sales decline formore than two years, the R&D credit is gone .What do we do for companies that are experi-encing slow sales? They need R&D more tha nother companies .

Would you care to offer a reprise onwhether or not we can afford to do the righ tthing? Under the assumption that the revenueestimates are absolutely correct . If that is so, Ithink we should recognize that on an average -

year basis, that comes to 15/ 100ths of 1 percen tof the proposed fiscal 1991 budget, and a smallerpercentage for the remaining four years overthe five-year projection period . I can't believefor a moment, and I don't believe anybody i nthis room could believe that we could not, if w echose to place the right priority on R&D an ddomestic and foreign source income, find 15 /100ths of one percent of other spending in th efederal budget that could be sacrificed for thi spurpose. The whole approach to looking a tstructural tax policy from the point of view ofbudgetary constraints is paralyzing us, and w ehave got to break out of this . It is absolutelyessential. We are going to be stuck with a nunstable and very bad tax system.

A [Menssen] : My answer to the gentle-men here in the U.K. [Reference to U.K. is fromprior inaudible question .] I don't know. This isan area where we need more research on th ething, but we are competing for sources ofcapital. We are competing for goods and serv-ices out there, and you have to link up the U .K . ,and say what the R&D companies are compet-ing with over there for those source of funds .What is their cost of capital versus agricultura lor something like that? That is where we gotinto on the study, and I think it is somethingthat you would have to look at an individua lcountry to find out what is hindering R&D . I tmight be a different solution or it might be adifferent problem than we have here . But Ithink too often in this creative area of R&D; wedon't have really creative solutions and I thinkwe simply have to .

I told our Chairman that we could ge tsome money — let's float 20 percent debt . Wewill buy back our stock, float debt, take th emoney we got in tax savings and spend it onR&D. There are all kinds of rocks you can lookunder if you want to .

Then, Professor Billings comes up hereand says if we do that we get into a problem onthe turn-down of the economy and we have abond covenant to take care of . There are a lot ofways you can skin this thing if it stays still longenough. There has got to be some creativesolution to what we are doing .

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R&D Tax Polic y

Q: Is the "super-royalty" provision a seri-ous factor in the transfer of technology, or is i tbecause there is a lot of fear but there is not a lo tof real impact?

A [Graetz] : I really don't know the answe rto that. There has been a lot of concern aboutthe 482 solutions, and I have heard a good bi tabout that with respect to the white paper and482 regulations. The audit issue — you do hea rstories about these kinds of audit issues — andthat we need to improve and re-think the whol eprocess of auditing throughout the system, butwith particular emphasis on large corpora-tions. I think we are aware that there are prob-lems with the system. We are hoping to worktoward solutions to them.

Comment [Mattson] : I would just like toadd my support about the danger of havin gmade progress in the 1986 Act in terms o fgetting an understanding of the importance o fthe incremental rate and what that can reall ydo to people's thinking . I think it is very impor-tant that we not back up from that . At the sametime, I think if we slip into the notion of gettin gour revenue by constantly redefining the ta xbase, we are also redefining the incrementa lrate on those items that happen to be swep tinto the tax base that weren't there before . Thatis what is behind some of the disaster situ-ations in the taxation of foreign income . Thereal increase of incremental taxation arising

out of the combination of making an additiona lforeign investment when you come to give acharitable contribution is much bigger thananybody has anticipated . It costs a lot more forIBM to pay its state tax bill in California as aresult of the changes that have taken place thananything we have ever seen .

Q: Is the Professor's study close to beingpublished any time soon?

A [Billings]: We are in the stage of doingadditional computations, and I would say inanother month or two it should be ready . Whatwe will try to do is get comments from variou sparties before we try to go to publication .

If I may make an additional point, thegentlemen spoke of integration in the U.K.versus the U.S. With respect to that question ,the literature here seems to think the benefits o fR&D tend to take up to six years to develop ,and are much riskier than alternate projects . I fwe consider debt held by the firm, they receiv ea fixed amount regardless of profits . They areindifferent — at least minimum amounts ofR&D would be okay with them . Equity hold-ers, on the other hand, depend on paying th edebt holders and excess that accrues from th eholdings. They have much more incentive t ospend on R&D.

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