Proposed regulations - Treatment of research credit among controlled group members 

December 12:  The Treasury Department and IRS today released for publication in the Federal Register proposed regulations (REG-159420-04) concerning the calculation of the research credit for a controlled group that includes one or more foreign corporations that derive foreign-source gross receipts.

The issue relates to whether the controlled group can exclude from its credit calculation gross receipts from an intra-group transaction that involves the same property or services that a foreign corporation member of the group sells to a person outside the group.

The proposed regulations [PDF 98 KB] provide guidance on the treatment of qualified research expenditures (QREs) and gross receipts resulting from transactions between members of a controlled group of corporations or a group of trades or businesses under common control (intra-group transactions) for purposes of determining the research credit under section 41.

Comments concerning the proposed regulations must be received by March 13, 2014, which is a date 90 days after December 13, 2013 (the date when these proposed regulation will be published in the Federal Register). A public hearing on the proposed regulations is scheduled for April 23, 2014.


The traditional method of computing the research credit allows a taxpayer a credit equal to 20% of its qualified research expenses (QREs) for the tax year in excess of a base amount.

The base amount is determined in part by reference to average gross receipts in earlier tax years. The larger those average gross receipts are, generally a smaller amount of the QREs will be allowed the 20% credit.

All members of a controlled group of taxpayers—corporations, partnerships, trusts, estates, and sole proprietors—must compute the credit as if they are a single taxpayer, and allocate the group credit among them.

Regulations provide that, because of the single-taxpayer group computation, transactions between members of the group are generally disregarded.

A provision in the Code says that a foreign corporation, in computing its research credit, is to count only gross receipts that are effectively connected with the conduct of a trade or business in the United States, Puerto Rico, or a U.S. possession.

In 2006, IRS examiners took the position in non-precedential published guidance that a U.S. taxpayer that is in a controlled group with a more-than-50% owned controlled foreign corporation (CFC) is not to exclude gross receipts from sales to the CFC. The 2006 guidance did not limit this position to situations in which the CFC had gross receipts from non-U.S. third party sales of the same property or services.

In 2010, a federal district court held that the IRS could not enforce this position, and that the law allows a controlled group to exclude all intragroup gross receipts in computing its research credit. Procter & Gamble Company v. United States, 733 F.Supp.2d 857 (S.D. Ohio 2010).

Following that decision, the IRS stopped enforcing the 2006 position of IRS Examination. However, the IRS and Treasury turned to work on developing regulations addressing the issue.

Proposed regulations

The proposed regulations issued today would require a controlled group to count the gross receipts from an intragroup sale of tangible or intangible property, or of services, if there is a foreign corporation in the controlled group that sells that same property or services to a third party in a transaction that is not effectively connected with the conduct of a trade or business in the United States, Puerto Rico, or a U.S. possession.

For example, if a U.S. parent receives gross receipts from selling goods to its foreign corporate subsidiary, and the subsidiary sells those goods to a third party in a sale that is not effectively connected with the conduct of a trade or business within the United States, Puerto Rico, or a U.S. possession, the foreign subsidiary does not recognize any gross receipts from the sale, but the U.S. parent would not be able to exclude the gross receipts from its sale to the foreign subsidiary.

The preamble to today’s proposed regulations explains that the IRS and Treasury believe that a complete exclusion of gross receipts in that situation distorts the base amount, and thus distorts the amount of credit that Congress intended to be allowed.

If there are multiple intragroup transactions relating to the same tangible or intangible property or service that is eventually sold outside the group by the foreign corporation, the proposed regulations would require only the last intragroup transaction giving rise to gross receipts to be counted in the controlled group calculation. The intragroup transaction would be counted in determining gross receipts at the time the transaction outside the group occurs.

The proposed regulations note, in an example, that the statutory rule excluding gross receipts from foreign third-party sales applies only to a foreign corporation, and not to gross receipts of a foreign partnership. If there is a sale of goods by a U.S. parent to a foreign partnership and then to a foreign corporation and then to an unrelated person, the foreign partnership is not entitled to exclude the gross receipts. The proposed regulations, in this situation, explain that the controlled group needs to recognize the foreign partnership’s gross receipts, as it was the last intragroup transaction before the sale outside the group.

The regulations are proposed to be effective for purposes of computing the research credit for tax years beginning on or after the date final regulations are published.

Other than this change affecting gross receipts, the regulations would continue to respect the current rule that transfers between members of a controlled group are disregarded in determining the research credit of the controlled group.

Conformity issues

The proposed regulations also state that taxpayers would need to apply the new rule about intragroup gross receipts in all earlier years that are relevant to determining the base amount used to compute the credit, even if they had not computed their gross receipts in that manner previously.

The preamble includes a statement that the IRS and Treasury recognize that accounting for intragroup transactions in prior years presents a unique burden because taxpayers may not have records for the base years with sufficient information to satisfy the proposed regulations’ requirement of consistency.

Also, the IRS and Treasury stated that these proposed regulations are not intended to preclude research credit claims for taxpayers that do not have adequate information in their books and records for the base years. Thus, they request comments on whether a special rule or safe harbor might be needed to allow taxpayers to comply with the intragroup gross receipts rules.

KPMG observation

The preamble does not mention it, but these proposed regulations would modify the result in the Procter & Gamble decision.

Determining which gross receipts from an intragroup sale relate to a later third-party transaction by a CFC could be an enormous accounting and recordkeeping challenge. Determining the amount the controlled group must include would be complicated by the fact that each successive sale is likely to be at a higher price. The proposed rule that the group’s gross receipts amount would not be recognized until the time of the sale outside the group potentially imposes even more burdens, and could distort gross receipts between years.

Since 2007, taxpayers have been allowed to elect to compute their research credit under an alternative method—the Alternative Simplified Credit (ASC)—that does not require a taxpayer to determine its gross receipts for any year. These regulations would not have any effect on taxpayers that use the ASC. However, any accounting complexity that these proposed regulations impose could encourage some taxpayers to begin to use the ASC—even if they would otherwise be content to compute their research credit under the traditional method.

For more information, contact a tax professional with KPMG’s Research Credit Study group:

Christine Kachinsky

212 872 2187

Adam Boyar

213 955 8332

Charles Medallis

310 475 5706

David Culp

202 533 4014

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