Foreign Branch Income & the Research Tax Credit

The research tax credit is one of the most complicated provisions in our tax code. The international tax law aspects of this credit are even more difficult to follow.

In Deere & Company v. Commissioner, 133 T.C. No. 11, the U.S. Tax Court considered whether income from foreign branches must be included in the gross receipts in computing the research tax credit.

Facts & Procedural History

Deere & Company (“Deere”) was in the business of manufacturing, distributing, and financing a full line of agricultural equipment, a variety of commercial and consumer equipment, and a broad range of equipment for construction and forestry and other products and providing various services to a worldwide market.

Deere was owned by a parent entity and the parent entity had branches in Germany, Italy, and Switzerland. Deere received income from the branches in Germany, Italy, and Switzerland. Deere included all of the income and all of the expenses from Deere’s operations through Deere’s German branch, Deere’s Italian branch, and Deere’s Swiss branch in computing its U.S. income tax liability.

Deere claimed a $5,978,898 research tax credit in 2001. Deere computed its research tax credit using the alternative incremental method, which factors in the average annual gross receipts (“AAGR”) for the prior four years. Deere computed its AAGRs using the total income that it reported on page 1, line 11, of its consolidated return for each of the prior four years less the following total of (a) gross receipts less returns and allowances and (b) other income items for each of those years from the operations that Deere conducted though Deere’s German branch, Deere’s Swiss branch, and Deere’s Italian branch (total annual gross receipts of Deere’s foreign branches).

The IRS audited the claim and disallowed the research tax credit as it concluded that Deere did not compute its AAGR correctly, as it should have included the income from its foreign branches for each of the four preceding tax years in AAGR.

Foreign Branch Income is Gross Receipts

The statute and regulations are not clear as to whether income from its foreign branches is to be included. Deere raised a number of statutory construction and policy arguments in support of its position. The court did not agree with Deere’s arguments.

The court agreed with the IRS as a matter of law, concluding that Deere must include the income from its foreign branches for each of the four preceding tax years in AAGR.

The Takeaway

This means that taxpayers should make sure they include this type of income in computing their research tax credits. If this has a negative impact on the taxpayer’s credits, they may need to consider the alternative simplified method for computing their credits as that method does not factor in gross receipts.