ETI and IC-DISC Export Tax Benefits for Government Contractors

As contracts for the Middle East and tsunami-ravaged areas are being awarded, government contractors, as well as traditional commercial exporters, find themselves exporting goods and services through defense, humanitarian and developmental programs sponsored directly or indirectly by the U.S. Unfortunately, government contractors have to jump through many hoops before they can enjoy the permanent tax savings available under the extraterritorial income exclusion (ETI) regime or the interest-charge domestic international sales corporation (IC-DISC) regime.

Limitations

The ETI and IC-DISC rules look at where goods and services are consumed and, especially when the U.S. may be concerned, who the customer is. For ETI purposes, exports are goods consumed outside the 50 states, the District of Columbia and Puerto Rico. Under the IC-DISC regime, domestic consumption includes shipments to U.S. possessions. As a result, traditional manufacturers and distributors may find that selling goods for resale on foreign military bases, for example, is the first limitation to affect them. Sales of nondurable goods to U.S. military agencies for resale abroad through post exchanges are qualified export receipts; however, sales to the U.S. Department of Defense (DOD) for resale abroad at military commissaries are not.

Beyond resale of exports at commissaries, there are three situations in which exports are not eligible for tax benefits:

1. Property for ultimate use inside the U.S.;

2. Property for use by the U.S. or an instrumentality of the U.S., if the use of the property is required by law or regulation; and

3. Transactions subsidized by the U.S. or an instrumentality of the U.S.

Opportunities for Government Contractors

Opportunity #1—a narrow definition of U.S.: The definition of the U.S. in the tax law includes the 50 states, the District of Columbia, Puerto Rico and, for IC-DISCs, possessions. Other legal, diplomatic or military definitions of the “United States” are not applicable. Goods sold to U.S. embassies, for example, may be qualified exports, even though for legal purposes an embassy is U.S. soil.

Opportunity #2—bidding circumstances: Sometimes, government agencies are required to “buy American.” However, the majority of contracts are put out to bid when the preference (but not the requirement) is for the government to purchase American-made goods, and these sales are eligible for tax benefits. Understanding when a department or agency is or is not required to purchase American-made goods is critical, and a legal matter that contractors must document.

Opportunity #3—subsidized programs: Many humanitarian and developmental aid programs are provided to recipient nations as a subsidy or grant. For example, most contracts awarded by the United States Agency for International Development are considered subsidized. If a contractor can demonstrate that “the purchaser had a reasonable opportunity to purchase, on competitive terms and from a seller who was not a U.S. person, goods which were substantially identical to such property and which were not manufactured, produced, grown, or extracted in the United States,” subsidized contracts qualify for export benefits; see Regs. Sec. 1.993-1(j)(3)(i).

Exceptions to FEP Tests

Under the ETI and IC-DISC re-gimes exporters have to pass foreign economic process (FEP) tests to qualify for tax benefits. Generally, this can be done by engaging in certain sales activities and incurring certain types of expenses aimed at developing foreign markets. However, at times these requirements are modified for government contractors.

Small-exporter exception: While available to all exporters, small ex-porters can qualify for an exception to the FEP tests under both export benefit regimes if their export sales are $5 million or less (and exporters can elect to limit otherwise qualifying exports for ETI purposes).

Foreign military property: There is an exception to the FEP requirements for ETI benefits when items are considered “foreign military property.” Contracts qualifying as military property are exempted from the FEP requirements. Note: the ETI regime does not call for a scale-back of export tax benefits for military property as did its predecessors—the foreign sale corporation regime and the IC-DISC regime. Moreover, when the IC-DISC is not used as a deferral mechanism, the military property limitation becomes irrelevant.

Infrastructure contracts: Government contractors that have been awarded infrastructure contracts should consider whether their contracts qualify for export tax incentives. Construction and construction-related services are generally eligible for export benefits. Engineering and architectural services may be performed within or outside of the U.S. The critical component is the location of the project, which must be outside of the U.S. For example, the revenue received by an engineering firm for designing a building to be built in Canada would qualify even if the engineers never step foot outside of the U.S.

A hypothetical statement of work for a contract awarded by the DOD might read as follows:

This Statement of Work (SOW) defines the scope of construction and engineering activities to renovate, replace, and construct facilities and provide infrastructure installation and repairs at police headquarters, Baghdad, Iraq. This SOW encompasses site remediation activities and construction and ancillary services.

The contractor has documented the absence of a domestic procurement requirement when the DOD put the contract out to bid. The contract is not a subsidized program; it is for engineering services. Further, the work can be provided directly by contractor employees or through the use of subcontracted labor, as long as the contractor is responsible for the supervision of those laborers. Under these circumstances, this contract would be eligible for export tax benefits.

Conclusion

Government contractors do have some additional hoops to jump through to obtain export tax benefits. They must vet contracts to demonstrate eligibility, which requires close coordination between the tax function, accounting department and contract officers. Sometimes, this might require going back to the agency that awarded the contract for details on the bidding circumstances. And there will be times when contracts are classified and cannot be directly examined by tax and accounting personnel. Even with these challenges, many government contractors may benefit from the application of the EDI or IC-DISC rules to their export-related activities.

From Christine Ballard, MST, Washington, DC