New Opportunities to Exclude Foreign Income

While many of the benefits of the extraterritorial income exclusion (EIE) also existed under the foreign sales corporation (FSC) regime, certain taxpayers may derive additional benefits after passage of the Extraterritorial Income Exclusion Act of 2000 that were previously unavailable.

Small Business

Small exporters can benefit from the EIE without significant incremental efforts or expenses. Unlike the FSC regime, there is no need to set up a foreign entity with its own accounting, foreign management and U.S. and foreign taxes. EIE benefits are extended to passthrough entities, including S corporations, partnerships and sole proprietorships. As long as exports do not exceed $5 million per year, such exporters are not required to perform foreign economic processes. Thus, a small business can enjoy FSC benefits even if it sells to a U.S. distributor, as long as it can document that its products are sold for ultimate use outside the U.S. (although it cannot use the foreign trading gross receipts method in computing EIE if the distributor is related). The greatest cost to a small business in taking advantage of the EIE may be the training involved in maintaining documentation and completing Form 8873, Extraterritorial Income Exclusion.

Foreign Manufacturing

Under the old FSC rules, to qualify as "export property," an article had to be manufactured, produced, grown or extracted in the U.S.; moreover, not more than 50% of the fair market value (FMV) of such property could be attributed to articles imported into the U.S. (import content).

For purposes of the 50%-import content test, the FMV of exported property, if sold to an unrelated party, is the sale price for such property. The FMV of imported articles is generally their appraised value as determined under Section 403 of the Tariff Act of 1930 and evidenced by the customs invoice issued in connection with their importation.

Under the EIE rules, qualifying foreign trade property can be manufactured, produced, grown or extracted either within or without the U.S., provided that not more than 50% of the FMV of such property is attributed to articles manufactured, produced, grown or extracted outside the U.S., and direct costs for labor performed outside the U.S. (the 50%-foreign-content rule). However, if the property is not manufactured in the U.S., it must be manufactured by a person taxable in the U.S. (i.e., a domestic corporation, an individual subject to U.S. taxation, a foreign company that has elected to be subject to U.S. tax or a partnership made up of such U.S. taxpayers).

By removing the requirement for manufacturing within the U.S., there is more flexibility for imported products. Some importers may qualify for the EIE even if the FMV attributable to U.S. manufacturing is less than that attributable to imported articles. For example, a U.S. company can hire a foreign contract manufacturer to produce products for $60; have a foreign branch further manufacture at a cost of $15; incur $25 in U.S. costs (including intangible development); and resell the product for $150. In this case, the U.S. company has incurred 20% of the manufacturing costs, and thus meets the manufacturing requirement; yet all of the manufacturing has occurred overseas. The viability of this strategy will depend on the profitability and local taxation of the U.S. company's foreign branch, because such branch will be subject to U.S. taxation.

When a U.S. taxpayer performs production activities outside the U.S., it is not clear how to interpret the new 50%-content rule. For example, an article valued at $100 is manufactured outside the U.S., using U.S.-made components with a $60 FMV. Alternatively, that same article was manufactured outside the U.S. without any U.S.-made components, but $60 of the selling price is attributable to a popular trademark imprinted during manufacturing. In each case, how is the FMV attributable to foreign-manufactured articles determined?

This issue was addressed in the U.S.'s argument to the World Trade Organization (WTO) in defense of the EIE legislation ("Second Written Submission of the U.S. of America," 2/27/01, Section III). According to that document, "the 50-percent rule takes into account only the value of foreign articles and foreign direct labor used in producing a finished product. The rule does not limit other foreign value. Thus, property can meet the fifty-percent rule even if 100 percent of its content is foreign."

To comply with the rule that qualifying foreign trade property must be manufactured by a U.S. taxpayer, a U.S. parent may need to elect to treat the foreign manufacturer as a disregarded entity. In each case, the potential benefits of the EIE must be weighed against alternative tax benefits, including the ability to defer the foreign manufacturing and sales income from U.S. taxation, the ability to fully use foreign tax credits on repatriation of profits, and a higher amount of foreign-source income (FSI) than that allowed under the EIE rules.

Foreign Distributors and FSALI

As noted, foreign companies electing to be taxed in the U.S. can qualify for EIE. This may provide a benefit if a taxpayer has a current income inclusion under Subpart F due to foreign base company sales income (FBCSI). For example, an exporter may have a sales office (SalesCo) in a European country in which the local tax rate is 30%. If 70% of SalesCo's $10 million income results from sales of its parent's products in countries other than its resident country, all its income must be recognized by the U.S. taxpayer as FBCSI. When a U.S. taxpayer treats this income as a deemed dividend, a tax credit of $3 million (30% 3 $10 million) will be allowed, reducing the U.S. tax from $3.5 million (35%) to $500,000 (5%). If the U.S. taxpayer elects to treat SalesCo as a disregarded entity, it is likely that the foreign sales and leasing income (FSALI) method will be applied, as substantially all of SalesCo's income would probably be allocable to foreign economic processes. Hence, $3 million (30%) of such income could be excluded. The remaining $7 million income would be subject to U.S. tax of $2.45 million but would be entitled to a tax credit of $2.1 million (70% 3 $3 million). The incremental U.S. tax would be $350,000 instead of $500,000; hence, the overall tax on SalesCo's income would be 33.5%.

The entire $10 million of SalesCo's FSALI would be FSI. Because only a $2.1 million foreign tax credit (FTC) is allowed on the FSALI, there is potential to soak up excess FTC from other sources.

If the FSALI method is used in connection with a FSC treated as a disregarded entity, the potential benefit of EIE increases as the foreign tax rate of the sales company decreases. This may create an incentive to shift selling activities relating to foreign sales into a low-tax jurisdiction, even if tax deferral is proscribed under Sec. 954(d) (dealing with FBCSI). If a U.S. parent is in an excess FTC position, it may make sense to treat a foreign selling company in a low-tax jurisdiction as a disregarded entity, even if it is not subject to Subpart F.

Transition to EIE

The EIE legislation generally applies to transactions after Sept. 30, 2000. After that date, no corporation can elect to be an FSC. A taxpayer with an existing FSC can continue to use it through the end of 2001, or may elect to apply the EIE rules to any or all transactions. When a FSC has entered into a binding contract (including a purchase option) with an unrelated person before Oct. 1, 2000, any transactions occurring under such contract will continue to be subject to the FSC rules (unless the taxpayer elects the EIE rules).

There is no need to dissolve FSCs immediately. The EIE can be applied to any or all qualified transactions beginning Oct. 1, 2000, whether or not a FSC continues to exist. Even after 2001, a FSC can continue to operate as a branch of the U.S. taxpayer, if it makes an election to be treated as a disregarded entity. However, in the case of a small FSC (which performs no foreign economic processes), it may be beneficial to dissolve it to save maintenance costs. Before deciding to dissolve a FSC, it is important to consider the tax costs of such liquidation.

Many taxpayers have decided to keep their FSCs in operation for 2001, pending the WTO's decision on whether the EIE is an illegal export subsidy. (The WTO's final decision is expected to be announced in the summer of 2001.) There remains a possibility that the U.S. will have to amend the EIE legislation, and taxpayers prefer not to change their procedures twice, unless a greater benefit can be achieved under EIE compared to FSC.

For now, taxpayers should:

1. Consider whether the taxpayer has any characteristics that would cause the EIE to produce a better result than an FSC. For example, does it export military property? Is it in an alternative minimum tax position?

2. If the answer to 1 is "yes" or "maybe," execute blanket agreements by which the FSC performs foreign economic processes on behalf of the U.S. taxpayer from Sept. 30, 2000 through the end of 2001.

3. Determine the most efficient ways for the U.S. taxpayer to assume or delegate sufficient foreign economic processes after FSC benefits are no longer available.

4. Become familiar with EIE pricing methods and tax forms, and develop software/spreadsheets to perform the calculations.

The EIE does not apply to any taxpayer that is a member of a controlled group that includes a domestic international sales corporation (DISC) at any time during the tax year. Holders of interest-charge DISCs (IC-DISCs) must weigh the cashflow benefits derived from the IC-DISC against the permanent tax benefits afforded by the EIE. If a decision is made to dissolve an IC-DISC, such dissolution must be completed by the end of the current tax year, to avoid losing an entire year of EIE benefits in 2002.

From Radhika Reddy, Cohen & Company, LTD, Cleveland, OH