ETI Exclusion Repeal: Transition Relief

In response to the World Trade Organization (WTO) declaring the foreign sales corporation (FSC) regime a prohibited export subsidy, the FSC rules were replaced by the extraterritorial income (ETI) provisions as part of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000. Although the basic exclusion rules under the ETI regime function differently from the FSC regime, many of the concepts contained in the ETI rules are similar to those under the FSC regime. As a result, the European Union challenged the ETI regime in the WTO, as it had challenged the FSC regime. In January 2002, the WTO Appellate Body held that the ETI regime was also a prohibited export subsidy under the relevant trade agreements.

New Law

AJCA Section 101, amending Secs. 114 and 941943, repeals the ETI regime for transactions entered into after 2004, subject to a phaseout that allows current beneficiaries to claim ETI benefits as follows:

Binding contract rule: Benefits continue to be fully available for transactions undertaken pursuant to a binding contract with an unrelated person in effect on Sept. 17, 2003.

Effective Date

The provision is effective for transactions after 2004.

Implications

Because of the elimination of full ETI benefits after 2004, ETI beneficiaries should evaluate opportunities to accelerate qualified gross receipts into 2004 and defer 2004 allocable expenses to post-2004 years. For example, qualified gross receipts may be accelerated by offering discounts to foreign customers (related or unrelated) in exchange for prepaying purchases of qualified foreign trade property. In addition, deductions can be deferred through tax accounting method elections (e.g., capitalizing research and development costs under Sec. 59(e)) or deferring payment of expenses (e.g., compensation, pension contributions, etc.).

In analyzing the potential benefits of these strategies, consideration must be given to the (1) time value of money when accelerating income/deferring deductions; (2) foreign tax implications to related controlled foreign companies that receive discounts for prepayments of inventory; and (3) timing and ability to unwind the strategies. In addition, thought must be given to the potential effect of these strategies on a taxpayers qualified production activities income deduction.

From Marjorie Rollinson, Washington, DC