Extraterritorial Exclusion and the FTC

More taxpayers that export goods are reaping the tax benefits from the extraterritorial income exclusion (EIE). The EIE allows a corporation to exclude qualifying foreign-trade income (FTI) from income. The EIE's overall result is a tax rate of 29.75% (or less) on income realized from the sale of qualified export property.

However, for companies with excess foreign tax credits (FTCs), the EIE regime may have an adverse effect on a U.S. exporter's FTC. The primary culprit is the interplay between the EIE rules and Sec. 863(b) foreign-sourcing rules.

EIE Re-Sourcing Rule

Taxpayers look for ways to generate foreign-source income to use excess FTCs. A crucial component of foreign-source income is Sec. 863(b) sales; if a U.S. person manufactures goods in the U.S. and completes the sale overseas (i.e., title passes overseas), it would treat 50% of the income on such sale as foreign-source income.

Similar to rules under the former foreign-sales-corporation regime, Congress sought to limit the foreign-source income on a transaction from which the taxpayer also reaps an EIE benefit. Under Sec. 943(c), when a taxpayer uses the FTI method, only 25% of a transaction's profit is foreign source for Sec. 863(b) purposes. Under the foreign trading gross receipts (FTGR) rules, the limit on the foreign-source income is half the difference between the FTI and 4% of FTGR.

Example 1: A transaction results in FTGR of $1,250 and FTI of $100. Under the FTI method, taxpayer A excludes $15 (15% of $100), leaving only $25 (25% of $100) as foreign-source income. Under the FTGR method, A excludes $15 (1.2% of $1,250), and only $25 (50% x [$100 – (4% x $1,250)]) is foreign-source income.

Comparison of FTCs to the EIE Benefit

The true effect of the re-sourcing rule must be examined after determining the FTCs.

Example 2: The facts are the same as in Example 1, except A applies the EIE method to an excess FTC with Sec. 863 sales. This can cost A 20% of the tax benefits that it may have otherwise obtained without the limit; see the exhibit.

The EIE rules offer taxpayers a great deal of flexibility—from group to group, or even year to year. Therefore, a taxpayer should determine the optimum amount of overseas sales needed to use excess FTCs when claiming EIE benefits.

From Bill Kingsley, CPA, MST, and Bill Roth, III, CPA, Grand Rapids, MI