ETI Tax Benefit for Domestic Sales

The extraterritorial income (ETI) tax regime, which recently replaced the foreign sales corporation (FSC) regime, provides valuable income tax benefits to many U.S. taxpayers who export U.S.-manufactured property. Taxpayers, however, often forget that certain sales of property manufactured within the U.S. could qualify for ETI tax benefits if the property were subsequently resold or transferred outside the U.S. This, combined with the extension of export benefits to individuals, partnerships and S corporations under the ETI tax regime, should dramatically increase the number of U.S. taxpayers that can take advantage of Federal tax benefits associated with export benefits. Thus, taxpayers who think the ETI tax regime does not apply to their circumstances should reexamine sales revenue to determine whether they do indeed qualify.

In general, both the ETI tax regime and its predecessor provide a 15%-or-greater reduction in taxable income from the sale or lease of export property. To be "qualifying foreign-trade property," property must generally be produced in the U.S. and held by a taxpayer for sale, lease or rental, in the ordinary course of business, for direct use, consumption or disposition outside the U.S.

Qualifying Transactions

The typical beneficiary of the ETI tax provisions is a U.S. taxpayer receiving an ETI tax benefit for the direct export of U.S.-manufactured or -produced property to persons who use the property overseas. However, ETI tax benefits are also available to U.S. taxpayers who sell or lease such goods to U.S. buyers, as long as the U.S. buyer exports or leases the goods for use or consumption outside the U.S. within a year. For instance, if a U.S. farmer grows oranges and sells them to a local wholesaler, and the wholesaler sells the oranges in Europe, both the farmer and the wholesaler would be entitled to ETI tax benefits.

For U.S. taxpayers to receive ETI tax benefits for U.S. sales that are eventually exported, they must meet certain requirements. First, they must be able to verify that the products sold are actually exported, a practice that is often difficult. For example, a U.S. wholesaler selling U.S.-manufactured goods outside the U.S. may not be able to identify for the manufacturer the product type or quantity (or both) specifically sold.

Second, taxpayers receiving ETI tax benefits must satisfy foreign-economic-process (FEP) criteria, which generally require certain transactions to take place outside the U.S. Although the rules are relatively simple to satisfy for most exporters, taxpayers with only U.S. sales may not be able to meet them; the rules must be met during the tax year for which the taxpayer is claiming the ETI tax benefits.

Taxpayers should also consider that the FEP requirements allow persons other than the taxpayer (e.g., related or unrelated persons) to meet the requirements on the taxpayer's behalf, provided those persons perform the activities pursuant to a contract. The person performing the activity does not have to enter into a contract directly with the entity and may be a direct or indirect subcontractor of a person under contract with the taxpayer.

For example, an entity can enter into an agreement with a related party under which the latter agrees to perform on the entity's behalf all sales activities for the entity's transactions with its foreign customers. Through an agreement with a domestic unrelated person, the related party subcontracts the activities to a domestic unrelated person, who subcontracts them to foreign sales agents. The foreign sales agents' activities are deemed to be performed on the entity's behalf for FEP purposes; see the prior FSC rules under Regs. Sec. 1.924(d)-1(b)(1).

In addition, under Sec. 942(b)(4), a taxpayer would be treated as meeting the requirements for a sales transaction involving property if any related person has met the requirements for that same transaction or any other sales transaction involving that property. Third, property being sold must be resold or transported outside the U.S. within one year of the sale to reap the ETI tax benefits.

Finally, special consideration should be given to related-party transactions in which two related parties take ETI tax benefits on sales of the same property. In a technical explanation of the Extraterritorial Income Exclusion Act of 2000 (ETI Act), the Joint Committee on Taxation (JCT) demonstrates the limits on the use of the foreign-trading-gross-receipts (FTGRs) method, one of the three methods for computing ETI tax benefits under this circumstance (see JCT Staff, Tech. Expl'n of the Senate Amendment to HR 4986, the "FSC Repeal and Extraterritorial Income Exclusion Act of 2000" (JCX-111-00), 11/01/00, p. 6).

Example 1: A manufacturer and a distributor of the same product are related persons. The manufacturer sells the product to the distributor at an arm's-length price of $80 (generating $30 of profit); the distributor sells the product to an unrelated customer outside the U.S. for $100 (generating $20 of profit). If the distributor chooses to calculate its qualifying foreign-trade income on the basis of 1.2% of FTGRs, the manufacturer is then deemed to have no qualifying foreign-trade income and, thus, would have no excluded income.

The distributor's qualifying foreign-trade income would be 1.2% of $100, and the manufacturer's qualifying foreign-trade income would be zero. This limit prevents a duplication of exclusions from gross income, because the distributor's $100 of gross receipts includes $80 of the manufacturer's gross receipts. Absent this limit, $80 of gross receipts would have been double counted for exclusion purposes. If both persons were permitted to use 1.2% of their FTGRs, the related-person group would have an exclusion based on $180 of FTGRs, even though it really generated only $100 of gross receipts from the transaction.

Example 2: The facts are the same as in Example 1, except the distributor chooses to calculate its qualifying foreign-trade income using the 15%-of-foreign-trade-income method (15% x $20 profit). The manufacturer would also be eligible to calculate its qualifying foreign-trade income using the 15% method (15% x $30 profit).

Each related person excludes income based on its respective profits. The related-person group's total foreign-trade income is $50. Accordingly, allowing each person to calculate the exclusion based on its respective foreign-trade income does not result in duplication of exclusions. The manufacturer could also compute qualifying foreign-trade income based on 30% of foreign sale and leasing income.

For Example 2 purposes, a party would be deemed related if the parties are members of a controlled group of corporations, in which control means owning more than 50% of the vote or value of the shares or, for partnerships under common control, owning more than 50% of the capital or profits interests (Sec. 943(b)(3)). Under the ETI tax regime, the related-party rules could include, for example, transactions between an S and a C corporation owned by the same individuals.

Conclusion

Taxpayers should take another look at domestic sales to see whether benefits are available under the ETI tax regime. A taxpayer's U.S. exports (as well as certain sales of U.S.-manufactured or -produced property sold to U.S. buyers) may qualify. Because the ETI tax regime provides permanent tax savings to those who qualify, taxpayers who overlook these rules may miss opportunities to reduce their tax liabilities substantially.

In response to World Trade Organization and European Union complaints that the ETI tax regime is a prohibited export subsidy, U.S. Representative and House Ways and Means Committee Chair William Thomas recently introduced legislation to repeal the ETI. The bill includes significant other changes affecting U.S. companies with foreign sales and operations and is currently being debated. Meanwhile, taxpayers may still take benefits under the ETI tax regime and will likely be able to do so for at least part of 2002.

From Kay Ann Kernek, CPA, and Joe Loftin, PKF of Texas, P.C., Houston, TX