Future of Export Tax Benefits

Since its introduction in 1984, the major tax benefit for U.S. exporting companies has become an industry of its own—the foreign sales corporation (FSC). This export incentive was intended to replace the domestic international sales corporation (DISC) and satisfy the "substance" requirements of the General Agreement on Tariffs and Trade (GATT). However, in 1997, the European Union (EU) challenged the legality of the FSC as an export tax benefit, complaining formally to the World Trade Organization (WTO) to force the U.S to remove this "illegal export subsidy," as violative of WTO agreements. On Feb. 24, 2000, the WTO issued its final decision, declaring the FSC an illegal export subsidy under WTO agreements and asking the U.S. to terminate the FSC by Oct. 1, 2000 or face a trade war with the EU. The U.S. had to act quickly to avoid that conflict.

The FSC Repeal and Extraterritorial Income Exclusion Act of 2000

On July 27, 2000, the House Ways and Means Committee introduced H.R. 4986, a bill to replace the FSC with a new exclusion from gross income for extraterritorial income. This legislation is intended to be in compliance with the WTO decision (as well as the Oct. 1, 2000 deadline) and provide U.S. tax savings similar to the FSC regime.

The proposal repeals existing Secs. 921–927 as of Sept. 30, 2000, with transition rules allowing any FSC in existence on that date to continue operating until (1) Dec. 31, 2001 or (2) contracts entered into prior to Oct. 1, 2000 expire. Instead of the partial tax exclusion provided under FSC rules, the new system adopts a complete tax exclusion for "extraterritorial income" (EI) under new Sec. 114. The exclusion would apply to qualified foreign trade income (QFTI), as defined in new Secs. 941–943. These new rules retain many of the familiar attributes of the FSC, such as determination of profits on a transactional basis, marginal costing principles, foreign economic process requirements (FEP) and safe-haven administrative pricing rules. The percentages of excluded income are practically identical to the results under the FSC rules. For example, the new legislation allows QFTI to be the larger of 1.2% of foreign trading gross receipts (FTGR) or 15% of foreign trade income, limited to two times 1.2% of FTGR. Under the FSC rules, comparable percentages were 1.83% and 23%, subject to a tax exclusion of 65.217%, which exempts 1.19% of FTGR or 15% of foreign trade income.

Advantages of this proposed legislation include:

• No separate entity is required to receive the tax benefit.
• The tax exemption is similar to the existing FSC exemption.
• The EI exclusion can be used by any U.S. taxpayers, even individuals.
• The new rules can apply to non-U.S. manufacturing activities. Foreign entities can elect to be treated as domestic entities and not be subject to Subpart F, but would lose related foreign tax credits.
• Transition relief gives existing FSCs until the end of 2001 (or life of contract for leasing FSCs) to change.
• Military sales will enjoy full benefits (currently, 50%).

Disadvantages of the proposed legislation include:

• The U.S. content of qualifying foreign trade property (QFTP) is still required to exceed 50%, even if manufactured outside the U.S. This requirement makes the exclusion still applicable to export property; in most cases, a significant part of the manufacturing or materials of the final product would have to be of U.S. origin to qualify.
• Small exporters will have to establish a foreign presence and actually incur certain costs outside the U. S. to fulfill the FEP requirements, unless their sales are less than $5 million.
• The EU will likely respond unfavorably to this proposal, because it actually expands the existing tax benefits.
• Individual retirement accounts (IRAs) currently owning FSCs will no longer provide benefits. However, Roth IRAs could still benefit their owners.

Consequences of Proposed Legislation and Alternatives

The last words have not been spoken on FSC replacement; however, it is becoming increasingly clear that the U.S. will try to avoid a trade war with the EU, and will not likely keep the FSC legislation in place. Therefore, U.S. exporters have to consider preparing themselves for an end to the FSC, possibly as of Oct. 1, 2000. It remains very likely that any replacement legislation will include transition relief, and that no new FSC elections will be allowed after Sept. 30, 2000.

Especially for small closely held exporters, the interest-charge DISC (IC-DISC) remains a viable alternative. All exporters need to consider the proposed legislation in light of their foreign operations, foreign tax credits currently used and the new election for foreign entities to be taxed in the U. S. with exclusion of qualifying EI. Careful consideration of all developments in U. S. legislation is needed to avoid incorrect strategic decisions with potentially large tax consequences.

From Olaf Barthelmai, CPA, McLeod & Company, Roanoke, VA