Elections Pursuant to FSC Repeal and Extraterritorial Income Exclusion Act of 2000

The IRS issued Rev. Proc. 2001-37 on May 18, 2001, providing guidance on the procedures for certain elections available under the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (Act). Specifically, Rev. Proc. 2001-37 provides guidance on the election (1) to exclude gross income from foreign trading gross receipts (FTGRs) under Sec. 942(a)(3), (2) to apply the extraterritorial income (ETI) exclusion provisions, in lieu of the foreign sales corporation (FSC) provisions under Section 5(c)(2) of the Act and (3) by a foreign corporation for treatment as a domestic corporation under Sec. 943(e)(1).

The President signed the Act into law on Nov. 15, 2000, repealing the FSC provisions under Secs. 921927 and replacing them with the ETI exclusion under Secs. 941943. Under the Act, the ETI exclusion applies to transactions that occur after Sept. 30, 2000. Section 5(c)(1) provides a transition rule applicable to FSCs in existence on Sept. 30, 2000, by which the FSC provisions continue to apply to transactions that occur before 2002.

Election to Exclude Gross Income from FTGRs

Under the Act, a taxpayer can elect to exclude gross receipts from FTGRs under Sec. 942(a)(3). The taxpayer makes the election by simply checking the box on line 1 in Part I of Form 8873, Extraterritorial Income Exclusion, the form prescribed by the IRS to report extraterritorial income and to calculate the ETI exclusion. If a taxpayer wishes to treat gross receipts from certain transactions as FTGRs and exclude gross receipts from other transactions, it must attach a schedule to Form 8873, identifying all gross receipts that are excluded.

The ability to exclude certain gross receipts from FTGRs is significant if there are loss transactions. Under the FSC provisions, an election to exclude transactions from FTGRs was unnecessary. Generally, the contract between the FSC and a domestic related-party supplier could be drafted such that the supplier could choose not to use the FSC for any transaction. As a result, the domestic related-party supplier could essentially choose the transactions that it wished to include in the calculation of the FSC's commission.

Under the provisions of the ETI exclusion, all qualifying transactions are FTGRs, in the absence of an affirmative election to exclude certain transactions. The failure to properly elect not to include certain transactions in FTGRs could adversely affect the calculation of the allowable exclusion.

The election is also significant for taxpayers who rely on the exception for the foreign-economic-process requirement provided by Sec. 942(c), which treats a taxpayer as having FTGRs for any transaction only if certain foreign economic processes take place outside the U.S. A taxpayer need not meet the foreign-economic-process requirements under Sec. 942(b) if its FTGRs do not exceed $5 million. If a taxpayer has transactions that result in receipts that would otherwise qualify as FTGRs in excess of $5 million, it must make an election to reduce them to $5 million to qualify for the exception under Sec. 942(c). If the taxpayer were not to make such an election and were not to otherwise meet the foreign-economic-process requirements, the taxpayer would not meet the requirements for the exception provided by Sec. 942(c) and none of its transactions would qualify as FTGRs. Consequently, the taxpayer would forfeit any potential benefits.

Election by a Foreign Corporation for Treatment as a Domestic Corporation

Under Sec. 943(e), a foreign corporation can elect to be treated as a domestic corporation for all Code purposes if it waives all treaty benefits. Such an election is necessary if a taxpayer were to claim the ETI exclusion for property manufactured and sold by a foreign subsidiary. The taxpayer makes the election by checking the box on line 3 in Part I of Form 8873 and attaching the completed form to a timely filed Form 1120 for the first tax year of the election.

Election to Apply ETI Exclusion Provisions in Lieu of FSC Provisions

As noted, under Act Section 5(c)(1), the FSC provisions continue to apply to transactions occurring between Oct. 1, 2000Dec. 31, 2001, involving a FSC in existence on Sept. 30, 2000. However, a taxpayer can elect under Section 5(c)(2) to apply the ETI exclusion provisions instead of the FSC provisions on a transaction-by-transaction basis. Such an election is effective for the year of the election and all subsequent years.

The taxpayer makes the election by checking the box on line 2 in Part I of Form 8873 and attaching the completed form to its timely filed return for the year of the election. In addition, the taxpayer must attach a schedule reflecting the transactions for which it is making the election.

Because the calculation of the ETI exclusion results in a tax benefit that is nearly identical to that of an FSC, an election to apply the ETI exclusion in lieu of the FSC provisions would appear to render little benefit. However, there may be a significant benefit for taxpayers who rely on the $5 million exception as provided in Sec. 924(b)(2) for small FSCs and in Sec. 942(c) of the ETI provisions. The ability to use both an FSC and to claim the ETI exclusion appears to result in doubling the level of gross receipts that qualify for benefits without satisfying the foreign-economic-process requirements. There might be an opportunity for taxpayers with FSCs in place on Sept. 30, 2000, to rely on the "small FSC" provisions under Sec. 924(b)(2) for sales of up to $5 million. For transactions that result in gross receipts in excess of $5 million, taxpayers can elect to apply the ETI exclusion to avoid the foreign-economic-process requirements.

The Service's position on the interplay between the small FSC provisions and the ETI exclusion is unknown. It is possible it would argue that, although the ETI exclusion is not claimed on the first $5 million of gross receipts, the receipts are still FTGRs and, as a result, Sec. 942(c) would not apply.

Summary

Rev. Proc. 2001-37 is effective as of Oct. 1, 2000. The procedures for making the elections are relatively simple, requiring only proper completion of Form 8873 and the disclosure of certain detailed information. Careful consideration of the elections, however, is important, as a missed or inappropriate election could result in a significant decrease in the available benefit under the FSC provisions or ETI exclusion.

From Michael W. Granberg, CPA, Oak Brook, IL