Julie McGuire

Monday, 22 July 2002 09:59

An untapped tax haven

The Foreign Sales Corporation (“FSC”) is one of the few great tax benefits left in the U.S. tax code. And it’s available to most U.S. exporters. Surprisingly, the FSC remains underutilized, leaving untapped the opportunity for exporters to pay less income tax.

Many businesses mistakenly believe that the FSC has become obsolete, or was at some point statutorily abolished. In fact, the opposite is true. In 1997, Congress explicitly expanded the definition of qualified export property to include computer software licensed for reproduction abroad.

The sole purpose of the FSC legislation is to promote United States exports in a manner compatible with GATT (General Agreement on Tariffs and Trade). Congress advisedly elected to give up tax revenue when it enacted the FSC provisions in the mid-1980s.

Basic FSC concept

Even though the statutory rules surrounding the FSC are somewhat complex, the FSC idea is simple: The U.S. exporter sets up an offshore subsidiary—the FSC—in an approved foreign jurisdiction. The savings is achieved by “pushing” a portion of export income to the FSC and exempting a portion of that export income from U.S. tax.

This can be done two ways:

1. The U.S. parent could sell its product to its FSC under regulated pricing rules, with the FSC then reselling to the ultimate customer.

2. The U.S. parent could pay the FSC a commission based on the amount of the FSC’s export sales.

Under either structure, a portion of the export profit is attributable to the FSC—not the U.S. company. Without the FSC legislation, this type of profit, simply shifted offshore, would be immediately subject to U.S. tax. The FSC exceptions are codified in Sections 921 through 927 of the U.S. Internal Revenue Code.

Export Property

The U.S. exporter must sell, lease or otherwise dispose of “export property” to benefit from an FSC. Generally, “export property” is defined as property manufactured, produced, grown or extracted in the U.S. by someone other than the FSC (not more than 50 percent of the fair market value of the property can be attributable to articles imported into the U.S.). It’s also held primarily for sale, lease or other disposition in the ordinary course of business for direct use or disposition outside the U.S.

The actual calculations necessary to determine the exemption amount are complex. But the amount on which the exemption is based revolves around “Foreign Trading Gross Receipts.” FTGRs are gross receipts of the FSC resulting from the sale or other disposition of “export property.”

Foreign management factor

The FSC can have FTGRs—and therefore qualify for the exemption—only if the FSC meets two additional requirements: (1) the “foreign management” requirement and (2) the “foreign economic processes” requirement.

The “foreign management” requirement is met if: (a) all meetings of the board and all meetings of the shareholders are outside the U.S.; (b) the principal bank account of the FSC is maintained outside the U.S. at all times during the taxable year; and (c) all dividends, legal and accounting fees, and salaries of officers and members of the board of directors disbursed during the taxable year are disbursed out of bank accounts of the FSC maintained outside the U.S.

The foreign economic processes generally require testing to make certain that activities performed by or on behalf of the FSC take place outside the U.S.

Pricing rules

Finally, the pricing rules included with the FSC provisions are critical to the use—and to reaping the benefit—of the FSC. The pricing between the parent and its FSC subsidiary will determine the profit that can be shifted offshore.

Under the pricing regulations, two different pricing “standard” schemes are considered:

  • 23 percent of Combined Taxable Income Method (“the administrative pricing method”). Under this method, 23 percent of the combined taxable income of the FSC and its supplier from the export transaction will be considered the FSC’s income from that transaction.

  • 1.83 percent of Foreign Trade Gross Receipts Method (“gross receipts method”). Under this method, the FSC’s profit derived from the export transaction is equal to 1.83 percent of the foreign trading gross receipts from the transaction.

U.S. exporters with export revenue of $1 million or more should evaluate the potential savings opportunity offered by the FSC. Generally, by using an FSC, a U.S. exporter can lower its effective tax rate on its export income from 35 percent to just under 30. The tax savings are immediately measurable.

Julie E. McGuire is a shareholder, tax attorney and state-licensed CPA in the Pittsburgh law firm of Hull McGuire, P.C. This article is presented for informational and opinion purposes only and is not intended to constitute legal advice. Reach McGuire at (412) 261-2600.

Monday, 22 July 2002 09:45

Foreign sales fiasco

In October 1999, a panel created by the Dispute Settlement Body of the World Trade Organization (WTO) issued its final report concluding that the U.S. Foreign Sales Corporation (FSC) tax regime creates illegal export subsidies.

An FSC is a corporation given special tax treatment under U.S. tax laws. The purpose of FSC provisions is to promote U. S. exports in a manner compatible with the agreements negotiated between the United States and its trading partners.

The European Union, which has opposed the FSC regime since its enactment in the mid-1980s, filed a complaint against the U.S. in November 1997. In July 1998, after consultations between the E.U. and the U.S. failed to resolve differences, the E.U. requested that the WTO’s Dispute Settlement Body form a panel to rule on the issue.

In October 1999, the WTO panel released its findings in a 298-page report (“United States — Tax Treatment for “Foreign Sales Corporations;” Report of the Panel). The panel concluded that the U.S. FSC regime creates illegal export subsidies and should be abolished by Oct. 1, 2000.

E.U. complaint

The E.U. complaint alleged that the FSC regime violates certain export subsidy prohibitions of the WTO Agreement of Subsidies and Countervailing Measures by granting tax subsidies contingent upon export performance and the use of domestic over imported goods. It also alleges it violates the WTO Agreement on Agriculture by granting tax subsidies to agricultural goods in excess of the budgetary outlay and quantity commitment levels specified in negotiated schedules.

U.S. position

The U.S. position has consistently been that the FSC regime is not an illegal export subsidy. In fact, the U.S. had taken great care to meet the requirements of its trade treaties when it enacted the legislation in the mid-1980s.

The FSC regime was enacted to enable U.S. manufacturers — confronted with a harsh taxing scheme based on worldwide income — to compete with non-U.S. manufacturers that face less onerous taxing schemes, often territorial in scope. The FSC represents a partial adoption of the territorial approach to taxation, common in Europe, and intended to equalize the position of U.S. manufacturers in markets outside the United States.

The WTO ruling

The WTO found that the FSC income exemptions violate the SCM Agreement, which prohibits “subsidies” that are “contingent upon export performance.” The SCM Agreement defines subsidy as requiring both a financial contribution by a government and a conferred benefit.

Second, the panel found that the FSC regime “clearly confers a benefit, in as much as both FSCs and their parents need not pay certain taxes that would otherwise be due.” Finally, the WTO panel determined that the subsidies are “contingent upon export performance” because they are available only with respect to “foreign trade income.”

Foreign trade income arises from the sale or lease of export property, limited to goods made, produced or grown in the U.S. that are held for use or disposition outside the jurisdiction.

U.S. appeal filed

In early December 1999, the U.S. appealed the WTO’s determination. The E.U. cross-appealed, raising two issues included in the original complaint but not addressed by the panel in its report: administrative pricing and the U.S. content requirement.

The WTO Appellate Body is expected to take 60 to 90 days to rule on the appeals. Julie Elizabeth McGuire is a shareholder in Hull McGuire PC, attorney and CPA. The firm’s practice areas are limited to international corporate planning and transactions, tax law, intellectual property (trademarks, copyrights, trade secrets and licensing), complex litigation, employment practices, federal legislation, and natural resources law.