part4-309

4.61.8 
ETI (Extraterritorial income), IC-DISCs and FSCs

4.61.8.1 
(05-01-2006)
Introduction

  1. Prior to the enactment of IRC Section 114, taxpayers were allowed to
    use Foreign Sales Corporations to exempt a portion of qualifying foreign trading
    gross receipts from U.S. taxation. In general, the Foreign Sales Corporation
    provisions were repealed effective October 1, 2000, and the Extraterritorial
    Income exclusion provisions are effective for transactions entered into after
    September 30, 2000. In addition, no corporation may elect to be a FSC after
    September 30, 2000. FSCs may continue to apply the FSC provisions instead
    of the ETI exclusion provisions at their option with respect to transactions
    entered into prior to January 1, 2002. In addition, FSCs may continue to
    apply the FSC provisions to transactions entered into pursuant to a binding
    contract with an unrelated person and in effect on September 30,2000 and at
    all times thereafter. See Rev. Proc. 2001-37, 2001-1 C.B. 1327. Because FSC
    years are still being examined, the FSC audit techniques are provided in this
    section. The Domestic International Sales Corporation (DISC) provisions were
    enacted in 1971 and were substantially modified by the tax reform act of 1984
    that enacted the Foreign Sales Corporations provisions. The Interest charge
    DISC (IC-DISC) provisions are discussed in this section.

4.61.8.2 
(05-01-2006)
Background

  1. Internal Revenue Code Section 114 provides that gross income does not
    include extraterritorial income. Because the extraterritorial income exclusion
    is a means of avoiding double taxation, no foreign tax credit is allowed for
    income taxes paid with respect to such excluded income. Extraterritorial income
    is eligible for the exclusion to the extent that it is qualifying foreign
    trade income. Because U.S. income tax principles generally deny deductions
    for expenses related to exempt income, otherwise deductible expenses that
    are allocated to qualifying foreign trade income are disallowed.

4.61.8.3 
(05-01-2006)
Extraterritorial Income

  1. Internal Revenue Code Section 114 provides that gross income does not
    include extraterritorial income, so long as it is qualifying foreign trade
    income as described below.

4.61.8.4 
(05-01-2006)
Disallowance of Deductions

  1. Any deductions allocable to extraterritorial income that is excluded
    are not allowed. Deductions apportioned and allocated to a taxpayers extraterritorial
    income are allocated on a proportionate basis between:

    1. the income excluded, and

    2. the income not excluded.

4.61.8.5 
(05-01-2006)
Disallowance of Foreign Tax Credit

  1. No foreign tax credit is allowed with respect to any income excluded
    under the extraterritorial income provisions.

4.61.8.6 
(05-01-2006)
Qualifying Foreign Trade Income

  1. Qualifying Foreign Trade Income is defined in IRC Section 941(a)(1).
    It is income from a qualifying transaction equal to the greater of:

    1. a. 30 percent of the foreign sale and leasing income ( Section 941(a)(1)(A)),

    2. b. 1.2 percent of the foreign trading gross receipts ( Section 941(a)(1)(B)),
      or

    3. c. 15 percent of the foreign trade income (Section 941(a)(1)(C)).

  2. A taxpayer may elect on a transaction-by-transaction basis not to exclude
    extraterritorial income from gross income. Such election is made on line 1
    of Form 8873 ( “Extraterritorial Income Exclusion”
    ).

4.61.8.7 
(05-01-2006)
Foreign Trade Income

  1. Foreign Trade Income is taxable income attributable to foreign trading
    gross receipts. Taxable income from foreign trading gross receipts is those
    receipts reduced by all deductions properly allocated and apportioned to those
    receipts.

4.61.8.8 
(05-01-2006)
Foreign Sale and Leasing Income

  1. Foreign sale and leasing income includes foreign trade income that meets
    at least one of the following three criteria:

    1. attributable to the foreign economic processes described in section 942(b),

    2. derived in connection with the lease or rental of property for use by
      the lessee outside the U.S.; or

    3. derived from the sale of property described in (b) above.

4.61.8.9 
(05-01-2006)
Foreign Trading Gross Receipts

  1. Foreign trading gross receipts are:

    1. from the sale or disposition of qualifying foreign trade property,

    2. from the lease or rental or qualifying foreign trade property for use
      outside the U.S.,

    3. from services related and subsidiary to the sale or lease, described in
      (a) or (b) above

    4. from engineering and architectural services for construction projects
      outside the U.S., or

    5. from managerial services to an unrelated person to further the production
      of foreign trading gross receipts described in (a), (b), and (c) above. For
      managerial services to qualify at least 50 percent of the taxpayers foreign
      trading gross receipts must be from the sale or lease of foreign trade property
      (including income from services related to a qualifying sale or lease).

  2. ) A transaction does not generate foreign trading gross receipts if
    the property or services are for ultimate use in the United States.

  3. A taxpayer may elect on line 1 of Form 8873 not to include gross receipts
    from any transaction in foreign trading gross receipts.

4.61.8.10 
(05-01-2006)
Foreign Economic Process Requirements – Generally

  1. Gross receipts from a transaction qualify as foreign trading gross receipts
    only if certain economic processes with respect to the transaction take place
    outside the United States:

    1. The taxpayer (or a person acting under contract with such taxpayer) must
      participate with respect to such transaction outside the United States in
      the solicitation (not including advertising), negotiation, or making of the
      contract, and

    2. foreign direct costs (see 4.61.8.11(2)) of the five specified activities
      (see 4.61.8.11(1)) incurred by the taxpayer with respect to such transaction
      must represent at least 50% of the total direct costs of the five specified
      activities. Alternatively, foreign direct costs of two of the five specified
      activities incurred by the taxpayer with respect to such transaction must
      represent at least 85% of the total direct costs of those two activities.

4.61.8.11 
(05-01-2006)
Five Specified Activities

  1. ) The five specified activities are:

    1. advertising and sales promotion

    2. processing of customer orders and arranging for delivery

    3. transportation outside the U.S. in connection with delivery to the customer

    4. determination and transmittal of a final invoice or statement of account,
      or the receipt of payment, and

    5. assumption of credit risk

  2. “Total direct costs” means the costs attributable to the five specified
    activities (for the transaction) performed at any location by the taxpayer,
    by any person acting under a contract with the taxpayer. “Foreign direct costs”
    is the portion of total direct costs attributable to activities performed
    outside the United States.

  3. This direct costs test will be treated as met by a taxpayer if the total
    foreign trading gross receipts for a year do not exceed $5,000,000. Foreign
    trading gross receipts of all related persons are aggregated for this purpose.
    In the case of any pass-through entity, the limitation applies with respect
    to the entity and with respect to each partner, shareholder, or other owner.

4.61.8.12 
(05-01-2006)
Definitions and Special Rules

  1. “Qualifying foreign trade property” is property manufactured, produced,
    grown or extracted either within or outside the United States which is held
    primarily for sale, lease or rental for direct use, consumption or disposition
    outside the United States. In addition, no more than 50 percent of the fair
    market value of the property can be attributable to the value of articles
    manufactured, produced, grown, or extracted outside the United States, plus
    the direct costs for labor performed outside the United States.

  2. Property manufactured, produced, grown, or extracted by a person outside
    the United States may constitute qualifying foreign trade property only if
    such person is a domestic corporation, a U.S. citizen or resident individual,
    a foreign corporation that made a domestication election under section 943(e),
    or a pass-thru entity all of the partners or owners of which are otherwise
    described in this sentence.

  3. Qualifying foreign trade property does not include:

    1. property leased or rented by the taxpayer for use by any related person,

    2. intangible property as described in IRC Section 943(a)(3)(B),

    3. oil or gas,

    4. products that cannot be transferred pursuant to the Export Administration
      Act of 1979 (Public Law 96-72)

    5. unprocessed softwood timber, or

    6. property designated in short supply by the President of the United States.

4.61.8.13 
(05-01-2006)
IC-DISCs and FSCs

  1. The legal requirements for an IC-DISC are provided
    in IRC section 992(a). Verify the following:

    1. The corporation has only one class of stock and
      the par value of such stock is at least $2,500.

    2. IC-DISC election made and not terminated [IRC section
      992(a)(1)(D) and 992(b)]

    3. The DISC is not related to a FSC (IRC section 992(a)(1)(E).

    4. If a corporation has previously revoked or lost
      its IC-DISC status, see IRC section 992(a)(3).

4.61.8.14 
(05-01-2006)
IC-DISC Gross Receipts Test

  1. The 95 percent gross receipts test provided in
    IRC section 992(a)(1)(A) requires that 95% or more of the corporations gross
    receipts constitute qualified export receipts as defined in section 993(a).

4.61.8.15 
(05-01-2006)
IC-DISC Qualified Export Property

  1. Qualified export property is defined by IRC section
    993(c) as follows:

    1. Must be produced in the United States and consumed
      outside the United States

    2. Less than 50 percent of the fair market value can
      be attributable to foreign content.

4.61.8.16 
(05-01-2006)
IC-DISC Asset Test

  1. The adjusted basis of at least 95% of the corporations
    assets must be attributable to qualified export assets. Qualified export assets
    are defined in IRC section 993(b).

4.61.8.17 
(05-01-2006)
IC-DISC Transfer Pricing

  1. The taxpayer may apply one of the following intercompany
    transfer pricing methods to each transaction:

    • Gross receipts method

    • Method of combined taxable income (CTI), or

    • IRC section 482 method

4.61.8.18 
(05-01-2006)
IC-DISC Expenses

  1. The IE should compute the effect of export promotion
    expense (EPEs) on the commission or transfer price. Verify that:

    1. EPEs are added back to the commission, and

    2. Transfer price is added to the 4 percent gross of
      50–50 CTI method

  2. Review the effect of Reg. 1.861–8 and –8T
    to –17T on the computation of CTI for the method of combined taxable
    income. In case of taxpayers using the gross receipts method, the no loss
    rule applies so that CTI must also be computed. Review the following:

    1. All costs should be properly allocated,

    2. General and administrative (G&A) expenses must
      be properly allocated,

    3. Research and development (R&D) expenses must
      be allocated,

    4. If the taxpayer is using taxable income rather than
      book income make proper adjustments (M–1s, LIFO inventory, etc.),

    5. Post 1986 years require consolidated items be allocated,
      and

    6. Note that interest expense and income cannot be
      netted.

4.61.8.19 
(05-01-2006)
IC-DISC No Loss Rule

  1. If there are loss sales compute the commission
    or transfer price applying the no loss rule to those sales.

  2. If the taxpayer uses the marginal costing rules,
    consider the following:

    1. The CTI is computed using direct costs only,

    2. The CTI is limited to overall profit percentage
      (OPP),

    3. The no loss rules apply to marginal costing also,
      and

    4. Product grouping rules apply.

4.61.8.20 
(05-01-2006)
IC-DISC Taxation

  1. IC-DISC income may be taxable to the shareholders
    when the following occurs:

    • Deemed distribution,

    • Distribution upon disqualification,

    • 50% of taxable income attributable to military property,

    • Disposition of DISC stock,

    • There is a foreign investment attributable to IC-DISC
      earnings, or

    • Income attributable to qualified export receipts
      exceeds $10 million.

4.61.8.21 
(05-01-2006)
Interest Charge on an IC-DISC

  1. Form 8404 (Computation of Interest
    Charge on DISC-Related Deferred Tax Liability    ) must be filed to report
    the interest charge on an IC-DISC. The priority of distributions are:

    1. Out of previously taxed income (PTI)

    2. Out of accumulated DISC income, then

    3. Out of other E&P

4.61.8.22 
(05-01-2006)
Foreign Sales Corporation (FSC)

  1. The legal requirements of a FSC are provided in
    IRC section 922(a). The requirements are:

    1. Less than 25 shareholders,

    2. No preferred stock,

    3. An office must be maintained outside the United
      States in a qualified country, including all possessions except Puerto Rico,

    4. Books must be maintained in the foreign office as
      well as those required by IRC section 6001 in the United States,

    5. There must be at least one nonresident of the United
      States on the Board of Directors,

    6. There cannot be a related IC-DISC,

    7. The taxpayer must elect FSC status,

    8. Puerto Rico is not a qualified country, and therefore
      a taxpayer can receive both FSC benefit and benefits under section 936, but
      the FSC provisions are applied before the section 936 provisions.

      Note:

      A small FSC does not have to meet
      the economic process and management tests described in IRC section 924.

4.61.8.23 
(05-01-2006)
FSC Foreign Management Requirements

  1. The requirements of IRC section 924(c) are:

    1. All director and shareholders’ meetings must
      be held outside the United States,

    2. The FSC must maintain a foreign bank account in
      a qualified country, and

    3. All dividends, if distributed, legal and accounting
      fees, and salaries of officers and directors must be disbursed from the foreign
      bank account or reimbursed to the FSC.

4.61.8.24 
(05-01-2006)
FSC Economic Process Requirements

  1. The requirements of IRC section 924(d) are:

    1. Solicitation, negotiation or making of contracts
      must occur outside the U.S. (See IRC section 924(d)(1)(A).),

    2. At least 50 percent of the direct costs from activities
      listed in IRC section 924(e) must be foreign direct costs,

    3. There is an alternative 85 percent test for two
      of the five categories listed in IRC section 924(e).

4.61.8.25 
(05-01-2006)
FSC Gross Receipts

  1. Foreign trading gross receipts (FTGR) are defined
    in IRC section 924.

4.61.8.26 
(05-01-2006)
FSC Transfer Pricing Rules

  1. The transfer pricing methods are provided in IRC
    section 925. The three methods are:

    • 1.83 percent of FTGR, limited to 46% of full costing
      or marginal costing CTI,

    • 23 percent of CTI, and

    • IRC section 482 method.

  2. If the limitation under the 1.83% of FTGR method
    is based on marginal costing CTI, then the “no loss”
    rule
    applies.

  3. The marginal costing rules are applicable. These
    are:

    1. The CTI is computed using direct costs only,

    2. The CTI is limited to the overall profit percentage
      (OPP),

    3. The no loss rules apply to marginal costing.

    4. The maximum marginal costing commission is 100 percent
      of the full costing CTI.

    5. The product grouping rules must be considered.

4.61.8.27 
(05-01-2006)
FSC Expenses

  1. The computation of CTI must account for the effects
    of Reg 1.861–8 and –8T through –17T. The IE must:

    1. Insure all costs are properly allocated,

    2. Insure that the proper method of allocating G&A
      expense was used,

    3. Insure that 100 percent of R&D expense has been
      allocated,

    4. Ascertain the taxpayer is using book income rather
      than taxable income (are M–1’s allocated, is inventory computed
      under LIFO, etc.),

    5. Insure consolidated items are allocated for post
      1986 years, and

    6. Insure no netting of interest income and interest
      expenses.

4.61.8.28 
(05-01-2006)
Taxation of FSC

  1. The FSC is taxed on 8/23 of its foreign trade
    income, 15/23 is exempt from U.S. tax. Interest, investment income and carrying
    charges are fully taxed to the FSC as non-foreign trade income.

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