Extraterritorial exclusion and the FTC.

• Author: Packard, Pamela
• Position: Foreign tax credits

More taxpayers that export goods are reaping the tax benefits from the extraterritorial income exclusion (EIE). The EIE allows a corporation to exclude qualifying foreign-trade income (FTI) from income. The EIE'S overall result is a tax rate of 29.75% (or less) on income realized from the sale of qualified export property.

However, for companies with excess foreign tax credits (FTCs), the EIE regime may have an adverse effect on a U.S. exporter's FTC. The primary culprit is the interplay between the EIE rules and Sec. 863(b) foreign-sourcing rules.

EIE Re-Sourcing Rule

Taxpayers look for ways to generate foreign-source income to use excess FTCs. A crucial component of foreign-source income is Sec. 863(b) sales; if a U.S. person manufactures goods in the U.S. and completes the sale overseas (i.e., title passes overseas), it would treat 50% of the income on such sale as foreign-source income.

Similar to rules under the former foreign-sales-corporation regime, Congress sought to limit the foreign-source income on a transaction from which the taxpayer also reaps an EIE benefit. Under Sec. 943(c), when a taxpayer uses the FTI method, only 25% of a transaction's profit is foreign source for Sec. 863(b) purposes. Under the foreign trading gross receipts (FTGR) rules, the limit on the foreign-source income is half the difference between the FTI and 4% of FTGR.

Example 1: A transaction results in FTGR of $1,250 and FTI of $100. Under the FTI method, taxpayer A excludes $15 (15% of $100), leaving only $25 (25% of $100) as foreign-source income. Under...