New rules for taxing extraterritorial income.

• Author: Benson, David M.
• Position: Foreign Income & Taxpayers

Legislation enacted in 2000 repealed the foreign sales corporation rules and permitted U.S. taxpayers to exclude part of their extraterritorial income. This article explains the new provisions, compares them to prior law and explains the ramifications and controversy.

On Nov. 15, 2000, former President Clinton signed into law the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (Act). The Act repealed the foreign sales corporation (FSC) rules and added new Code provisions allowing U.S. taxpayers to exclude a portion of their extraterritorial income (ETI) from gross income.

In general, ETI may arise when items are produced in the U.S. or abroad for use or consumption outside the U.S. This article describes the new provisions and highlights significant differences between the ETI-exclusion regime and the FSC rules.

Background

In July 1998, the European Union (EU) brought a case in the World Trade Organization (WTO) challenging the FSC rules, arguing that they were a prohibited export subsidy under two WTO trade agreements to which the U.S. is a party. (1) Despite a vigorous defense by the U.S., a WTO Panel in October 1999 agreed with the EU. The WTO Appellate Body (AB) upheld the Panel's ruling in February 2000; it gave the U.S. until Oct. 1, 2000 (later extended until Nov. 17, 2000) to comply with the trade agreements' terms or risk retaliatory sanctions against U.S. goods sold in the EU (such as increased import tariffs). Before the deadline, Congress repealed the FSC rules.

The ETI regime was born against this backdrop. Although it was crafted by Treasury (with business community input) to be WTO-compliant (and Congress believed that it would be compliant), the EU reacted to the Act's passage by quickly bringing another case in the WTO, claiming that the ETI regime (like the FSC rules) was a prohibited export subsidy. The WTO Panel found in favor of the EU again; the decision was upheld on appeal. At press time, a WTO arbitration panel was considering the EU's claim for damages against the U.S. Even though it is unclear how the U.S. will ultimately address the loss and, at the same time, comply with its WTO obligations (as government officials have said it will), ETI remains the law of the land unless and until it is repealed. Accordingly, exporters should understand the ETI regime's requirements and benefits and how they compare to the FSC rules.

FSC Rules

Under Secs. 921-927, in general, an FSC is a foreign corporation established in a qualifying jurisdiction that meets a number of offshore-activity requirements and elects FSC treatment. A portion of an FSC's income from its participation in qualifying export transactions with a U.S. affiliate is characterized as foreign-source income not connected with a U.S. trade or business and not subjected to U.S. tax. An FSC is also generally excluded from subpart F treatment. As a result, the combined income of the FSC and its U.S. affiliate from qualifying export transactions is subject to a U.S. tax rate of 29.75% (or less); had such income been received entirely by the U.S. affiliate, it would have been subject to the usual 35% corporate tax rate. In addition, dividends from an FSC qualify for the 100% dividends-received deduction when paid to a U.S. corporate shareholder. Thus, an FSC may repatriate its earnings to a U.S. parent without incurring further U.S. tax liability. Most FSCs are established in the U.S. Virgin Islands or Barbados and pay no foreign income tax on earnings.

ETI Provisions

The Act repealed the FSC provisions and mandated that no new FSCs be formed after Sept. 30, 2000. For FSCs in existence on that date, the FSC rules apply to transactions occurring before 2002. For then-existing FSCs, the FSC rules continue to apply indefinitely to transactions occurring after Sept. 30, 2000 if pursuant to a binding contract with a third party in effect on that date. Taxpayers could elect (2) to apply the new ETI rules in lieu of the FSC rules beginning Oct. 1, 2000. Unlike the FSC rules, ETI is based on a single-entity concept and does not require formation and operation of a separate special-purpose vehicle.

Under new Sec. 114, added by Act Section 3, gross income does not include ETI, defined in Sec. 114(e) as gross income attributable to foreign trading gross receipts (FTGRs), as defined in new Sec. 942.

Sec. 114(b) provides that ETI that is not "qualifying foreign trade income" (QFTI) is not ETI. Sec. 114(c) denies deductions properly allocable to ETI that a taxpayer excludes from gross income. Similarly, Sec. 114(d) denies foreign tax credits (FTCs) for foreign-income, war-profits and excess-profits taxes incurred on such income.

Under Sec. 941(a)(1) generally, QFTI is gross income from transactions that, if excluded, would result in a reduction of a taxpayer's taxable income, not to exceed the greatest of:

* 30% of the taxpayer's foreign-sale-and-leasing income.

* 1.2% of the taxpayer's FTGR income.

* 15% of the taxpayer's foreign-trade income.

Thus, under the chosen statutory construction, a taxpayer in effect "backs into" the QFTI amount.

According to Sec. 941(a)(1), QFTI determined under the 1.2%-of-gross-receipts method may not exceed twice the amount determined to be QFTI under the 15% method. (Similarly, an FSC that uses the 1.83%-of-gross-income administrative-pricing method cannot take into account more than twice as much income as determined under the 23%-of-combined-taxable-income method.) A taxpayer need not choose the method that results in the highest QFTI. If the 1.2%-of-gross-receipts method is used, no related person may earn QFTI from any transaction involving the same property (similar to an FSC provision essentially designed to prevent "pyramiding" of benefits). Also similar to the FSC rules, Sec. 941(a)(4) and (5) provide regulatory authority mandating the adoption of marginal-costing rules and sanctions for participating in an international boycott or bribery or kickbacks to government officials.

For purposes of the 15% method, Sec. 941(b) defines "foreign trade income" as taxable income attributable to FTGRs. Sec. 942(a) defines FTGRs as gross receipts from:

* A sale, exchange or other disposition of qualifying foreign-trade property (QFTP).

* A lease or rental of QFTP for use outside the U.S.

*Services related and subsidiary to the above activities.

* Performance of managerial services in connection with any of the foregoing activities, if at least 50% of a taxpayer's other FTGRs for the year are derived from those activities.

* Engineering and architectural services for non-U.S, construction projects.

For purposes...