Comments on application of estimated tax rules to foreign sales corporations December 21, 1990.

Comments on Application of Estimated Tax Rules to Foreign Sales Corporations 

This letter follows up on our recent meeting with respect to the corporate meeting with respect to the corporate estimated tax payments of foreign sales corporations (FSCs).

As we have previously discussed, taxpayers have experienced great difficulty in making adequate estimated tax payments with respect to FSCs and their related suppliers. TEI recommended that te IRS adopt a rule whereby ne estimated tax penalties, failure-to-pay penalties, or interest charges would be imposed if no such penalties and interest would be due on an aggregate basis with respect to FSC commissions when estimated tax payments of both the FSC and the related supplier are taken into account. In addition, TEI recommended adoption of a safe harbor that would treat the FSC as having made adequate tax payments for purposes of section 6655 of the Code if the quarterly installments equal or exceed the tax on 1.83 percent of the foreign trading gross receipts of the related supplier and the FSC for that quarter. You asked the Institute to provide examples of situations in which the IRS had exercised its discretion to grant relief with respect to the estimated tax or similar provisions. This letter responsible to that request.

Prefatorily, we note that a FSC and its related supplier in reality operate as a single economic unit. The FSC provisions were enacted to replace the domestic international sales corporations (DISC) -- not for tax reasons -- but to address concerns raised by our trading partners with respect to the General Agreement on Tariffs and Trade (GATT). Unnecessary interest and penalty charges attributable to the operation of the estimated tax rules diminish the value of the FSC as an export incentive and frustrate the purpose of the provisions. Thus, we submit that there is no policy reason to deny a safe harbor from the estimated tax penalty with respect to FSCs and their related suppliers.

Annualized Income Exception

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) increased estimated tax payments for corporations from 80 to 90 percent of the current year's tax liability. Because the increased estimated tax payments demanded greater precision in preparing the estimates, the estimated tax penalty was restructured and the annualized income exceptions expanded. See Staff of the Joint Comm. on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, 97th Cong., 2d Sess. 155 (1982). With respect to the annualized income exceptions, the Treasury was directed to amend its regulations regarding the computation of taxable income for the period before the installment due date. H.R. Rep. No. 97-760, 97th Cong., 2d Sess. 552 (1982) (Conference Report). Congress was sympathetic to the problems inherent in accurately estimating corporate taxes, stating that --

Many items which substantially impact taxable income cannot be determined accurately by te installment due date. Examples of these include (but are not limited to) the LIFO index for taxpayers using dollar-value LIFO inventory method, the deferred gross profit for taxpayers with revolving charge accounts, intercompany adjustments for taxpayers who file consolidated returns, and a temporary liquidation of a LIFO layer at the installment date.

To alleviate these problems, Congress authorized the Secretary of the Treasury to issue regulations providing that reasonable estimates of certain items, based on existing data, could be used. As an example, Congress suggested that taxpayers using the dollar-value LIFO method of accounting might be allowed to interpolate from an available inflation index for a previous period in calculating the cost of goods sold in a period of less than a full taxable year in the absence of a reliable inflation index. Conference Report at 552. Proposed regulations issued under section 6655 generally adopted the language and examples of the Conference Report. See Prop. Reg. & 1.6655-2(e)(3) (issued March 26, 1984).

When the FSC provisions were enacted by the Tax Reform Act of 1984, for purposes of the annualized income exceptions, the IRS utilized its authority to permit the taxpayer to rely on reasonable estimates, based on existing data, until guidance on FSC transfer pricing rules could be published. See IR-85-35 (April 10, 1985). The news release provided:

As long as the FSC and its related supplier agreed to the transfer prices or commissions no later than the installment due date and as long as the FSC and related supplier use the same agreed-upon transfer prices or commission for the same transactions or group of transactions, the income or deductions resulting from those transfer prices or commissions generally will be considered a reasonable estimate based on existing data. However, an estimate will not be accepted as reasonable if it causes the related supplier to realize a loss under normal accounting principles or it is substantially distorts the income of either the FSC or the related supplier.

IR-85-35 became inoperative with the publication of temporary regulations under section 925 (T.D. 8126, issued March 2, 1987). We believe that the history of the annualized income exceptions generally supports the development of reasonable rules to address the computational difficulties the FSC rules pose for FSCs and their related suppliers.

Consolidated Return

Regulations

The consolidated return regulations provide an example of an exception to the requirement that the section 6655 penalty be calculated separately for each corporation. Treas. Reg. [section] 1.1502-5 provides that if a group files a consolidated return for two consecutive taxable years, it must make payments of estimated tax on a consolidated basis for each subsequent year. With respect to the first two taxable years for which a group filed a consolidated return, the group may compute the estimated tax payments on a consolidated or separate return basis, regardless of the method of payment.

The consolidated return regulations treat the members of an affiliated group as one economic unit. We believe that FSCs and their related suppliers should also be treated as a single unit. Although a FSC cannot file a consolidated return with its related supplier, we submit that there is no policy reason to deny such entities as safe harbor for estimated tax purposes.

Quarterly Financial Statement

Safe Harbor

Under Treas. Reg. [section] 1.922-1(i), A-12(iii), a FSC may meet the requirement that quarterly income statements be maintained at its corporate offices if it maintains a reasonable estimate of the FSC's income and expense items. The regulations also provide that, if the FSC is a commission FSC, 1.83 percent of the related supplier's gross receipts will be considered a reasonable estimate of the FSC's income. The usefulness of this safe harbor is diminished however, because a FSC is not permitted to pay its estimated taxes using 1.83 percent of export trading gross receipts. We therefore recommend the adoption of such a rule as consistent with the intent of the FSC statutory scheme and regulations. We also submit that the safe harbor should apply to buy-sell FSCs since there is no discernible congressional intent to discriminate between buy-sell and commission FSCs.

Conclusion

Tax Executives Institute appreciates this opportunity to supplement our views with respect to payments of estimated taxes by FSCs. If you have any questions, please do not hesitate to call Raymond G. Rossi, chair of TEI's International Tax Committee, at [phone] or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at [phone].