Comments on foreign sales corporations, March 2, 1990.

Comments on Foreign Sales Corporations 

On March 2, 1990, Tax Executives Institute filed the following comments with the Internal Revenue Service on various issues relating to foreign sales corporations (FSCs). The comments were prepared under the aegis of the International Tax Committee, whose chair is Bernard J. Jerlstrom, and addressed three issues - estimated taxes, Notice 89-84, and Rev. Rul. 89-93.

This letter discusses three issues in respect of foreign sales corporations (FSCs) and makes the following recommendations:

* Estimated tax: Developed a procedure

whereby a FSC and its

related supplier would be permitted

to aggregate its tax

payments for purposes of determining

whether a penalty

was due under sections 6651

and 6655 of the Internal Revenue

Code.

* Notice 89-84: Clarify that

Notice 89-94, relating to sections

267(a)(3) and 163(a)(3) of

the Internal Revenue Code,

does not apply to FSCs.

* Rev. Rul. 89-93: Clarify Rev.

Rul. 89-93, relating to the

sourcing of a related supplier's

income, to take into account

the differences in computation

of combined taxable income 

under the FSC rules and taxable

income under section 863

of the Code.

Estimated Tax Rules

In general, a portion of the income of a foreign sales corporation (FSC) is exempt from tax if certain conditions are met. The exemption is available with respect to income allocated to the FSC under special transfer-pricing rules. The transfer prices are based on either optional administrative rules or arm's-length pricing under section 482 of the Code. Under the administrative pricing rules, transfer prices shall be such that the FSC's taxable income will not exceed the greater of (i) 23 percent of the combined taxable income (CTI) of the FSC and its related supplier (generally, its U.S. parent) attributable to foreign trading gross receipts derived from the sale of property by the FSC, or (ii) 1.83 percent of the gross receipts derived from the sale of the property by the FSC.

Although FSCs must file U.S. tax returns, as foreign corporations they cannot join their U.S. parent in filing a consolidated return. Thus, a FSC must separately file a corporate tax return and separately pay estimated taxes. The estimated tax rules effectively operate as a "Catch-22" for FSCs and their related suppliers.

The problems in the FSC estimated tax area are twofold. First, CTI is often not susceptible to accurate calculation until after the close of the taxable year, particularly if grouping or marginal costing is used. Temp. Reg. [Sub-section] 1.925(a)-1T(e)(4) permits a FSC and its related supplier to recalculate the amount of foreign trading gross receipts at any time prior to the expiration of the statute of limitations for the taxable year. If this provision is utilized, CTI will obviously change after year-end - long after estimated tax payments would have been made.

A similar problem exists with respect to the tax payments required to accompany extension of time requests for filing income tax returns. Under Treas. Reg. [Sub-section] 1.6081-3, a taxpayer (including a FSC) may receive an automatic six-month extension to file its tax return, if at least 90 percent of the tax liability is paid by the original due date. Because of the problems inherent in calculating CTI, it is difficult (if not impossible) to accurately determine the amount of tax owed by a FSC by the original due date of the return.

In the above circumstances, any underpayment of tax by the FSC will invariable be offset by a reciprocal overpayment by its related supplier, and vice versa. Because the government is thus "made whole" by the offsetting overpayment, there is no policy or revenue basis for penalizing the underpaying entity.

Recommendation

(1) The IRS should adopt a rule whereby no estimated tax penalties, failure-to-pay penalties, or interest charges would be imposed if no such penalties and interest would be due on a net basis with respect to FSC commissions when the payments of both the FSC and its related supplier are taken into account. We recognize that matching estimated tax payments of FSCs and their related suppliers may complicate the processing of the returns by the IRS. We suggest, however, that a simplified procedure could be developed that would not require the IRS to physically "match" the returns of the FSC and its related supplier. For example, Form 2220 (Underpayment of Estimated Tax by Corporations) could be revised to permit the FSC or supplier to show an overpayment of estimated tax by the other entity. TEI would be pleased to work with the IRS in devising a procedure.

(2) The IRS should consider the adoption of a safe harbor for computing FSC estimated tax payments that would ameliorate the difficulty of accurately estimating combined taxable income on a quarterly basis during the taxable year. One method, patterned after the gross receipts method in section 925(a)(2) for computing FSC commissions, would be to treat the FSC as having made adequate tax payments for purposes of sections 6655 and 6151, provided 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.

Notice 89-84: Applicability to

FSCs

Notice 89-84, 1989-31 I.R.B. 8, provides rules under sections 267(a)(3) and 163(e)(3) of the Code with respect to interest and other amounts that are owed by a domestic taxpayer to a related foreign person but not paid in the year in which the deduction for the item would otherwise be allowed. The Notice states that it is generally inapplicable to amounts that are taxable to a related party as effectively connected income from a U.S. trade or business. Because the excludable portion of CTI is treated as non-effectively connected income, the Notice could be interpreted as requiring the deferral of a related supplier's FSC commission deduction until the year in which the commission is paid. TEI submits that such a result would not further the legislative purpose underlying sections 267(a)(2) and (3) of the Code and, indeed, could dilute the incentive effect intended by the FSC provisions.

Section 267(a)(2) requires related persons to use the same accounting method with respect to transactions between themselves so that a deduction is allowed to one entity only when there is a corresponding income inclusion by the other. Thus, an accrual-basis payor would be placed on the cash-basis method of accounting with respect to the deduction of amounts (such as interest) owed to a related cash-basis taxpayer. Staff of the Joint Comm. on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 542 (1984).

The technical corrections provisions of the Tax Reform Act of 1986 extended the "matching" rule of section 267(a)(2) to situations in which the related payee is a foreign person. See I.R.C. [Sub-section] 267(a)(3). The Treasury Department was authorized to clarify the application of the matching rule in cases where the related foreign payee does not include in income non-effectively connected foreign source income. Staff of the Joint Comm. on Taxation, General Explanation of Technical Corrections to the Tax Reform Act of 1986 and Other Recent Tax Legislation 76 (1986).

Under sections 921(a), 923(a), and 291(a)(4) of the Code, 15/23 of a FSC's taxable income derived from foreign trading receipts (i.e., its commission) is treated as not effectively connected with the conduct of a U.S. trade or business. The remaining portion is treated under section 921(d) as effectively connected income. Because FSCs and their related suppliers are generally accrual-basis taxpayers, the FSC has effectively connected income in the same taxable year in which the related supplier accrues its deduction. Thus, the accrual of a FSC commission does not represent the "matching" problem that concerned Congress in enacting section 267(a)(2) and (3), i.e., the deduction of an amount by an accrual-basis taxpayer with no concomitant income inclusion by a cash-basis related party. The statute should therefore not be construed to defer the deduction of an accrued commission to an accrual-basis FSC until the commission is paid. It is our understanding that the IRS did not intend to reach foreign sales corporations when it issued Notice 89-84.

Recommendation

An amelioratory notice should be issued clarifying that Notice 89-84 does not apply to foreign sales corporations.

Rev. Rul. 89-93

Under section 927(e)(1) of the Code, a related supplier's income may not exceed the amount which would be treated as foreign source taxable income had the comparable pricing rule of section 994 (relating to domestic international sales corporations (DISCs)) been applied. In Rev. Rul. 89-93, 1989-32 I.R.B. 51, the IRS concluded that, for purposes of section 927(e)(1), a related supplier's foreign source income may never exceed 25 percent of CTI after applying Treas. Reg. [Sub-section] 1.863-3(b)(2), Example (2). The ruling fails to take into account, however, that the income computation rules under the FSC rules and section 863 may produce different results when a taxpayer has research and experimental (R&E) expenditures.

Treas. Reg. [Sub-section] 1.863-3(b)(2), Example (2) provides a two-factor property and sales formula for computing taxable income. The formula applies to worldwide taxable income from the sale of property that is produced in the United States and sold abroad (or vice versa) as determined by the allocation and apportionment rules for deductions under Treas. Reg. [Sub-section] 1.861-8. With respect to the allocation of R&E expenditures, Treas. Reg. [Sub-section] 1.861-8(e)(3)(ii)(A)(3) provides that 30 percent of such expenditures are to be apportioned exclusively to the geographic source in which the R&E activity takes place. Because of intervening legislation, however, this 30-percent apportionment formula is currently inapplicable in determining taxable income under section 863; rather, R&E expenses are to be allocated according to various percentages, depending upon the year in which the expenses were incurred.(*)

With respect to the computation of CTI for FSC or DISC purposes, however, the IRS has ruled that the congressional moratorium does not apply. See, e.g., Rev. Rul. 86-144, 1986-2 C.B. 101.

In general, CTI for DISC and FSC purposes will be less than the taxable income computed under section 863(b) (prior to the application of section 927(e)(1)). Even if a taxpayer reduces its taxable income by 50 percent of CTI (as required by Rev. Rul 89-93), the resulting foreign source income will necessarily exceed 25 percent of the related supplier's and FSC's CTI. Thus, the ruling errs in assuming that the related supplier's foreign source income may not exceed 25 percent of CTI after application of [Sub-section] 1.863-3(b)(2).

Recommendation

Rev. Rul. 89-93 should be revised to take into account the different allocation and apportionment rules for CTI purposes.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views with respect to certain issues affecting foreign sales corporations. If you have any questions, please do not hesitate to call Bernard J. Jerlstrom, chair of TEI's International Tax Committee, at [phone], extension 2163 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at [phone].

(*) A congressional moratorium on the enforcement of [Sub-section] 1.861-8 in respect of the sourcing of R&E expenses, was first enacted in 1981 and was extended or revised several times. Under the most recent revision set forth in the Omnibus Budget Reconciliation Act of 1989, 64 percent of R&E expenses that are attributable to activities conducted in the United States are allocated to U.S.-source income, and 64 percent of R&E expenses that are attributable to activities conducted outside the United States are allocated to foreign-source income. The rule is applicable in respect of the taxpayer's first tax year beginning after August 1, 1989, and before August 2, 1990.