Extraterritorial exclusion and the FTC.

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 the FTGR method, A excludes $15 (1.2% of $1,250), and only $25 (50% X [$100 - (4% X $1,250)]) is foreign-source income.

Comparison of FTCs to the EIE Benefit

The true effect of the re-sourcing rule must be examined after determining the FTCs.

Example 2: The facts are the same as in Example 1, except A applies the EIE method to an excess FTC with Sec. 863 sales. This can cost A 20% of the tax benefits that it may have otherwise obtained without the limit; see the exhibit.

The EIE rules offer taxpayers a great deal of flexibility--from group to group, or even year to year. Therefore, a taxpayer should determine the optimum amount of overseas sales needed to use excess FTCs when claiming EIE benefits.

Exhibit: Comparison of FTC to EIE Benefit

                          Sec. 863(b) sales       Sec. 863(b)
                             with no EIE         sales with EIE

FTI                             $100                  $100
50% FTI                          n/a                  (50)

Foreign source %                $100                  $ 50
                                x 50%                 x 50%

Foreign-source income           $ 50                  $ 25
Excluded FTI                       0                    15 *

Total "excluded" income         $ 50                  $ 40

Tax savings (at 35%)             $17.50                $14.00

Tax cost of ETI                             $3.50

* ($100 x 15% FTI)

FROM BILL KINGSLEY, CPA, MST, AND BILL ROTH, III, CPA, GRAND RAPIDS, MI

Pamela Packard, CPA
Vice Chairman
Tax Services
BDO Seidman LLP
New York, NY