Proposed and temporary FSC regulations.

On June 12, 1998, Tax Executives Institute submitted to the Internal Revenue Service the following comments concerning the agency's proposed and temporary regulations on the source and grouping rules for foreign sales corporations. The comments were prepared under the aegis of TEI's International Tax Committee whose chair is Joseph S. Tann, Jr. of Ameritech Corporation. The following members of the Institute also participated in the development of the submission: Joseph E. Bernot and Timothy F Windholtz of NCR Corporation, Richard L. Sartor of The Boeing Company, and Gary L. Vest of Caterpillar Inc.

On March 2, 1998, the U.S. Department of the Treasury and the Internal Revenue Service issued proposed source and grouping rules for foreign sales corporation transfer pricing (REG-102144-98). The proposed regulations were published in the March 3, 1998, issue of the Federal Register. One month later, the Treasury Department announced its intention to withdraw the proposed source rules set forth in the announcement. In these comments, we urge that the Treasury Department and IRS also withdraw the new grouping restrictions provided in Temp. Reg. [sections] 1.925(a)-1T(c)(8)(i).

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the temporary regulations under section 925 of the Internal Revenue Code, relating to the grouping of transactions of foreign sales corporations.

Temp. Reg. [sections] 1.925(a)-1T(c)(8): Transfer Pricing Rules For FSCs

A. Background. 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 of two optional administrative pricing rules or the arm's-length pricing rules of 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 of the FSC and its related supplier (generally, its U.S. parent) attributable to foreign gross trading receipts derived from the sale of property by the FSC, or (ii) 1.83 percent of the gross receipts derived from the sale of property by the FSC. Subject to the special no-loss rule of Temp. Reg. [sections] 1.925(a)-1T(e)(1)(iii), any, or all, of the transfer pricing methods may be used in the same taxable year of the FSC for separate transactions (or separate groups of transactions). If either administrative pricing method is used, the Commissioner may not make adjustments for deemed distributions, apportionments, or allocations as provided by section 482.

Temp. Reg. [sections] 1.925(a)-1T(c)(8)(i) provides that "the determinations under this section are to be made on a transaction-by-transaction basis. However, at the annual choice made by the related supplier if the administrative pricing methods are used, some or all of these determinations may be made on the basis of groups consisting of products or product lines." Under this rule, taxpayers may change their grouping basis or change from a grouping to a transaction-by-transaction basis. The most recent temporary regulations add the requirement, however, that the election to group or "ungroup" transactions must be made on the FSC's timely filed original U.S. income tax return (including extensions) for the taxable year. Taxpayers will not be permitted to elect to group, change a grouping basis, or change from a grouping basis to a transaction-by-transaction basis for that taxable year on any untimely or amended return. Thus, the new regulations restrict the ability of taxpayers to file amended returns changing their grouping elections.

The regulations are effective for taxable years beginning after December 31, 1997. A transitional rule for taxable years beginning before January 1, 1998, permits taxpayers to redetermine their grouping of transactions as long as the redetermination is made no later than the due date of the FSC's timely filed U.S. income tax return (including extensions) for its first taxable year beginning after December 31, 1997. Thus, for calendar-year taxpayers, amended returns must be filed by September 15, 1999.

B. Taxpayers Should Be Permitted to Use the Most Up-to-Date Information and Information Technology to Prepare Their Returns. The preamble to the temporary regulations justifies the new restrictions, as follows:

The IRS and Treasury have

become increasingly aware of

taxpayers who, through the

use of sophisticated computer

programs, substantially

revise their transaction

groupings just prior to the

expiration of the statute of 

limitations and many years

after the original returns

were filed. These revised

groupings typically employ

complex estimating techniques.

The recent rise in

this practice is placing a significant

burden on the auditing

process and is creating

a potential for abuse.

The Treasury and IRS's apologia underscores the complexity of the FSC rules. The calculation of FSC income involves a number of intricate, interrelated steps. For example, the calculation of the FSC commissions (on either a grouping or a transaction-by-transaction basis) turns on all items of income and expense included in a company's tax return. As a result, the FSC commissions are normally the last item calculated by the taxpayer in determining its taxable income, as well as the last item redetermined by the IRS in any subsequent audit. This is a requirement of the statute, a consequence of the Code's interconnections, not a nefarious scheme by taxpayers. Indeed, the sheer complexity of determining the best methodology has often limited the efficacy of the FSC regime. In recent years, computer software programs have been developed to permit taxpayers to make calculations that were not reasonably possible when they filed their original returns. These tools are still evolving. To decree that taxpayers cannot take advantage of new and emerging technology is akin to denying a sick patient the benefit of the newest antibiotic simply because the FDA had not approved the drug the first time the patient visited the office. The new regulations inappropriately constrict taxpayers' ability to use new technology.(1)

The Treasury Department and IRS fail to identify any abuse inherent in changing from one permissible method to another under the FSC grouping rules. Although the regulations are directed only at limiting the opportunity for choosing a methodology, their practical effect is to deny taxpayers the flexibility necessary to navigate a series of interrelated tax provisions. For example, the Code has numerous provisions that allow the carry-forward and carryback of tax attributes such as net operating losses and foreign tax credits, and the application of these complex provisions is exacerbated by the regular and alternative minimum tax systems. Each of these provisions affects the determination of the FSC benefit, requiring time to work through the various permutations.

The FSC rules, which were enacted in 1984, were designed to further goals underlying the predecessor domestic international sales corporation (DISC) provisions encouraging economic activity and job creation in the United States by providing an incentive for exports. See H.R. Rep. No. 533, 92d Cong., 1st Sess. 1 (1971); S. Rep. No. 437, 92d Cong., 1st Sess. 1 (1971) (discussing the DISC provisions); Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess., 1037-1042 (1984) (discussing the FSC provisions). The temporary regulations undermine taxpayers' ability to take full advantage of the export incentive intended by Congress and may prompt taxpayers to derogate this tax benefit in planning the expansion of their businesses. Although the Treasury and IRS may find it difficult to audit FSC transactions, their complaint properly lies with Congress, not the affected taxpayers. Indeed, taxpayers that seek to regroup their FSC transactions are merely acting in accord with Judge Learned Hand's maxim that --

[A]nyone may so arrange his

affairs that his taxes shall

be as low as possible; he is

not bound to choose that patterns

which will best pay the

Treasury; there is not even a

patriotic duty to increase

one's taxes. Over and over

again courts have said that

there is nothing sinister in

so arranging affairs as to

keep taxes as low as possible,

everyone does it, rich

and poor alike and all do

right; for nobody owes any

public duty to pay more than

the law demands. Taxes are

an enforceable exaction, and

not a voluntary contribution.

Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935). To be sure, the Treasury and IRS must safeguard against abuse, but unproven, chimerical concerns cannot justify denying taxpayers access to the amended return procedures.

Moreover, the temporary regulations raise troubling issues of fairness because they prevent taxpayers from making correlative changes in the face of audit adjustments. Assume, for example, that the IRS reallocates and apportions a taxpayer's expenses. The temporary regulations would deny the taxpayer the opportunity to change its other choices based on the new calculations. At a minimum, we strongly believe that taxpayers should be permitted to amend their returns in such circumstances.

In addition, the temporary regulations imply that taxpayers have a limited number of choices in determining their FSC benefit and that the necessary grouping has to be determined at the time that the return is filed. From a practical standpoint, however, companies may have millions of transactions and the definitions of transactions and groups of transactions are not clear. In fact, some FSC calculations start with a transactional analysis that leads to groupings for presentation on the return. The key is whether a grouping (or regrouping) reported on an amended return is justifiable; if it is, it should be permitted. If the Treasury and IRS believe the law is too complex, it should seek a legislative solution, not a denial of benefits to taxpayers.

If the IRS is concerned about its ability to assess tax against the FSC, the problem should be approached in a different manner. The obvious solution is to obtain extensions of the statute of limitations from the FSC consistent with those obtained from the related supplier. This has, in fact, been the IRS's practice for many years.(2)

C. Transition Rule. TEI believes that the temporary regulations should be withdrawn, but if they are not, a longer transition rule should be provided. As the preamble recognizes, these grouping rules are extremely complex. Taxpayers may have multiple open years that will need to be examined to determine the proper groupings. Thus, we recommend that, if the grouping rules are retained, the restrictions on filing amended returns not be effective for at least two years.

TEI submits that the prior temporary regulations effectuated more closely congressional intent in respect of the FSC export incentive. We therefore recommend that the addition to Temp. Reg. [sections] 1.925(a)-1T(c)(8)(i) be withdrawn in its entirety.

Conclusion

TEI appreciates this opportunity to present our views on the FSC regulations. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at (312) 7505074, or Mary L. Fahey of the Institute's professional staff at (202) 6385601.

(1) Indeed, the sheer complexity of the FSC rules dictate that, at a minimum, a longer transition period should be adopted. See the discussion on the following page, section C.

(2) The temporary regulations apparently restrict a taxpayer filing a late return to using a transaction-by-transaction basis for calculating FSC income. Large companies may have millions of transactions; even the best software available today may not be up to the task. Since the three-year statute of limitations runs from the date the late return is filed, it is difficult to perceive how these returns fit within Treasury's concern about filings late in the statutory period.