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Group's state tax organization offers FSC opportunities.

Example: A manufacturing company operates as a contract manufacturer (cost-plus) and has a presence in only one state. A warehousing company holds title to inventory from completion by the manufacturer until ordered by a distribution company. The distribution company makes actual sales, then orders from the warehousing company. Profits are all in this third company.

The taxpayer wants to claim foreign sales corporation (FSC) benefits on all three sales for products exported by the distribution company. It can do this, but must deal with the following issues.

[] Are the sales separate transactions, or parts of the same one? The answer to this question will determine if each sale must be separately qualified and priced.

[] If separate sales, can FSC benefits be claimed at all levels, since this is a single controlled group? Yes, if the gross receipts pricing method is not used on any sale.

[] How can sales No. 1 and 2 qualify? The destination test of Temp. Regs. Sec. 1.927(a)-1T(d)(3) must be met. Then, as separate sales, each must separately qualify under the economic process tests:

1. Contracts are needed between the seller and the FSC.

2. Participation in sales process requirements must be met. With only one customer, a solicitation letter may suffice.

3. Foreign direct cost elements must be carefully considered. Two out of five direct cost categories must have a specified proportion of foreign expenses, although they do not always work as they do with normal FSC sales:

a. Advertising and sales promotion. FSC advertising may not qualify when there is only one potential customer. The regulations define advertising in terms of reaching "multiple" customers. A concept known as "cooperative advertising" may help get around this.

b. Transportation. FSCs cannot transport products delivered domestically. This foreign direct cost test is therefore unavailable.

c. Credit risk. Sales No. 1 and 2 probably do not experience bad debts. Some of the other methods of meeting this test also require an unrelated customer. This test needs to be examined much more carefully than in normal FSC situations.

4. If the client cannot meet the necessary two foreign direct cost tests from the "preferred" list above, its tax adviser may need to explore these two relatively unused foreign direct cost categories:

a. Order processing and arranging for delivery. If sales No. 1 and 2 are FOB plant, this may arrange. It requires real foreign activity if sales are not FOB plant or FOB warehouse.

b. Invoicing and receipt of payment. This category works the same way intragroup as for normal exports.

[] With a sales structure like this, should sales No. 1 and 2 be qualified, even if they do not generate much income? In the example, the manufacturer makes a 5% profit, and the warehousing company makes no profit. The sales structure therefore is vulnerable to Sec. 482. Normally, the IRS would not apply Sec. 482 within an affiliated group, but doing so here would have the incentive of reducing FSC benefits. To prevent this, or preserve the FSC benefit if Sec. 482 were applied, the taxpayer should qualify sales No. 1 and 2. Then, if income is reallocated from the distribution company to either other company, it will be eligible for FSC benefits.
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Article Details
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Title Annotation:foreign sales corporation
Author:Cronin, John J.
Publication:The Tax Adviser
Date:Mar 1, 1993
Previous Article:Exempt organizations: basis of property at the time of loss of exemption or transfer to taxable subsidiary.
Next Article:Supreme Court decides back pay taxability.

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