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New FSC regulations bar future redetermination of benefits.

New temporary foreign sales corporation (FSC) regulations, issued on March 2, 1998, contained two amendments to the existing regulations that limit FSC benefits for U.S. exporters. The first amendment contained severe restrictions on applying for a redetermination of FSC pricing benefits under Sec. 925 after Sept. 15, 1999. The second amendment expanded the resourcing rules (from foreign-to-U.S. source) under Sec. 927(e)(1) to apply to export leasing and licensing. These regulations were aimed at the entertainment and software industries that are now eligible to claim FSC benefits for products reproduced outside the U.S. for distribution to foreign customers. After 1997, the sourcing of a portion of those foreign sales as U.S.-source income will result in the loss of foreign tax credits (FTCs) for companies in the software and entertainment industry with excess FTCs if an FSC benefit is claimed.

New Rules Severely Limit Redeterminations

Caterpillar Co. was involved in the most notable redetermination of domestic international sales corporation and FSC commissions in 1994, resulting in a tax refund of over $350 million. Since then, many other companies have redetermined their FSC benefits and filed amended returns. The FSC commission in Caterpillar's redetermination was computed on a transaction-by-transaction (T x T) pricing method, after it had initially been determined on an aggregate of all foreign sales. Most companies aggregate (or group) their foreign sales, which allows the different administrative pricing methods to be applied only to those aggregations or groupings. In most cases, it would be more beneficial to apply the administrative pricing rules to each foreign transaction. In Caterpillar's case, the redetermination of the FSC benefit also included marginal costing, which is a way to increase foreign profit margins based on product groupings. This approach requires the analysis of worldwide sales transactions. A redetermination usually involves "un-grouping" or "re-grouping" transactions, groups of sales or the aggregate of all sales, as well as the reapportionment of expenses in computing combined taxable income under Regs. Sec. 1.861-8(c).

Under the old regulations, a company could elect to apply the T x T method or the grouping rules for each tax year and then change any of those annual elections within the statutory three years to redetermine the FSC benefit. For tax years starting after 1997, changes in groupings or changing from T x T to another method (or vice versa) is no longer permitted in redeterminations. Under the temporary regulations, a binding election to group or apply the T x T method must be made on Schedule P of a timely filed Form 1120-FSC (including extensions). In addition, any redeterminations for previous open tax years will have to be filed by the extended due date of the 1998 FSC tax return under a transitional rule. This deadline for a calendar-year FSC is Sept. 15, 1999. The revised regulations still permit adding transactions, amending expense apportionment methods or changing transfer-pricing methods, including the application of marginal costing in redetermination studies.

Based on the new regulations, exporters must elect either to group or apply the T x T method in estimating FSC and corporate income tax liability during 1998. Underpaying the FSC tax liability during the year by using a simplified method (such as the 1.83% of sales method) can result in substantial penalties for the 1998 tax year. The clock is ticking on redetermination benefits, and every exporter with an FSC should immediately consider opportunities available to maximize the tax benefit while they are still available. The aggregate benefit of redeterminations can be significant; the tax benefit is permanent and international tax consultants may agree to contingent fee arrangements that eliminate cost risks for the FSC.

The major items to consider during the redetermination process are:

1. Determine additional qualified transactions, such as from indirect sales;

2. Determine expense allocation and apportionment;

3. Elect the T x T, grouping or marginal costing method;

4. Eliminate loss transactions; and

5. Reclassify "military property"

An example of how some of these items affect the potential tax refund is shown in Exhibit 1, below.


Should the FSC attempt to do the redetermination itself or hire outside consultants? The owners of an FSC should consider the human resources, availability of voluminous data, computing power, capacity, software and time to attempt this process before the deadline. Technical expertise and computer programs, combined with a contingent fee, may make an outside consultant the better choice.
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Title Annotation:foreign sales corporations
Author:Barthelmai, Olaf
Publication:The Tax Adviser
Date:Oct 1, 1998
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