Extraterritorial Income Exclusion
December 2000
Export Tax Incentive
Congress recently enacted legislation providing a tax incentive for export sales. It is referred to as the Extraterritorial Income (ETI) exclusion. The tax benefit is an exclusion of 15 to 30 percent of export sales income from U.S. taxation.
The ETI exclusion replaces the existing foreign sales corporation (FSC) regime. The new rules simplify the requirements and expand eligibility for benefits. Companies with existing FSCs will need to transition to the new ETI regime, and exporters that do not currently have FSCs should adopt procedures to qualify for the ETI benefits. Some new situations that benefit under the ETI regime include individuals, S corporations and partnerships; U.S. companies with net operating losses or that are in an alternative minimum tax position and income from certain products produced outside the United States.
The ETI legislation is effective as of October 1, 2000, but the FSC rules continue to apply through the end of 2001.
Who Can Benefit?
The ETI tax benefits are generally available to any U.S. taxpayer that exports property that is manufactured or produced in the United States. Businesses qualifying for benefits include U.S. manufacturers and producers and U.S. wholesalers and distributors of goods manufactured or produced by others in the United States.
Under the new rules, the goods may also be manufactured outside the United States, so long as 50 percent or less of the value of the goods is attributable to articles manufactured and produced or grown outside the United States, plus the direct costs of labor performed outside the United States. While only U.S. taxpayers qualify for benefits, the ETI regime allows a foreign corporation to elect to be treated as a domestic corporation and, thereby, become eligible for benefits (although under certain circumstances there may be disadvantages of such an election that outweigh the benefits).
Transactions that qualify for ETI benefits include sales to foreign purchasers; sales to U.S. purchasers where the goods are destined for use in a foreign country and certain leasing transactions.
The new regime provides favorable rules for cooperative exporters. At the cooperative level, qualifying export income derived from goods marketed through cooperatives is excluded in the same manner as for other taxpayers. Moreover, the amount of any patronage dividends or per-unit retain allocations paid to a member of an agricultural or horticultural cooperative is excluded to the extent allocable to qualifying export income of a cooperative.
ETI Tax Benefits
The calculation of federal income tax savings under the ETI regime is essentially the same as under the FSC regime. The ETI rules exclude 15 to 30 percent of qualifying export income from U.S. taxation. For corporations, assuming a 35 percent tax rate, the effective tax rate on export income would be reduced to between 29.75 and 24.5 percent (a reduction in rate of between 5.25 and 10.5 percent). For individuals and S corporations, assuming a 40 percent tax rate, the reduction in the tax rate on export income would range from 34 to 28 percent.
Under the FSC regime, individuals and S corporations (and partnerships or LLCs with individual owners) actually suffered a tax detriment because the FSC was subject to corporate level tax on a portion of its income, and FSC dividends were fully taxable to such shareholders. The ETI regime instead excludes from taxation a portion of export income derived by individuals and S corporations and, thereby, provides a net benefit for such exporters.
Companies with net operating losses did not often use the FSC regime because it created taxable income at the FSC level. This disadvantage does not apply to the ETI exclusion, which has the result of reducing the amount of net operating losses absorbed by export income. Also, the ETI benefit is not subject to alternative minimum tax. The foreign tax credit results under the FSC rules essentially carry over to the ETI regime.
To claim the export tax benefit, a U.S. taxpayer simply excludes a portion of its qualifying income from U.S. taxation on its tax return. It is expected that the IRS will provide a special form for computing the exclusion.
ETI Requirements
To qualify for the ETI exclusion, certain requirements must be satisfied. The ETI regime requirements are similar to those regarding FSCs, although several have been eliminated. Unlike the FSC regime, U.S. taxpayers do not need to organize a foreign corporation. As a result, it will no longer be necessary to follow the complex formalities of establishing and maintaining a separate foreign entity, such as holding director and shareholder meetings outside the United States, maintaining foreign bank accounts and keeping books and records in a foreign jurisdiction.
The ETI regime retains certain of the foreign activity and cost tests of the FSC regime. Taxpayers must satisfy the foreign economic process test by soliciting, negotiating or making the contract with respect to export sales transactions outside of the United States. They must also incur certain costs outside the United States, such as advertising and transportation.
Businesses with existing FSCs will need to rethink how such foreign requirements can be met without the participation of the FSC and modify their existing procedures accordingly. Businesses without FSCs will need to put systems into place to meet the requirements.
Taxpayers with an annual qualifying export income of $5 million or less will qualify for the ETI exclusion without satisfying such requirements.
Effective Dates
The ETI regime applies to any export transaction occurring after September 30, 2000 that satisfies the above requirements. The FSC regime continues to apply to transactions through the end of 2001 and applies after 2001 if a transaction occurs pursuant to a binding contract between a FSC and an unrelated person that was in effect on September 30, 2000.
A taxpayer with an existing FSC can choose which regime to apply to its export income during the transition period. Also, both the ETI and FSC regimes may be used during the transition period, but only for different transactions. After September 30, 2000, however, no corporation may elect to become a FSC.
The ETI legislation was enacted in response to a successful challenge of the FSC regime brought by the European Union (EU) in the World Trade Organisation (WTO). The EU has since asked the WTO for a ruling that the FSC replacement regime also constitutes an illegal export subsidy. While the U.S. government believes that the ETI exclusion is consistent with its international trade obligations, whether the new regime satisfies the WTO will remain uncertain until mid-2001 when a final WTO decision is expected.
McDermott, Will & Emery has a number of lawyers and paralegals who have provided FSC services to clients and are experienced in advising clients with respect to the new ETI exclusion. Some of the specific services McDermott, Will & Emery provides include the following:
- Assessment of ETI benefits under the particular circumstances of an exporter.
- Advice regarding procedures for satisfying the various ETI requirements, with emphasis on cost efficiency and minimal disruption to normal business activities.
- Liaison with foreign trust companies and banks for satisfying the foreign requirements.
- Advice regarding documentation for establishing compliance with the ETI requirements.
- Advice regarding transition from the FSC regime to the ETI regime, including liquidation of FSCs.
- IRS audits of FSCs, from the agent level through IRS appellate to litigation, and state tax audits.
