- 4.61.8 ETI (Extraterritorial income), IC-DISCs and FSCs
- 220.127.116.11 Introduction
- 18.104.22.168 Background
- 22.214.171.124 Extraterritorial Income
- 126.96.36.199 Disallowance of Deductions
- 188.8.131.52 Disallowance of Foreign Tax Credit
- 184.108.40.206 Qualifying Foreign Trade Income
- 220.127.116.11 Foreign Trade Income
- 18.104.22.168 Foreign Sale and Leasing Income
- 22.214.171.124 Foreign Trading Gross Receipts
- 126.96.36.199 Foreign Economic Process Requirements - Generally
- 188.8.131.52 Five Specified Activities
- 184.108.40.206 Definitions and Special Rules
- 220.127.116.11 IC-DISCs and FSCs
- 18.104.22.168 IC-DISC Gross Receipts Test
- 22.214.171.124 IC-DISC Qualified Export Property
- 126.96.36.199 IC-DISC Asset Test
- 188.8.131.52 IC-DISC Transfer Pricing
- 184.108.40.206 IC-DISC Expenses
- 220.127.116.11 IC-DISC No Loss Rule
- 18.104.22.168 IC-DISC Taxation
- 22.214.171.124 Interest Charge on an IC-DISC
- 126.96.36.199 Foreign Sales Corporation (FSC)
- 188.8.131.52 FSC Foreign Management Requirements
- 184.108.40.206 FSC Economic Process Requirements
- 220.127.116.11 FSC Gross Receipts
- 18.104.22.168 FSC Transfer Pricing Rules
- 22.214.171.124 FSC Expenses
- 126.96.36.199 Taxation of FSC
Part 4. Examining Process
Chapter 61. International Program Audit Guidelines
Section 8. ETI (Extraterritorial income), IC-DISCs and FSCs
May 14, 2013
(1) This transmits revised IRM 4.61.8, International Program Audit Guidelines, ETI (Extraterritorial Income), IC-DISCs and FSCs.
(1) Added additional paragraph to IRM section 188.8.131.52 describing the repeal of the ETI law.
(2) Added link to IC-DISC Audit Guide in IRM section 184.108.40.206.
(3) Editorial corrections made throughout.
Director, International Business Compliance
Large Business and International Division
Prior to the enactment of IRC Section 114, taxpayers were allowed to use Foreign Sales Corporations to exempt a portion of qualifying foreign trading gross receipts from U.S. taxation. In general, the Foreign Sales Corporation provisions were repealed effective October 1, 2000, and the Extraterritorial Income exclusion provisions are effective for transactions entered into after September 30, 2000. In addition, no corporation may elect to be a FSC after September 30, 2000. FSCs may continue to apply the FSC provisions instead of the ETI exclusion provisions at their option with respect to transactions entered into prior to January 1, 2002. In addition, FSCs may continue to apply the FSC provisions to transactions entered into pursuant to a binding contract with an unrelated person and in effect on September 30,2000 and at all times thereafter. See Rev. Proc. 2001-37, 2001-1 C.B. 1327.
ETI was repealed with respect to transactions after December 31, 2004 with two transition rules. A phase-out rule for 2005 and 2006 for transactions entered into in those years and a binding contract rule similar to the FSC binding contract rule. The binding contract rule applies to transactions entered into pursuant to a binding contract with an unrelated person and in effect on September 17, 2003 and at all times thereafter. Please note that all references to IRC Section 114 are to its version pre-repeal. This also applies to IRC Sections 941, 942 and 943 which are referenced in this IRM section. Because FSC and ETI years are still being examined, FSC and ETI audit techniques are provided in this section. The Domestic International Sales Corporation (DISC) provisions were enacted in 1971 and were substantially modified by the Tax Reform Act of 1984 that enacted the Foreign Sales Corporations provisions. The Interest charge DISC (IC-DISC) provisions are discussed in this section.
The Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA" ) repealed the binding contract rules. Pub. L. No. 109-222, 120 Stat. 345, §513 (2006). TIPRA was enacted on May 17, 2006. Thus, the repeal of the binding contract rules is effective for taxable years beginning after May 17, 2006.
IRC Section 114 provides that gross income does not include extraterritorial income. Because the extraterritorial income exclusion is a means of avoiding double taxation, no foreign tax credit is allowed for income taxes paid with respect to such excluded income. Extraterritorial income is eligible for the exclusion to the extent that it is qualifying foreign trade income. Because U.S. income tax principles generally deny deductions for expenses related to exempt income, otherwise deductible expenses that are allocated to qualifying foreign trade income are disallowed.
IRC Section 114 provides that gross income does not include extraterritorial income, so long as it is qualifying foreign trade income as described below.
Any deductions allocable to extraterritorial income that is excluded are not allowed. Deductions apportioned and allocated to a taxpayer's extraterritorial income are allocated on a proportionate basis between:
the income excluded, and
the income not excluded.
No foreign tax credit is allowed with respect to any income excluded under the extraterritorial income provisions.
Qualifying Foreign Trade Income is defined in IRC Section 941(a)(1). It is income from a qualifying transaction equal to the greater of:
a. 30 percent of the foreign sale and leasing income ( Section 941(a)(1)(A)),
b. 1.2 percent of the foreign trading gross receipts ( Section 941(a)(1)(B)), or
c. 15 percent of the foreign trade income (Section 941(a)(1)(C)).
A taxpayer may elect on a transaction-by-transaction basis not to exclude extraterritorial income from gross income. Such election is made on line 1 of Form 8873 ("Extraterritorial Income Exclusion" ).
Foreign Trade Income is taxable income attributable to foreign trading gross receipts. Taxable income from foreign trading gross receipts is those receipts reduced by all deductions properly allocated and apportioned to those receipts.
Foreign sale and leasing income includes foreign trade income that meets at least one of the following three criteria:
attributable to the foreign economic processes described in section 942(b),
derived in connection with the lease or rental of property for use by the lessee outside the U.S.; or
derived from the sale of property described in (b) above.
Foreign trading gross receipts are:
from the sale or disposition of qualifying foreign trade property,
from the lease or rental or qualifying foreign trade property for use outside the U.S.,
from services related and subsidiary to the sale or lease, described in (a) or (b) above
from engineering and architectural services for construction projects outside the U.S., or
from managerial services to an unrelated person to further the production of foreign trading gross receipts described in (a), (b), and (c) above. For managerial services to qualify at least 50 percent of the taxpayers foreign trading gross receipts must be from the sale or lease of foreign trade property (including income from services related to a qualifying sale or lease).
A transaction does not generate foreign trading gross receipts if the property or services are for ultimate use in the United States.
A taxpayer may elect on line 1 of Form 8873 not to include gross receipts from any transaction in foreign trading gross receipts.
Gross receipts from a transaction qualify as foreign trading gross receipts only if certain economic processes with respect to the transaction take place outside the United States:
The taxpayer (or a person acting under contract with such taxpayer) must participate with respect to such transaction outside the United States in the solicitation (not including advertising), negotiation, or making of the contract, and
foreign direct costs (see 220.127.116.11(2)) of the five specified activities (see 18.104.22.168(1)) incurred by the taxpayer with respect to such transaction must represent at least 50% of the total direct costs of the five specified activities. Alternatively, foreign direct costs of two of the five specified activities incurred by the taxpayer with respect to such transaction must represent at least 85% of the total direct costs of those two activities.
The five specified activities are:
advertising and sales promotion
processing of customer orders and arranging for delivery
transportation outside the U.S. in connection with delivery to the customer
determination and transmittal of a final invoice or statement of account, or the receipt of payment, and
assumption of credit risk
"Total direct costs" means the costs attributable to the five specified activities (for the transaction) performed at any location by the taxpayer, by any person acting under a contract with the taxpayer. "Foreign direct costs" is the portion of total direct costs attributable to activities performed outside the United States.
This direct costs test will be treated as met by a taxpayer if the total foreign trading gross receipts for a year do not exceed $5,000,000. Foreign trading gross receipts of all related persons are aggregated for this purpose. In the case of any pass-through entity, the limitation applies with respect to the entity and with respect to each partner, shareholder, or other owner.
"Qualifying foreign trade property" is property manufactured, produced, grown or extracted either within or outside the United States which is held primarily for sale, lease or rental for direct use, consumption or disposition outside the United States. In addition, no more than 50 percent of the fair market value of the property can be attributable to the value of articles manufactured, produced, grown, or extracted outside the United States, plus the direct costs for labor performed outside the United States.
Property manufactured, produced, grown, or extracted by a person outside the United States may constitute qualifying foreign trade property only if such person is a domestic corporation, a U.S. citizen or resident individual, a foreign corporation that made a domestication election under section 943(e), or a pass-thru entity all of the partners or owners of which are otherwise described in this sentence.
Qualifying foreign trade property does not include:
property leased or rented by the taxpayer for use by any related person,
intangible property as described in IRC Section 943(a)(3)(B),
oil or gas,
products that cannot be transferred pursuant to the Export Administration Act of 1979 (Public Law 96-72)
unprocessed softwood timber, or
property designated in short supply by the President of the United States.
The legal requirements for an IC-DISC are provided in IRC section 992(a). Verify the following:
The corporation has only one class of stock and the par value of such stock is at least $2,500.
IC-DISC election made and not terminated [IRC section 992(a)(1)(D) and 992(b)]
The DISC is not related to a FSC (IRC section 992(a)(1)(E).
If a corporation has previously revoked or lost its IC-DISC status, see IRC section 992(a)(3).
The following is a link to the IC-DISC Audit Guide on irs.gov: http://www.irs.gov/Businesses/International-Businesses/IC-DISC-Audit-Guide.
The 95 percent gross receipts test provided in IRC section 992(a)(1)(A) requires that 95% or more of the corporation's gross receipts constitute qualified export receipts as defined in IRC section 993(a) .
Qualified export property is defined by IRC section 993(c) as follows:
Must be produced in the United States and consumed outside the United States
Less than 50 percent of the fair market value can be attributable to foreign content.
The adjusted basis of at least 95% of the corporation's assets must be attributable to qualified export assets. Qualified export assets are defined in IRC section 993(b).
The taxpayer may apply one of the following intercompany transfer pricing methods to each transaction:
Gross receipts method
Method of combined taxable income (CTI), or
IRC section 482 method
The IE should compute the effect of export promotion expense (EPEs) on the commission or transfer price. Verify that:
EPEs are added back to the commission, and
Transfer price is added to the 4 percent gross of 50–50 CTI method
Review the effect of Reg. 1.861–8 and –8T to –17T on the computation of CTI for the method of combined taxable income. In case of taxpayers using the gross receipts method, the no loss rule applies so that CTI must also be computed. Review the following:
All costs should be properly allocated,
General and administrative (G&A) expenses must be properly allocated,
Research and development (R&D) expenses must be allocated,
If the taxpayer is using taxable income rather than book income make proper adjustments (M–1s, LIFO inventory, etc.),
Post 1986 years require consolidated items be allocated, and
Note that interest expense and income cannot be netted.
If there are loss sales compute the commission or transfer price applying the no loss rule to those sales.
If the taxpayer uses the marginal costing rules, consider the following:
The CTI is computed using direct costs only,
The CTI is limited to overall profit percentage (OPP),
The no loss rules apply to marginal costing also, and
Product grouping rules apply.
IC-DISC income may be taxable to the shareholders when the following occurs:
Distribution upon disqualification,
50% of taxable income attributable to military property,
Disposition of DISC stock,
There is a foreign investment attributable to IC-DISC earnings, or
Income attributable to qualified export receipts exceeds $10 million.
Form 8404 (Computation of Interest Charge on DISC-Related Deferred Tax Liability) must be filed to report the interest charge on an IC-DISC. The priority of distributions are:
Out of previously taxed income (PTI)
Out of accumulated DISC income, then
Out of other E&P
The legal requirements of a FSC are provided in IRC section 922(a) . The requirements are:
Less than 25 shareholders,
No preferred stock,
An office must be maintained outside the United States in a qualified country, including all possessions except Puerto Rico,
Books must be maintained in the foreign office as well as those required by IRC section 6001 in the United States,
There must be at least one nonresident of the United States on the Board of Directors,
There cannot be a related IC-DISC, and
The taxpayer must elect FSC status.
The requirements of IRC section 924(c) IRC are:
All director and shareholders’ meetings must be held outside the United States,
The FSC must maintain a foreign bank account in a qualified country, and
All dividends, if distributed, legal and accounting fees, and salaries of officers and directors must be disbursed from the foreign bank account or reimbursed to the FSC.
The requirements of IRC section 924(d) are:
Solicitation, negotiation or making of contracts must occur outside the U.S. (See IRC section 924(d)(1)(A).),
At least 50 percent of the direct costs from activities listed in IRC section 924(e) must be foreign direct costs,
There is an alternative 85 percent test for two of the five categories listed in IRC section 924(e).
Foreign trading gross receipts (FTGR) are defined in IRC section 924.
The transfer pricing methods are provided in IRC section 925 . The three methods are:
1.83 percent of FTGR, limited to 46% of full costing or marginal costing CTI,
23 percent of CTI, and
IRC section 482 method.
The marginal costing rules are applicable. These are:
The CTI is computed using direct costs only.
The CTI is limited to the overall profit percentage (OPP).
The no loss rules apply to marginal costing.
The maximum marginal costing commission is 100 percent of the full costing CTI.
The product grouping rules must be considered.
The computation of CTI must account for the effects of Reg 1.861–8 and –8T through –17T. The IE must:
Insure all costs are properly allocated,
Insure that the proper method of allocating G&A expense was used,
Insure that 100 percent of R&D expense has been allocated,
Ascertain the taxpayer is using book income rather than taxable income (are M–1’s allocated, is inventory computed under LIFO, etc.),
Insure consolidated items are allocated for post 1986 years, and
Insure no netting of interest income and interest expenses.