One of the most important steps a U.S. exporter can take to reduce federal income tax on export-related income is to set up a Foreign Sales Corporation (FSC). The tax exemption can be as great as 15% on gross income from exporting, and the expenses can be kept low through the use of intermediaries who are familiar with and able to carry out the formal requirements.


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INTRODUCTION

One of the most important steps a U.S. exporter can take to reduce federal income tax on export-related income is to set up a Foreign Sales Corporation (FSC). The tax exemption can be as great as 15% on gross income from exporting, and the expenses can be kept low through the use of intermediaries who are familiar with and able to carry out the formal requirements.

FSCs can be formed by manufacturers, export intermediaries, or groups of exporters, such as export trading companies. A FSC can function as a principal, buying and selling for its own account, or as a commission agent. It can be related to a manufacturing parent or can be an independent merchant or broker.

The U.S. exporter sets up a FSC in certain foreign countries or U.S. possessions to obtain a corporate tax exemption on a portion of its earnings generated by the sale or lease of export property. A corporation initially qualifies as a FSC by meeting basic formation tests. A FSC (unless it is a small FSC) must also meet several foreign management tests throughout the year. If it complies with those requirements, it is entitled to an exemption on qualified export transactions in which it performs the required foreign economic processes.

FORMATION REQUIREMENTS

A FSC must meet each of the following requirements to meet the FSC definition. The entity must be incorporated and have its main office in the U.S. Virgin Islands, American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, or a qualified foreign country. The Commonwealth of Puerto Rico is included within the definition of the U.S. and therefore, does not qualify for purposes of the FSC statute. It must have at least one director who is not a U.S. resident, keep one set of books of account (including copies or summaries of invoices) at its main offshore office, have no more than 25 shareholders, have no preferred stock, and must file a timely election to become a FSC with the IRS. The FSC also cannot be a member of a group which includes a Domestic International Sales Corporation.

MANAGEMENT REQUIREMENTS

All of a FSC's shareholders and directors meetings must be held outside the U.S.; its principal bank account must be maintained outside the U.S.; and all dividends, legal and accounting fees, officers' salaries, and directors' fees must be disbursed from a foreign bank account.

FOREIGN ECONOMIC PROCESS REQUIREMENTS

The FSC, or its agent, must comply with two economic process requirements to earn income exemption from tax for any export transaction.

First, the FSC, or its agent, must participate, outside the U.S., in any of the following in export transactions: 1) solicitation (other than advertising), 2) negotiation, or 3) contracting. As a general rule, the FSC must participate in only one of these three activities to obtain the FSC tax exemption.

Second, specific percentages of the transaction costs must be "foreign direct costs," incurred by the FSC for activities it, or its agent, performs outside the U.S. The activities tested are: advertising and sales promotion; processing customer orders and arranging for delivery of the export property; transportation; assembling and transmission of a final invoice or statement of account and the receipt of payment; and assumption of credit risk. A FSC meets the foreign direct cost test if its foreign direct costs are either 50% or more of total direct costs for these five activities, or are 85% or more of direct costs incurred in each of any two of the five activities.

ADMINISTRATIVE PRICING

The portion of the FSC's gross income from exporting that is exempt from U.S. corporate taxation is 30% for a corporate held FSC, if it buys from independent suppliers or contracts with related suppliers at an "arms- length" price. A FSC supplied by a related entity can use special administrative pricing rules to compute its tax exemption and achieve additional tax savings.

SMALL FSCs AND SHARED FSCs

Small FSCs and Shared FSCs are designed to give export incentives to smaller businesses. The tax benefits of a small FSC are limited by ceilings on the amount of gross income that is eligible for the benefits.

SMALL FSCs

Small FSCs are the same as FSCs, except that small FSCs must file an election with the IRS, and have their tax exemption limited to the income generated by $5 million or less in gross export revenues. Small FSCs do not have to meet foreign management or foreign economic process requirements but must fulfill additional requirements to benefit from administrative pricing rules.

SHARED FSCs

A "shared FSC" is a FSC which is "shared" by 25 or fewer unrelated exporter "shareholders", so as to reduce the costs while obtaining the full tax benefit of a FSC. Each exporter-shareholder owns a separate class of stock and each runs its own business as usual.

States, regional authorities, trade associations, or private businesses can sponsor a shared FSC for their state's companies, their association's members, their business's clients or customers, or for U.S. companies in general. A shared FSC is a means of sharing the cost of a FSC. However, the benefits and proprietary company information are not shared. The sponsor and the other exporter-shareholders: do not know who the exporter's customers are, do not participate in the exporter's profits, do not participate in the exporter's tax benefits, and are not at risk for another exporter's debts.

CITATIONS: Taxation of Foreign Sales Corporations (FSCs), 26 U.S.C. Sections 921-927 (1988), FSC Regulations, 26 C.F.R. Sections 1.921-1T to 1.927(f)-1.

CONTACTS: Office of the Chief Counsel for International Commerce (202) 482-0937.
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excepted from May 1994, U.S. Commerce Dept. material

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