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Foreign Sales Corporations

Everyone can identify with the happy experience of the unexpected discovery of a few extra dollars tucked away in a coat pocket. The same principle can be applied to international trade when exporting businesses realize that the income tax benefits which were enjoyed under the discontinued Domestic International Sales Corporations (DISC) rules have been reincarnated, with greater benefits, under the Foreign Sales Corporations (FSC) rules contained in Internal Revenue Code sections 921 through 927 and the corresponding regulations.


Whereas the DISC could only promise the partial tax deferment of a business' income, the FSC delivers a partial tax exemption of the same business' income. Although the tax exemption is partial, it is also significant. Under the several methods available to calculate an FSC's tax exempt income, discussed later, at least 15% and potentially as much as 30% of an FSC's foreign trade income will never be taxed. In addition, the FSC accomplishes its mission of promoting export business in a carefully designed manner which is fully compatible with the General Agreement on Tariffs and Trade (GATT) regulations. Unfortunately, because some planning and preparation is required in order to be compatible with GATT, many businesses shy away from a potentially important profit increase. This is despite the fact that there are now many management companies available which specialize in resolving the technical aspects of creating and maintaining a FSC. The purpose of this article is to present a brief overview of the mechanics of a FSC in the hope that, by stripping away some of the mystery, more export businesses will take advantage of the tax saving benefits available only with a FSC.

In essence, Congress is providing an export company, usually a corporation, with a method of shifting what would otherwise be a taxable export profit to a distributing FSC where only a portion of the FSC's profit, or commission, is taxed. This results in a reduction in the Exporter's tax rate on overall profit since the FSC is closely held by the Exporter as shareholder. The Exporter, as a supplier to the FSC , must export property which originates in the U. S. (of which at least 50% of its fair market value must be U.S. components) and which has a foreign destination. This raises the questions of how a FSC is created and just what foreign trade income of the FSC is exempt from U.S. taxes.


The creation of a FSC involves only a laundry list of 8 qualifying elements. An election to be an FSC must be made in the first 90 days of the tax year on Form 8279. The 8 requirements are:

  1. The FSC must be a corporation organized in a qualifying country or a U.S. possession.
  2. The FSC may not have more than 25 shareholders.
  3. The FSC may not have any preferred stock outstanding at any time during the year.
  4. The FSC must have one member of its Board of Directors who is not a resident of the United States.
  5. The FSC must maintain an office outside of the United States in a qualifying jurisdiction.
  6. The FSC must maintain a set of books and records both at the foreign office and within the United States.
  7. A "Small FSC" may not be a member of a controlled group of taxpayers which has a regular FSC as a member.
  8. The foreign corporation must make an election to be taxed as an FSC.


The issues involved in what constitutes an FSC's exempt portion of foreign trade income are more complex and can be broken down into two components:

  1. The sources and types of income which actually comprise an FSC's foreign trade income; and
  2. The calculation of the amount of foreign trade income which is tax exempt to the FSC.

An FSC's gross foreign trade income which qualifies for tax exemption is one or more of a selection of 5 types of Foreign Trading Gross Receipts (FTGR)as follows:

  1. The sale, exchange, or other disposition of export property;
  2. The lease or rental of export property for use outside the United States;
  3. Services related to a sale or lease of export property;
  4. Engineering or architectural services on projects outside the United States; and
  5. Managerial services for an unrelated FSC or DISC in support of its foreign trade.

No other type of an FSC's gross foreign trade income (i.e. investment income) qualifies as FTGR and, accordingly, cannot qualify as tax exempt income.

The obvious intent of Congress was to limit the tax exemption benefits to the income directly associated with the FSC's foreign trade activities. To that end, there is an additional subset of requirements which must also be satisfied for any FTGR to exist. These rules monitor the degree to which the FSC actually participates in the foreign trade activities of the Exporter. To ensure that an acceptable minimum amount of those activities do occur outside the United States, an FSC must be subject to both foreign management and foreign economic processes.


The foreign management criteria is simply a list of 3 requirements which are imposed on the FSC as a whole :

  1. All meetings of the Board of Directors and Shareholders are held outside the United States;
  2. The principle bank account of the FSC is maintained in a foreign country which has a United States income tax treaty or in a United States possession;
  3. The dividend distributions, legal and accounting fees, and salaries of officers and directors are disbursed out of bank accounts maintained outside the United States.


The foreign economic processes criteria is imposed on an individual transaction or group of transactions basis (a transaction being any sale, lease, or furnishing of services). The FSC is required to participate in the solicitation, negotiation, or conclusion of the contract underlying the transaction outside the United States. In addition, the foreign direct costs incurred by the FSC must equal or exceed 50% of the total direct costs of the transaction. An alternate foreign

direct costs formula is also provided which sets the required rate at 85% of costs but is based on only 2 of a possible 5 cost activities involved in the transaction:

  1. Advertising and sales promotion;
  2. Processing of customer orders and delivery of export property;
  3. Transportation of goods from the time of acquisition to delivery;
  4. Final billing and receipt of payment; or
  5. Assumption of credit risk.


Calculating the amount of an FSC's foreign trade income which is tax exempt is also based on formulas and is a two step process.

  • First, the proper allocation of foreign trade income must be made between an FSC and related U.S. supplier based on the prices paid by the FSC for goods from the related U.S. supplier. This allocation determines just how much of a transaction's total income should be attributed to the FSC and how much should be attributed to the related U.S. supplier.
  • Second, the FSC must calculate how much of that income is tax exempt. To accomplish this task, an FSC may choose either the arm's length prices method or the statutory formula of transfer prices method.


The arm's length prices method, by definition, assumes that the prices paid by the FSC for goods from its related U.S. supplier represent their true fair market value. Therefore, a proper allocation of the foreign trade income is automatically made between the FSC and its related U.S. supplier. The amount of the FSC's foreign trade income which is exempt from U.S. taxes under the FSC rules is set at 32% for individuals and 30% for corporations. The remainder of the FSC's foreign trade income falls outside the scope of the FSC rules. The taxability of that income will depend on whether it is effectively connected to a U.S. trade or business. Consequently, this income is also subject to taxation under IRC Subpart F and any dividends generated are not eligible for a 100% dividends-received deduction.

It is important to note that the FSC rules also protect an FSC's tax exempt foreign trade income from being taxed under the IRC Subpart F principles of goods sold through foreign base companies owned by U.S. persons. Furthermore, tax exempt foreign trade income based dividends paid by an FSC to its U.S. corporate shareholders (not individual shareholders) are also effectively exempt from U.S. taxes because the corporate shareholders are entitled to a 100% dividends-received deduction.


The statutory formula of transfer prices method offers an FSC two options for allocating foreign trade income between the FSC and the related U.S. supplier. One option is based on an FSC's gross receipts and the second option is based on the combined taxable income of the FSC and the related U.S. supplier. The gross receipts rule imputes a transfer price paid by the FSC for goods "purchased" from the related U.S. supplier. The rule provides the FSC with a foreign trade income amount which is 1.83% of the FSC's gross receipts from the sale of export property. However, this allowance amount is limited to a maximum of 46% of the combined taxable income of the FSC and the related U.S. supplier.

The combined taxable income rule utilizes the same principles of imputed transfer prices as does the gross income rule, but assigns a defined amount set at 23% of the combined net taxable income of the FSC and the related U.S. supplier from the sale of export property as the FSC's allocated share of foreign trade income. This allowance amount is not limited.

The amount of the FSC's foreign trade income which is exempt from U.S. taxes under these two special statutory rules is set at 16/23 of the FSC foreign trade income for individuals and 15/23 of the foreign trade income for corporations. This works out for the gross receipt option to an actual tax exemption of 1.27% (16/23 x 1.83%). The combined taxable income option has an actual tax exemption of 16% (16/23 x 23%).

By statute, the tax exempt foreign trade income of an FSC under these two special rules is designated as income not effectively connected with a U.S. trade or business. This tax exempt foreign trade income, as is the case under the arm's length prices method, is protected from being taxed under IRC Subpart F principles and dividends are eligible for the 100% dividends-received deduction by the corporate shareholders. The remainder of the FSC's foreign trade income, conversely, is designated as income effectively connected with a U.S. trade or business in the United States conducted through a permanent establishment for purposes of these two special rules. The effect of this designation is to make that non-exempt foreign trade income taxable at the FSC level, despite the fact that this income is actually foreign based. The dividends generated by this non-exempt foreign trade income, however, are eligible for the 100% dividends-received deduction by the corporate shareholders.

Finally, there are two additional requirements imposed on an FSC before it qualifies to use the two statutory formula of transfer prices methods. The conditions are tied to the FSC's foreign sales activities and borrow from the foreign economic processes criteria used in determining an FSC's foreign trading gross receipts.

  • The first condition incorporates the 5 activities used in the direct costs alternate formula but requires that the FSC perform all of them, not just 85% of two of them.
  • The second condition requires that all of the activities relating to the solicitation, negotiation, and making of sales contracts be performed by the FSC itself.


It should also be noted that a casualty of the FSC rules regarding taxable foreign trade income is the foreign tax credit. The credit is unavailable to an FSC's taxable foreign trade income with the exception of non-exempt foreign trade income calculated under the arm's length prices method.


It is perfectly understandable that the technical aspects of creating and maintaining an FSC presented in this article might intimidate a small business. In order to encourage small businesses to export goods under the FSC rules, there is available to them a "Small FSC".

A business electing to incorporate a "Small FSC" will find the requirements to be more relaxed. Specifically, the foreign management criteria and the foreign economic processes criteria normally necessary to qualify foreign trade income as foreign trading gross receipts are waived. The catch is that a "Small FSC" cannot take into account more than 5 million dollars of FTGR in calculating its tax exempt foreign trade income in any taxable year. The amount of FTGR exceeding the 5 million dollar cap is ineligible for tax exempt status and all other FSC tax benefits. For many small businesses, the "Small FSC" could be a viable alternative to the FSC.


A Foreign Sales Corporation represents an opportunity to increase a business' profits by exporting goods while utilizing the FSC's tax saving benefits. The fact that an FSC does require planning and organization should not deter an exporter from enjoying what is Congress' best effort yet to promote U.S. exports and international trade.

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