We all know that going global will be the wave of the future for the companies of the future. What would you say if I told you that your export company could exempt a portion of its income from tax? What if I also told you that this plan involved a Caribbean island? This is not some shaky off-shore deal. In fact, this plan is sanctioned by the United States government and codified in the Internal Revenue Code. Are you interested now?
If you are a small or medium size exporter, you may be able to take advantage of the rules for Foreign Sales Corporations (FSCs). FSCs were introduced as part of the federal Tax Code in 1984 to encourage exports and to put U.S. companies on a level playing field with competing foreign companies. FSCs replaced the Domestic International Sales Corporation (DISC). To receive FSC treatment, a special election must be filed via a Form 8279, and a special income tax return known as a 1120-FSC must be filed. Although at first blush the law seems complex for the average company, it is not unduly cumbersome.
An FSC is a foreign corporation created or organized under the laws of a country other than the United States. U.S. taxpayers using an FSC obtain a partial exemption from U.S. tax for export profits. An exporter passes the company's foreign sales through an FSC, which is a wholly owned subsidiary of the exporter. This is usually in the form of a commission paid to the FSC. The parent corporation receives a deduction for the commission and the FSC pays a reduced income tax on the commission it received. There are rules which control the amount of commission, but usually 23% of the taxable profit of the parent and the FSC subsidiary will equal the commission, and a portion (15/23) is deemed exempt. The profits earned by the FSC flow back to the exporter, which receives a "dividends received deduction." The cash can be swept back into a U.S. bank account, sometimes in the same day. Generally, U.S. exporters who use FSCs are manufacturers, distributors, and construction, architectural and engineering firms with qualifying foreign products.
The FSC operates under the basic principles of GATT (General Agreement on Tariffs and Trade), which are that the U.S. will not tax income attributable to economic activities occurring outside the United States, and that no corporate-level taxation will be imposed upon export income. Provided that the income is derived from a foreign presence and from foreign economic activity of the FSC, a portion of the FSC's foreign trade income (FTI) is exempt from tax at the corporate level, thereby avoiding double taxation in the hands of the exporter. Foreign Trade Income is the profit or commission derived by the FSC from an export transaction that yields gross income. FTI includes both profits earned by the foreign sales corporation itself from exports, and commissions earned by the FSC from products or services exported by others.
To have gross income of a transaction qualify as foreign trading gross income which is eligible for FSC benefits, there is a requirement that the "economic process" take place outside of the United States. The economic process includes (1) the solicitation (other than advertising), (2) the negotiation, or (3) the making of a contract outside of the United States. Only one of the three activities needs to take place outside of the United States. The lawyer or the agent can assist the FSC via a service agreement to have these activities performed in the FSC jurisdiction.
The FSC must be incorporated under the laws of certain "eligible" jurisdictions which have signed an exchange of information agreement or tax treaty partners whose treaties have effective exchange of information provisions, although a corporation which elects FSC treatment may not claim tax treaty benefits.
The U.S. Virgin Islands, Barbados, Jamaica, Bermuda, and the Cayman Islands are popular locations for FSCs. (You may be wondering why the U.S. Virgin Islands qualify as "foreign location." This is because they are not within the Customs Territory of the U.S. as defined in the Tariff Schedules of GATT.) The laws of the jurisdictions vary, so it is important to determine which one will be most favorable to your particular situation. The vast majority of FSCs (70%) are established in the U.S. Virgin Islands because of the lack of a local tax on FSC profits; the U.S. dollar is the form of currency; and the Virgin Islands government has enacted enabling legislation which guarantees the FSC benefits for thirty years. We use a local agent to help establish FSCs in the U.S. Virgin Islands and Barbados.
There are some technical requirements that must be met to establish the FSC, but most are taken care of by the company or lawyer doing the incorporation.
Once the company qualifies as an FSC, its gross receipts still must qualify as foreign trade income to be exempt from taxation. Only income derived from activities which are qualifying exporting activities such as the sale, lease or other disposition of export property constitute foreign trade income. Export property is defined as property which is manufactured (i.e., the product is transformed), produced, grown or extracted in the U.S. by a person or entity other than an FSC. (It is important to note that software and other intangible property such as patents, goodwill, and trademark exports do not qualify for the tax benefits of FSCs.)
Whether other income of an FSC will be subject to U.S. tax either in the hands of the FSC or in the hands of its shareholder in the absence of an actual distribution is determined under the Code provisions relating to the taxation of foreign corporations in general, such as the rules relating to U.S. source income and foreign personal holding company rules.
An FSC also needs to prove foreign management if its income is going to be treated as foreign trade income. In order to pass the foreign management test, all meetings of the Board of Directors and shareholders must take place outside of the United States. However, before everyone starts booking flights to the islands, it should be noted that the regulations state that the meeting need only be convened outside the U.S. Some foreign jurisdictions allow shareholder meetings via written proxies, while others allow meetings via telephone. Therefore, as long as the phone call originates outside the U.S., the foreign meeting requirement is met. It should also be noted that "small" exporters with less than $5,000,000 of foreign trading gross receipts need not meet the foreign management or economic process test.
The costs of establishing an FSC usually range from $1,000 to $5,000 depending upon the expected sales volume. (In St. Croix, the price is usually $1,000 to $1,500.) There are also maintenance costs. One needs to consider the cost of filing additional income tax returns and retaining local counsel or an agent to comply with local regulations. However, the savings can be considerable when you realize that the maximum corporate income tax rate is 34%.
Is an FSC always the right option? As with anything else, there are times when it will not make sense, such as when the exporter is operating at a loss; or when the cost of having an FSC is greater than the tax benefit; or when the principal export is software, as previously mentioned. One must also be careful not to run afoul of the foreign personal holding company rules, or the accumulated earnings tax. However, for any exporter with less than $5,000,000 in gross foreign receipts, the small FSC will most likely be the business entity of choice.