The Shared Foreign Sales Corporation: A Tax Saving Opportunity for Small Business

By Sherman, W. Richard | The National Public Accountant, December 1994 | Go to article overview

The Shared Foreign Sales Corporation: A Tax Saving Opportunity for Small Business


Sherman, W. Richard, The National Public Accountant


In today's global economy, it is becoming increasingly rare for any company, regardless of its size, not to have substantial foreign sales. Consequently, any accountant who has corporate clients earning more than a few hundred thousand dollars from their annual export sales should advise them about the potential advantages of the exemption from U.S. income tax offered to foreign sales corporations (FSCs).

Designed as a means of stimulating the economy by allowing U.S. companies to more effectively compete with foreign firms, the FSC was legislated into being by the 1984 Tax Reform Act. The FSC replaced the Domestic International Sales Corporation (DISC) as Congress' primary exporting incentive after the latter ran into complaints from U.S. trading partners that the DISC represented an illegal export subsidy in violation of the General Agreement on Tariffs and Trade (GATT).(1) While many of the rules for the formation, organization and operation of the FSC are bewilderingly complex, the potential tax savings are substantial. A simple example will suffice.

Assume that USC, a company incorporated in the United States, earns a $10,000 profit on its export sales. As a U.S. corporation, USC would be subject to U.S. tax on its worldwide income. Accordingly, if its tax rate is 34%, USC will have to pay $3,400 in taxes on its export profit. However, if USC were to set up a foreign sales corporation and run these same export sales through the FSC, its tax liability would be reduced to $2,890. This result is reached by a series of steps.

First of all, while the FSC can be a truly independently operating company with sales of its own, most frequently it is acting as little more than a commission agent for a U.S. corporation that is doing the actual exporting--in this case, USC. Under the most common pricing method, the USC would "pay" the FSC a commission of $2,300 or 23% of the export profit. In actual fact, the payment of the commission is no more than an accounting entry, with no actual cash passing between the two related parties. Nevertheless, the USC would be entitled to a deduction and have a remaining profit of $7,700 ($10,000 - 2,300 commission), on which a tax of $2,618 (34% of $7,700) would be due. The FSC would also be subject to U.S. taxation on its $2,300 of "U.S. source" commission income but would have a 15% exemption on the total export profit (i.e., $1,500) available to it under IRC Section 923. As a result, the FSC would owe a tax of $272 (34% of $800). Thus, slightly more than 5% in taxes would be saved be using the FSC [$3,400 (with no FSC) vs. $2,618 (USC's tax) + 272 (FSC's tax) or a $510 difference].(2) If and when the FSC pays a "dividend" to USC, the U.S. corporation would generally be entitled to a 100% dividends received deduction under Section 243 so no further adverse tax consequences would result.(3) See Exhibit 1 for a summary of the savings in U.S. income taxes through use of a FSC over a wider range of income assumptions.

Another variable that should not be overlooked is that in addition to the potential Federal income tax savings, a participant in a FSC may also qualify for a possible exemption from state income taxes as well.

Requirements

The tax saving potential of a FSC is not without its costs. To qualify for the 15% exemption, the FSC must satisfy several rules regarding its organization, management and "economic processes." In essence, the foreign sales corporation must indeed be "foreign." It must be incorporated, have its main office and keep its records outside the U.S.(4) Further requirements in regard to the management and operation of the FSC are designed to insure that there are substantial contacts with and activities in its non-U.S. base. For example, all the directors' and shareholders' meetings of the FSC must be held outside the U.S. In addition, the FSC must itself be part of the "sales process" by soliciting, negotiating or contracting the export sales. …

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