The world trading community's challenge to the U.S. 1972 export incentive vehicle, Domestic International Sales Corporations (DISCs), was overcome by the surprising inclusion of a new concept in the Tax Reform Act of 1984. A completely new approach, Foreign Sales Corporations (FSCs), allows for an immediate and permanent benefit through income exclusion whereas the DISC benefit was based on the deferral of income. The FSC concept introduced a level of minimal foreign activity and presence that was completely lacking under DISCs. In addition to structural variations, there is a major philosophical difference between DISCs and FSCs. The benefits derived from DISCs were directly related to an "increase in exports" over a floating base, whereas FSC benefits are available without regard to any base level.

What is a FSC?

1. A FSC is a corporation formed in one of about 30 countries which have been approved by the U.S. Treasury. It serves no function other than a means to grant incentives to exporters in the form of a tax exemption.

2. The state and federal tax benefits, derived from the FSC income exemption, are about equal to a 10% increase in foreign sales.

3. Another way to view the FSC benefit is its relationship to foreign sales. The minimum FSC benefit is equal to about 1/2% of gross foreign sales versus average annual fees of about $2,000.

How Does the FSC Concept Work?

The FSC is usually a wholly owned subsidiary which serves as a conduit to which a portion of the foreign profit may be passed, usually in the form of a commission. The related supplier (parent) generally reports 77% of the net foreign profit, the FSC receives a commission of the remaining 23% of profit, of which 8% is taxable; the remaining 15% being tax free. The FSC pays quarterly taxes on the 8% profit and at year end pays an after tax dividend eligible for a 100% dividend received deduction by corporate shareholders. While there are refinements, compliance requirements and alternative pricing formulas-as will be described later-this description generally applies to all FSCs.

In seeking to add credibility to the thinly disguised "foreign" aspects of the new concept, Congress imposed several compliance related burdens on FSCs before benefits would become available. Fortunately, Congress realized that smaller businesses usually do not have the resources, either within or without the U.S., to satisfy the compliance burdens making up the "foreign veil of substance." Consequently, Congress made provisions for an alternative FSC structure based on a simple election to be classified as a "Small FSC."

Professional FSC management companies, doing business in the host country, normally satisfy all formation and presence requirements.

Definition of Small FSCs

A Small FSC is one that elects to be so treated. While the election is in effect, the exporter may only select up to $5 million in annual foreign sales to be eligible for FSC benefits. In return for the sales limitation, the Small FSC is not subject to certain compliance and foreign meeting requirements. A Small FSC merely has to forward copies of the foreign invoices to their "foreign office" annually in order to be eligible for FSC benefits. The benefits are accounted for through journal entries since Small FSCs are not required to have a bank account.

In essence, by electing Small FSC status, companies can enjoy FSC benefits without being subject to most of the compliance burdens, as long as they limit their FSC benefits to those based on the net foreign profits from $5 million of foreign sales annually.

Congressional Intent: Small Exporters

The Conference Committee reports of June 22, 1984, directed the Treasury to avoid complexities that would make the provisions burdensome for small companies:

"The conferees wish to express concern that without special effort by the administration many small businesses which wish to export property will avoid making an election to become a FSC ... because they fear ... it will lead to complexity and administrative burden ... Conferees hope that small business will be given special encouragement and assistance by the Commerce Department in establishing and operating Small FSCs. . . ."

With the Congressional intent so stated, it is interesting to note that even as we begin 1990, the Department of Commerce has yet to release an explanatory publication on the concept or even refer to FSCs in the indexes of its many publications.

This is not to suggest a lack of awareness of Congressional intent. Instead, it highlights a failed approach. The basic approach followed by the Department of Commerce was based on an assumption that the awareness of the concept would trickle down through CPAs and other tax advisors. There is probably enough blame, associated with the failed approach, for CPAs to participate in a sharing process since the main theme trickling was the complexity of "economic process."

Government and professional firms participated in a year-long series of national seminars focusing on the intercomplexities of the FSC legislation and its impact on major corporations. It is little wonder that smaller CPA firms and their clients became confused. Little mention was made that the complexities being discussed simply didn't apply to electing Small FSCs.

Current Status

Statistically close to 100,000 smaller exporters could theoretically benefit from the formation of a FSC, but less than 3,000 have actually been formed through the later months of 1989. Conversely, close to 90% of the exporters with exports in excess of $5 million have formed FSCs. However, the comparison between Regular and Small FSC formations is really quite misleading since smaller exporters usually have a second option not normally available to larger corporations.

The option is an S Corporation election. S Corporation provisions were originally enacted in the IRC in 1958 as part of the Eisenhower Administration's plan that tax considerations should not be the deciding factor for business structures. A related provision, Sec. 1361, was in the IRC from 1959 through 1966. In essence, corporations could elect partnership status and partnerships could elect corporate status. Prior to 1986, S Corporations were used for loss planning more often than profit planning. With the passage of TRA 86, individual tax rates became lower than corporate rates for the first time in history, and the General Utilities doctrine was repealed. These two changes created an environment where qualifying corporations usually elected S Corporation status rather than form a FSC because the S Corporation tax advantages are generally superior to the FSC exclusion. In certain unique situations, not discussed herein, it is theoretically possible for S shareholders to benefit from the FSC legislation without giving up S Corporation status.

Thus, we come to the point where a lack of awareness, perceived complexity, cost/benefit evaluation and the availability of S Corporation elections have become the major reasons why the number of Small FSCs is much lower than originally forecasted.

Small FSCs: What, Where, How, How Much and How Complex

What.- A Small FSC is simply a Foreign Sales Corporation that has elected to be treated as a "Small FSC." The FSC may change its status annually simply by revoking the original election and making a new one. Both actions must be taken within the first 90 days of the FSC taxable year.

Where: IRC Sec. 922 lists 28 qualified countries, as of December 31, 1988, with appropriate reciprocity with Treasury, in addition to the four U.S. possessions initially listed in the law. There is very little difference, other than convenience and local taxes, between the host countries as long as the exporter is not otherwise doing business in the selected country.

How: Usually everything, including an office and a non-resident director, is provided through a professional FSC management company doing business in the host country. Simply because of convenience and, being one of the initial qualified countries, most FSCs have been formed in the U.S. Virgin Islands. The procedure is relatively simple in that a one-page application may be faxed to the FSC management office and the FSC is usually formed within 24 hours.

How Much: While costs vary among firms and countries, an average formation fee in the V.I. would be $2,000, including all V.I. filing costs. The annual costs associated with a Small FSC would also average about $2,000.

Who Should Consider a Small FSC?

U.S. Corporations who have not elected S Corporation status, do not operate as a de facto S Corporation and realize about $100,000 annually in taxable income. Since the minimum FSC benefit is about equal to 1/2% of gross foreign sales and the average annual FSC fees are about $2,000, the break even point for a FSC formation is about $400,000 in foreign sales.

How a Small FSC Functions

The FSC does not become involved in the commercial aspects of the transaction, nor is anyone aware of, nor have a reason to be aware of, any FSC involvement. The basic figure in FSC computations is Combined Taxable Income (CTI). This is the net profit from the foreign sale, including an allocation of G&A expenses based on gross profit allocations. The combined concept merely means that expenses of the parent-supplier and the FSC are to be aggregated so as to eliminate profit manipulation to arrive at a larger FSC benefit.

FSC Commission

The parent corporation is allowed to pay a commission to the FSC based on the following statutory formula:

The greater of 23% of CTI or 1.83% of gross foreign sales but not to exceed 46% of CTI. While this may sound involved it normally is not. In simpler terms the commission works out as follows:

If CTI is 8% or more of foreign sales, the commission is 23% of CTI. If CTI is 4% or less of foreign sales, the commission is 46% of CTI. If CTI is 4% to 8% of foreign sales, first compute CTI to be 8% . The commission is 23% of the computed CTI.

In essence, the income exclusion ranges from 15% to 30% of CTI.

The rest is simple:

* The parent company deducts the allowable commission.

* The FSC accrues the allowable commission and reports 15/23 or 65.2% as taxable income.

* The FSC makes quarterly tax payments at the parent's tax rate, files an annual FSC 1120, declares a tax-free dividend to the parent and forwards invoice documentation, P&L and Balance Sheet to the FSC office once a year.

The following illustrates the process:

a) Corporate taxable income before FSC

commission $100

b) Maximum commission payable to FSC 23

c) Corporate taxable income $ 77

d) Portion of FSC commission subject to tax $ 8

e) Portion of FSC commission not taxable $ 15

f) Combined taxable income of parent and $ 85

FSC (c + d)

Since a Small FSC is not required to have a bank account these transactions are simply recorded through journal entries.

Is it That Complex?

The exporter forms a FSC, computes a quarterly commission and exemption, pays a quarterly tax, files an annual tax return and forwards invoice documentation to the FSC office. The FSC benefit becomes almost instant since the income is excluded on a quarterly basis for estimated tax purposes. In essence, once awareness is overcome, complexity is not even an issue. The decision to form a FSC is simply and purely a matter of economics.

Maximizing FSC Benefits

The lack of awareness issue is far broader than whether a manufacturer knows of the rates of commission involved. While many manufacturers are aware of the FSC concept they may not think that their sales are foreign. Others may be aware of their foreign sales but may not know that by using marginal costing or the statutory pricing formulas, the cost/benefit factor becomes a positive factor rather than a negative.

Definition of Foreign Sales

The DISC definitional provisions are still applicable in determining a foreign sale. The most common oversights relate to sales to Canada and sales to forms of export trading companies. For example: A manufacturer in Detroit selling to an agent in New York, who resells to a buyer in Paris, need only obtain an annual statement from the agent that the goods were resold, intact, overseas within 12 months. Point of destination determines the classification of a foreign sale. In essence, this would be a foreign sale for both the manufacturer and the New York buyer. Another common occurrence is when a company is directed by its domestic buyer to ship the goods overseas to a third party. Even though the sale is to a domestic customer, this is now a foreign sale. The Department of Commerce states that over 30% of all foreign sales begin as "domestic" sales.

Use of Marginal Costing as an Alternative to a Commission

Marginal costing may be used in computing the commission when the exporter is trying to maintain or establish a foreign market. This intent is substantiated whenever the exporter's overall profit margin, including foreign sales, is higher than the margin applicable only to foreign sales. Under this circumstance the exporter may compute a commission based on what the profit "would have been" had foreign sales generated the same profit margin as company-wide sales. The limit to this approach is that the "commission" may not exceed full costing CTI. The bottom line is that under such conditions as much as 65.2% of full costing CTI may be exempt as compared to only 15% to 30% under normal conditions.

Low Margin Exporters Can Use a Percent of Sales

A commission formula available to exporters with a profit margin of less than 8% , namely 1.83% of gross sales, can result in an income exclusion of as much as 30% of the foreign profit (CTI). In essence, at this profit level the FSC dollar benefit can equal as much as 13% of the foreign profit. For example, an exporter of used material with sales of $1.2 million at 3% profit would earn $36,000 which would re resent the approximate FSC break-even level, i.e., where the annual after tax benefit about equals the annual FSC fees under the normal 23% commission method. However, by using the 1.83% of gross sales methods (subject to limitations), the FSC benefit would be about $4,700 or more than twice the average annual FSC costs.

What are the Timing Factors in Working with a FSC?

Formation

The FSC concept applies to all "shipments" made on or after the date of the FSC formation regardless of when the sale was actually consummated. However, the $5 million annual foreign sales limitation applicable to a Small FSC, is prorated on a daily basis during the initial year. Consequently, even though shipment dates may qualify, their dollar amount may exceed limitations if the FSC is not formed early enough in the tax year, which must be the same as the controlling parent.

For example, if a calendar year C Corporation forms a FSC on July 1, FSC benefits will only be available for the profits on $2.5 million of foreign sales "shipped" on or after July 1.

Use of Marginal Costing as an Alternative to a Commission

Marginal costing may be used in computing the commission when the exporter is trying to maintain or establish a foreign market. This intent is substantiated whenever the exporter's overall profit margin, including foreign sales, is higher than the margin applicable only to foreign sales. Under this circumstance the exporter may compute a commission based on what the profit "would have been" had foreign sales generated the same profit margin as company-wide sales. The limit to this approach is that the "commission" may not exceed full costing CTI. The bottom line is that under such conditions as much as 65.2% of full costing CTI may be exempt as compared to only 15% to 30% under normal conditions.

Low Margin Exporters Can Use a Percent of Sales

A commission formula available to exporters with a profit margin of less than 8% , namely 1.83% of gross sales, can result in an income exclusion of as much as 30% of the foreign profit (CTI). In essence, at this profit level the FSC dollar benefit can equal as much as 13% of the foreign profit. For example, an exporter of used material with sales of $1.2 million at 3% profit would earn $36,000 which would represent the approximate FSC break-even level, i.e., where the annual after tax benefit about equals the annual FSC fees under the normal 23% commission method. However, by using the 1.83% of gross sales methods (subject to limitations), the FSC benefit would be about $4,700 or more than twice the average annual FSC costs.

What are the Timing Factors in Working with a FSC?

Formation

The FSC concept applies to all "shipments" made on or after the date of the FSC formation regardless of when the sale was actually consummated. However, the $5 million annual foreign sales limitation applicable to a Small FSC, is prorated on a daily basis during the initial year. Consequently, even though shipment dates may qualify, their dollar amount may exceed limitations if the FSC is not formed early enough in the tax year, which must be the same as the controlling parent.

For example, if a calendar year C Corporation forms a FSC on July 1, FSC benefits will only be available for the profits on $2.5 million of foreign sales "shipped" on or after July 1.

Switching FSC Status

Small or Regular FSCs may change their election. They simply file a new election for the current tax year and a separate statement, revoking the prior status, during the first 90 days of the new tax year. Caution: When switching from Small to Regular, be aware that a large FSC is required to establish a foreign bank account within the first 30 days of the tax year. Consequently, even though a timely election is made within the 90-day period, the FSC still may not qualify as a large FSC because of the bank account timing requirement. When this occurs about the only resolution is to form a new FSC, since the original election was revoked and the new one is invalid.

Shared FSCs v. Solely Owned FSCs

Since a FSC may be formed with up to 25 shareholders there have been several attempts to market a Shared FSC concept. The idea originated when the FSC legislation was first passed in 1984 and many of the FSC management companies began charging substantial fees. This was not necessarily an attempt to overcharge as much as it was a lack of knowledge regarding the demand and actual needs of this new vehicle. At this point the marketplace has basically determined a more modest fee structure.

Shared FSCs make sense if they reduce complexity or costs for the smaller exporter. However, both tests seem strained under most of the available Shared FSC programs because of the following:

* Annual fees of a shared FSC are generally higher than a solely owned FSC.

* The probability of a different FSC tax year adds accounting complications.

* Since most shared FSCs are not Small FSCs, cash transfers are required.

In essence, even though Shared FSCs were originally envisioned for smaller exporters, the sophisticated structure developed to solve "economic processing" problems turns out to be a vehicle suitable for large FSCs. Conversely, the structure offers solutions to problems that would not be problems to smaller exporters if they simply formed their own Small FSC.

Economic Globalization

While smaller manufacturers may have viewed exporting as a means of expanding their domestic success, they are slowly shifting to the outlook that exporting is becoming a necessity, not only to stay competitive, but also in the near future, to retain their "domestic" base. The most immediate force appears to be European Economic Community (EEC) 1992 trade barriers. In contemplation of what may be very restrictive content source requirements, many larger U.S. manufacturers are planning to relocate major portions of their manufacturing operations to the continent. If this becomes a reality, smaller manufacturers presently functioning as suppliers may be forced to export just to follow their domestic customers. In essence, exporting is certain to become the "new" industry of the 1990s. Even the terminology has changed EEC 1992, Hong Kong 1995, Harmonization, U.S./Canada FTA, 1988 Omnibus Trade Bill, SAD and FSC were almost unknown terms five years ago. CPAs will be forced to learn the same concepts quickly as their clients enter into this new arena, desperately seeking guidance. However, in evaluating the relevance and opportunities of these new concepts, it may be worth noting that, after FSC, the most under- utilized export assistance program currently available is the Duty Drawback, passed by Congress in 1796.

NEED FOR ADDITIONAL EXPORT INCENTIVES FOR SMALL BUSINESS

In the effort by the U.S. to successfully compete in the world economy and to reduce its current imbalance, the globalization of small business is crucial. According to James Abdnor, director of the SBA, "Small businesses in America have barely scratched the surface in world trade." For example, 80% of all U.S. exports are accounted for by only 250 companies.

Although many reasons have been forwarded for the lack of exports by small businesses, it is widely recognized that small businesses generally lack the expertise and specialization necessary to thrive in the export market. Consequently, a myriad of government agencies (Commerce, Interior, SBA, TVA, SBDCs, state DEDs, etc.) have established programs to assist small businesses in exporting. The government's only economic incentive to export, however, is the tax benefits available through the utilization of a FSC. TRA 86 has removed, albeit unintentionally, this incentive for many small exporters. The four changes that have occurred with TRA 86 are:

1. The flip-flop in the relationship between the top corporate and top individual rates.

2. The loss of favorable capital gain tax rates and the repeal of the "General Utilities" doctrine.

3. The institution of the new AMT.

4. The reduction in the top corporate rate.

The first three changes encourage a Subchapter C Corporation to convert to Subchapter S Corporation status causing it to be unable to reap any tax benefit for the use of a FSC. The fourth change resulted in an increase in the break-even point for operating a FSC, causing many small exporters to no longer be able to justify the costs of a FSC.

Some may argue that TRA 86 was beneficial to small businesses, including those that lost their FSC benefits due to Subchapter S election. They reason that those companies that elected Subchapter S status after TRA 86 will have lower tax liabilities than before, even though they have lost their FSC benefit on export sales. But the end result is that TRA 86 has, for many small businesses removed an important tax incentive to export. Ironically, this has taken place during a period in which small businesses have been urged to seek foreign markets and with Europe 1992 on the immediate horizon.

There is evidence that many FSCs have been terminated due to Subchapter S election by their parent. William C. Williams is a partner in the Honolulu-based law firm of Carlsmith, Wichman, Case, Mukai, & Ichiki. His firm has provided legal services to over 75% of the 370 FSCs (small and large) that have been incorporated in the Territory of Guam. Mr. Williams estimates that between 20 and 30 companies that his firm has served have indicated that they dropped their FSCs due to Subchapter S election.

Congress has apparently recognized that small businesses are having problems taking advantage of the FSC incentive. The trade bill passed in August 1988 called for "specific recommendations on methods of improving the current Small FSC tax incentives and providing small businesses with greater benefits from this initiative" (Omnibus Trade and Competitiveness Act of 1988). Two suggestions for achieving this objective are:

1. Through relatively minor changes in the tax law, Subchapter S Corporations could utilize and derive benefit from FSCs.

2. An increase in the exemption percentage for Small FSCs from the current 15% to, for example 20%, would lower the break-even point for small exporters. if it is not possible to make this increase applicable to all small FSCs (i.e., those with exports under $5 million), then perhaps it could at least be instituted for those at the lower end, say under $1 million. This would make it feasible for many exporters now operating below break-even to utilize a FSC as an export tax incentive.