Most of us know the tax benefits of using a FSC. However, sometimes the cost of a FSC can outweigh the tax benefits. The cost-sharing arrangement of a shared FSC may reduce these costs to the individual exporter to the point where its use becomes feasible.

A shared foreign sales corporation (FSC), as defined in IRC Sec. 927(g)(3), is generally any FSC that maintains a separate account for transactions with and distributions to each shareholder (or related persons). The shared FSC is the primary tax-savings vehicle for small and medium-sized businesses seeking to enter international markets. The Treasury estimates that there are more than 20,000 such businesses that export more than 20% of their product. Due to statutory limitations, the shared FSC is not feasible for large corporate exporters. To encourage exports, TRA '84 created the FSC for large exporters and the shared FSC for small and medium-sized exporters.

Small and medium-sized exporters can benefit from participation in a shared FSC, and with increased awareness of the relatively low cost and simplicity of participating, more of them should take advantage of the shared FSC provisions. FSC tax benefits make the corporate tax rate approximately 24% on foreign sales, compared to the normal rate of 35%.

There is a 15%-30% tax exemption for all sales on exports from a FSC. Even allowing for professional and financial fees in establishing and operating a FSC, with a reasonable volume of exports, a business can realize a significant tax benefit. If the FSC operates from a tax-haven jurisdiction, this income can avoid all income taxes.

FSC Requirements

To qualify as a FSC, a business must satisfy the following requirements under IRC Sec. 922 (a)(1):

* Foreign Entity. Must be a corporation organized under the laws of a country that has an income tax treaty with the U.S. or of a U.S. possession (except Puerto Rico);

* Number of Shareholders. Cannot have more than 25 shareholders at any time during the tax year;

* Preferred Stock. Cannot have any preferred stock outstanding at any time during the tax year;

* Foreign Presence. Must maintain an office in a foreign country or U.S. possession and a set of books at that office;

* Domestic Presence. Must maintain required records under IRC Sec. 6001 at a U.S. location;

* Foreign Directors. Must have at least one individual director who is not a U.S. resident;

* DISC Members. Must not be a member of any controlled group or corporation that is a member of a DISC; and

* Timely Election. Must have made a timely election to be a FSC.

Foreign Management

A FSC is deemed to have foreign trade income (i.e., gross income attributable to foreign trading gross receipts) if it is managed outside the U.S. The foreign management requirement under IRC Sec. 924(c) is met if 1) all board and shareholder meetings are held outside the U.S., 2) the main corporate bank account is located outside the U.S. in a treaty country or U.S. possession, and 3) dividends, legal and accounting fees, and directors' and officers' salaries are paid from bank accounts maintained outside the U.S.

Foreign Economic Activity

The economic activities relating to the sales must be conducted outside the U.S. This requirement is met if the FSC solicits its orders (other than by advertising) or negotiates or enters into contracts regarding those orders outside the U.S. and 50% or more of the FSC's direct costs in a transaction are foreign direct costs.

The requirements of foreign management and foreign economic activity have created substantial obstacles for U.S. businesses seeking to take advantage of the tax benefits of FSCs. The best approach, particularly for smaller exporters, is participation in a "shared FSC."

Shared FSCs

A shared FSC consists of up to 25 separate, unrelated exporters that become shareholders in a single export company. The shared FSC performs necessary functions for all members at the same time and from the same office. As a result, management, operations, and accounting and legal expenses are spread among the shareholder-exporters, thereby achieving economies of scale, with reduced FSC costs for each individual exporter. Within a shared FSC, a smaller exporter may have a tax exemption for foreign trade gross receipts of up to $5 million.

Major Participants

There are seven primary participants in a shared FSC:

* Sponsor. Catalyst for developing and implementing a shared FSC. Can be an individual exporter-shareholder, (e.g., the World Trade Center Association), an independent company, a government entity, a trade association, a port authority, or a national bank. Sets policies, screens potential shareholders, approves applicants, monitors and reviews the shareholders' export activity, and holds meetings. Usually responsible for a program consisting of several shared FSCs. May, but is not required to, group participants by product similarity, geographical location, or size. The FSC can easily function with a diverse group of shareholders and even business competitors.

* Manager. Coordinates activities among the shareholders. Usually an independent party, but can be one of the exporters. Responsible for daily operations, including collections, banking, consulting, reporting, organizational meetings, tax management, and assisting shareholders in meeting shared FSC requirements.

* Overseas Service Organization. Assists with incorporation of the shared FSC, maintains the foreign office, provides a non-U.S. resident person to serve as the required foreign director, aids in meeting the foreign situs economic process test, and provides audits if required.

* Domestic Bank. Maintains a receiving account in the U.S. for export receipts generated by the exporter-shareholders.

* Overseas Bank. Manages the shared FSC's bank account and transfers payments from an exporter to the shared FSC and immediately back to the exporter if the exporter chooses to use a receipt-of-payment method in satisfying the foreign sales economic process requirements (a "sweep").

* Accounting Firm. Responsible for gathering financial information and preparing tax returns based on the aggregate information from all of the exporter-shareholders.

* Exporter-Shareholders. Responsible for successfully marketing and selling their products. Within the operational structure of the shared FSC, also responsible for conducting individual export transactions, receiving payment, meeting the economic process requirements, paying their share of costs, establishing an accounting system to capture foreign situs cost, preparing separate company information for the shared FSC tax return, executing shareholder agreements, attending annual shareholders' meeting, and transferring commissions to the shared FSC.

Simplifying Operations

The shared FSC attempts to simplify compliance with the IRC for small and medium-sized exporters. Under the prototype program initially sponsored in Delaware, shared FSCs are managed by a FSC company. As indicated above, all day-to-day activities and any foreign management or foreign economic activities are handled by the management company; accounting and tax preparation is performed by an accounting firm; foreign financial activities are handled by an overseas affiliate of the accounting firm; and banking functions are performed by a national bank. Thus, the only actions a shareholder must take are the following:

* Send sales information (copies or summaries of invoices) to the shared FSC's office in the foreign jurisdiction;

* Send solicitation letters to the exporter's customers through the shared FSC's foreign office. (The letter should bear the exporter's name, not that of the shared FSC.);

* Prepare advertisements to appear in foreign newspapers;

* Send commission payments to the shared FSC. (These will be returned to the exporter as a dividend.); and

* Track certain expenses for the shared FSC's tax return and other required financial statements. Since the shared FSC reduces the responsibilities of the shareholder-exporter, even a moderate after-tax savings justifies membership. Owners of closely held corporations are likely to seek participation in a shared FSC because the requirements allow them to do what they do best - sell their product, while leaving the management company to handle the more technical foreign management requirements and the accounting firm to handle tax preparation and financial planning.

EXHIBIT1

FSCTAXSAVINGSCALCULATIONS

Method2

Method123%ofMethod3

1.83%ofCombinedArm's-

FTGRIncomeLength

FTGR$2,000,000$2,000,000$2,000,000

FSCtaxableincome(36,600)(46,000)(100,000)

FSCsalesexpense(400,000)(400,000)(400,000)

Transferprice$1,563,400$1,554,000$1,500,000

FTGR$2,000,000$2,000,000$2,000,000

Transferprice(1,563,400)(1,554,000)(1,500,000)

FTI436,600446,000500,000

ExemptFTI284,740290,860150,000

Expensesallocable

toexemptFTI(260,870)(260,870)(120,000)

Tax-exemptFSCprofits23,87029,99030,000

Taxsavingsat35%$8,355$10,496$10,500

EXHIBIT2

FSCCOSTSTOEXPORTER(SOLOVS.SHARED)

SoloShared

Grossexportincome(millions)$5$125

Numberofexporters125

One-timestart-upcost:

Incorporationservices$750$0

Governmentfees:

Incorporation3900

Application1000

Initialstockpurchase012,500

Out-of-pocketexpenses1000

Totalstart-upcost$1,340$12,500

Start-upcostperexporter$1,340$500

Annualmaintenancecost:

Governmentfees$1,000$0

Localdirectors'fees2000

Management:officeandrecords6000

Foreignmanagement&economic

process:

Bankaccounts1,5600

Bankingsweeps2,0800

Other1,2500

Accounting,legal,bookkeeping

andtaxreturns3,0000

Annualmaintenancefee(*)0125,000

$9,690$125,000

Annualmaintenancecostper

exporter$9,690$5,000

*TheannualmaintenancefeeforaDelawaresharedFSCisbasedon

thefollowingformula:thegreaterof$3,000or.001ofthe

exporter'sgrossexportvalue.Thisexampleassumeseachmember

exporterhasgrossexportincomeof$5million.Themaintenancefee

perexporteris.001of$5million,or$5,000.

Computing Tax Incentive To Export

A FSC's exempt foreign trade income is foreign-source income not "effectively connected" with a U.S. trade or business and thus not subject to U.S. income taxes. In addition, it is not subpart F income and will not be included in the E&P subject to dividend treatment under IRC Sec. 1248 (gain on sales or exchanges of stock in foreign corporations).

To determine whether the exemption is worth the expense of creating a solo FSC or participating in a shared FSC, the tax savings must be calculated. Sales of U.S. products by a FSC generate foreign trade gross receipts (FTGR), which include -

* sales and exchanges of export property,

* leasing or rental of export property used by the lessee outside the U.S.,

* services related to the sale or exchange or leases of export property, and

* engineering or architectural services for construction projections outside the U.S.

Transfer Pricing Rules

Under the transfer pricing rules of IRC Sec. 925, one of three methods may be used to calculate the difference between a FSC's taxable income and its FTGR. After determining the FTGR, the taxable income and the direct expenses incurred by the FSC are subtracted from the FTGR. This results in a transfer price attributable to the U.S. products, which is then subtracted from the FTGR to arrive at the FSC's foreign trade income (FTI). A portion of the FTI is deemed to be exempt. The determination depends on whether the FSC uses administrative pricing rules, as well as whether it has noncorporate shareholders. A portion of the FSC's sales expense is then deducted from exempt FTI. Different percentages apply depending on whether administrative pricing rules are used, and whether sales are attributable to military property. The difference is exempt from U.S. tax. The extra income created by the exemption is passed on to the exporter as a dividend.

Example. A U.S. manufacturer considers forming a FSC and wants to calculate its tax savings on goods exported and sold by that FSC. The FSC will receive income from the sale of allowable exported goods of $2 million. It also costs the exporter $1,200,000 to manufacture and $200,000 to export the goods to the FSC. The FSC will incur $400,000 in sales expenses related to the goods.

The $2 million gross income from the sale of the goods is the FSC's FTGR. The transfer pricing rules provide three possible measures of an FSC's taxable income: 1) 1.83% of gross receipts, 2) 23% of combined taxable income, and 3) an arm's-length measure using the transfer pricing rules.

Exhibit 1 shows the tax savings from using the combined-taxable-income method is $10,496 and the arm's-length method to be $10,500. The tax savings for the percentage-of-gross receipts method is $8,355. Since the cost of operating a solo FSC is approximately $10,000 per year, this U.S. exporter does not realize any significant savings from creating a solo FSC, but would if it were a member of a shared FSC.

Cost to Exporting Company

The cost comparison in Exhibit 2 demonstrates the actual cost of creating and operating a solo FSC and the relative tax savings available through ownership in a shared FSC. It shows that if an exporter forms a solo FSC, its costs in the first year will be $11,030 ($9,690 annual maintenance fee + $1,340 start-up cost). Thereafter, its annual maintenance cost will be $9,690. If the exporter becomes a shareholder in a shared FSC, its first-year cost is $5,500 ($500 start-up cost and $5,000 annual maintenance cost). Thereafter, the annual maintenance cost is $5,000. An exporter saves $5,530 in the first year and $4,690 yearly thereafter by participating in a shared FSC.

When Does a FSC Make Sense?

When a small or medium-sized U.S. exporter reaches the break-even point of start-up and maintenance costs vs. financial savings, a solo or shared FSC begins to warrant serious consideration. Since international markets are growing more rapidly than domestic markets, and international sales tend to increase rapidly once a new exporter gets its foot in the door in a particular region, the FSC should be formed on reaching the breakeven point, so that future sales can be leveraged with income tax savings. At that point, the small business owner has a strategic choice - lower its price to attempt to rapidly increase its share in the international market, or begin receiving additional profit immediately, or both.

Choosing a Location

Once a U.S. company decides to form either a solo or shared FSC, it must choose a location that has advantageous tax laws and a favorable business climate for its products. As indicated above, the possible locations for FSCs are limited to possessions of the U.S., or foreign countries having certain treaties or agreements with the U.S.

Out of approximately 6,000 FSCs worldwide, nearly 4,800, or 80%, are incorporated in the U.S. Virgin Islands. These islands are English- speaking, located in the Caribbean, and therefore desirable for board meetings; the U.S. dollar is the currency. Barbados has approximately 420 FSCs, or seven percent of the total, and Jamaica has approximately four percent. Most of the remaining FSCs are dispersed throughout Guam, Canada, Belgium, the Netherlands, and Ireland.

Joel D. Bonfiglio, JD, is tax counsel with the Washington, D.C. law firm of Brownstein, Zeidman and Lore, P.C.

This article was adapted with permission from a similar article written by Mr. Bonfiglio that appeared in the September 1994 edition of The Journal of International Taxation. Copyright 1994, Warren Gorham & Lamont