TECHNICAL EXPLANATION OF

THE SENATE AMENDMENT TO H.R. 4986, THE

“FSC REPEAL AND EXTRATERRITORIAL INCOME

EXCLUSION ACT OF 2000”

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

November 1, 2000

JCX-111-00
(i)

CONTENTS

Page

I. INTRODUCTION ................................................ 1

II. OVERVIEW OF PRESENT-LAW FOREIGN SALES CORPORATION

RULES ........................................................ 2

III. TECHNICAL EXPLANATION OF THE SENATE AMENDMENT TO

H.R. 4986 ...................................................... 5
1

 This document may be cited as follows: Joint Committee on Taxation, Technical

Explanation of the Senate Amendment to H.R. 4986, the “FSC Repeal and Extraterritorial

Income Exclusion Act of 2000” (JCX-111-00), November 1, 2000.

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I. INTRODUCTION

This document,1 prepared by the staff of the Joint Committee on Taxation, is a technical

explanation of H.R. 4986 as passed by the Senate on November 1, 2000. H.R. 4986 was passed

by the House of Representatives on September 13, 2000. The Senate Finance Committee

favorably reported the bill with an amendment on September 19, 2000. The conference agreement

to H.R. 2614 included legislation that resolved the differences between the House and Senate on

this matter. The Senate amendment to H.R. 4986, as passed by the Senate on November 1, 2000,

adopts the compromise language of the conference agreement to H.R. 2614. 
2

 A variety of anti-deferral regimes impose current U.S. tax on income earned by a U.S.

person through a foreign corporation. The Internal Revenue Code of 1986, as amended, (the

“Code”) sets forth the following anti-deferral regimes: the controlled foreign corporation rules of

subpart F (secs. 951-954), the passive foreign investment company rules (secs. 1291-1298), the

foreign personal holding company rules (secs. 551-558), the personal holding company rules

(secs. 541-547), the accumulated earnings tax rules (secs. 531-537), and the foreign investment

company rules (sec. 1246). Detailed rules for coordination among the anti-deferral regimes are

provided to prevent a U.S. person from being subject to U.S. tax on the same item of income under

multiple regimes. 

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II. OVERVIEW OF PRESENT-LAW FOREIGN

SALES CORPORATION RULES

Summary of U.S. income taxation of foreign persons

Income earned by a foreign corporation from its foreign operations generally is subject to

U.S. tax only when such income is distributed to a U.S. persons that hold stock in such corporation. 

Accordingly, a U.S. person that conducts foreign operations through a foreign corporation

generally is subject to U.S. tax on the income from those operations when the income is repatriated

to the United States through a dividend distribution to the U.S. person.2 The income is reported on

the U.S. person's tax return for the year the distribution is received, and the United States imposes

tax on such income at that time. An indirect foreign tax credit may reduce the U.S. tax imposed on

such income.

Foreign sales corporations

The income of an eligible foreign sales corporation (“FSC”) is partially subject to U.S.

income tax and partially exempt from U.S. income tax. In addition, a U.S. corporation generally is

not subject to U.S. income tax on dividends distributed from the FSC out of certain earnings.

A FSC must be located and managed outside the United States, and must perform certain

economic processes outside the United States. A FSC is often owned by a U.S. corporation that

produces goods in the United States. The U.S. corporation either supplies goods to the FSC for

resale abroad or pays the FSC a commission in connection with such sales. The income of the

FSC, a portion of which is exempt from U.S. income tax under the FSC rules, equals the FSC's

gross markup or gross commission income less the expenses incurred by the FSC. The gross

markup or the gross commission is determined according to specified pricing rules.

A FSC generally is not subject to U.S. income tax on its exempt foreign trade income. The

exempt foreign trade income of a FSC is treated as foreign-source income that is not effectively

connected with the conduct of a trade or business within the United States.

Foreign trade income, other than exempt foreign trade income, generally is treated as U.S.-

source income effectively connected with the conduct of a trade or business conducted through a
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permanent establishment within the United States. Thus, a FSC’s income, other than exempt

foreign trade income, generally is subject to U.S. tax currently and is treated as U.S.-source

income for purposes of the foreign tax credit limitation.

Foreign trade income of a FSC is defined as the FSC's gross income attributable to foreign

trading gross receipts. Foreign trading gross receipts generally are the gross receipts attributable

to the following types of transactions: the sale of export property; the lease or rental of export

property; services related and subsidiary to such a sale or lease of export property; engineering

and architectural services for projects outside the United States; and export management services. 

Investment income and carrying charges are excluded from the definition of foreign trading gross

receipts.

The term “export property” generally means property (1) which is manufactured, produced,

grown or extracted in the United States by a person other than a FSC; (2) which is held primarily

for sale, lease, or rental in the ordinary course of a trade or business for direct use or consumption

outside the United States; and (3) not more than 50 percent of the fair market value of which is

attributable to articles imported into the United States. The term “export property” does not

include property leased or rented by a FSC for use by any member of a controlled group of which

the FSC is a member; patents, copyrights (other than films, tapes, records, similar reproductions,

and other than computer software, whether or not patented), and other intangibles; oil or gas (or

any primary product thereof); unprocessed softwood timber; or products the export of which is

prohibited or curtailed. Export property also excludes property designated by the President as

being in short supply.

If export property is sold to a FSC by a related person (or a commission is paid by a

related person to a FSC with respect to export property), the income with respect to the export

transaction must be allocated between the FSC and the related person. The taxable income of the

FSC and the taxable income of the related person are computed based upon a transfer price

determined under section 482 or under one of two formulas specified in the FSC provisions.

The portion of a FSC's foreign trade income that is treated as exempt foreign trade income

depends on the pricing rule used to determine the income of the FSC. If the amount of income

earned by the FSC is based on section 482 pricing, the exempt foreign trade income generally is 30

percent of the foreign trade income the FSC derives from a transaction. If the income earned by

the FSC is determined under one of the two formulas specified in the FSC provisions, the exempt

foreign trade income generally is 15/23 of the foreign trade income the FSC derives from the

transaction.

A FSC is not required or deemed to make distributions to its shareholders. Actual

distributions are treated as being made first out of earnings and profits attributable to foreign trade

income, and then out of any other earnings and profits. A U.S. corporation generally is allowed a

100 percent dividends-received deduction for amounts distributed from a FSC out of earnings and

profits attributable to foreign trade income. The 100 percent dividends-received deduction is not

allowed for nonexempt foreign trade income determined under section 482 pricing. Any

distribution made by a FSC out of earnings and profits attributable to foreign trade income to a
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foreign shareholder is treated as U.S.-source income that is effectively connected with a business

conducted through a permanent establishment of the shareholder within the United States. Thus, the

foreign shareholder is subject to U.S. tax on such a distribution.
3

 The term “transaction” means (1) any sale, exchange, or other disposition; (2) any lease

or rental; and (3) any furnishing of services.

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III. TECHNICAL EXPLANATION OF THE SENATE

AMENDMENT TO H.R. 4986

Overview

The Senate amendment repeals the present-law FSC rules and replaces them with an

exclusion for extraterritorial income. The Senate amendment, like the Senate Finance Committee

reported version of the bill, does not include the provision in the House bill that provides a

dividends-received deduction for certain dividends allocable to qualifying foreign trade income. 

The Senate amendment adopts the compromise language of the conference agreement to H.R. 2614.

Repeal of the FSC rules

The Senate amendment repeals the present-law FSC rules found in sections 921 through

927 of the Code.

Exclusion of extraterritorial income

The Senate amendment provides that gross income for U.S. tax purposes does not include

extraterritorial income. Because the exclusion of such extraterritorial income is a means of

avoiding double taxation, no foreign tax credit is allowed for income taxes paid with respect to

such excluded income. Extraterritorial income is eligible for the exclusion to the extent that it is

“qualifying foreign trade income.” Because U.S. income tax principles generally deny deductions

for expenses related to exempt income, otherwise deductible expenses that are allocated to

qualifying foreign trade income generally are disallowed.

The Senate amendment applies in the same manner with respect to both individuals and

corporations who are U.S. taxpayers. In addition, the exclusion from gross income applies for

individual and corporate alternative minimum tax purposes. 

Qualifying foreign trade income

Under the Senate amendment, qualifying foreign trade income is the amount of gross

income that, if excluded, would result in a reduction of taxable income by the greatest of (1) 1.2

percent of the “foreign trading gross receipts” derived by the taxpayer from the transaction,3 (2) 15

percent of the “foreign trade income” derived by the taxpayer from the transaction, or (3) 30

percent of the “foreign sale and leasing income” derived by the taxpayer from the transaction. The

amount of qualifying foreign trade income determined using 1.2 percent of the foreign trading gross

receipts is limited to 200 percent of the qualifying foreign trade income that would result using 15

percent of the foreign trade income. Notwithstanding the general rule that qualifying foreign trade

income is based on one of the three calculations that results in the greatest reduction in taxable
4

 For an example of these calculations, see the General Example, below. 

5

 Persons are considered to be related if they are treated as a single employer under

section 52(a) or (b) (determined without taking into account section 1563(b), thus including

foreign corporations) or section 414(m) or (o).

6

 The manufacturer also could compute qualifying foreign trade income based on 30

percent of foreign sale and leasing income.

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income, a taxpayer may choose instead to use one of the other two calculations that does not result

in the greatest reduction in taxable income. Although these calculations are determined by

reference to a reduction of taxable income (a net income concept), qualifying foreign trade income

is an exclusion from gross income. Hence, once a taxpayer determines the appropriate reduction

of taxable income, that amount must be “grossed up” for related expenses in order to determine the

amount of gross income excluded.4

If a taxpayer uses 1.2 percent of foreign trading gross receipts to determine the amount of

qualifying foreign trade income with respect to a transaction, the taxpayer or any other related

persons will be treated as having no qualifying foreign trade income with respect to any other

transaction involving the same property.5 For example, assume that a manufacturer and a

distributor of the same product are related persons. The manufacturer sells the product to the

distributor at an arm’s-length price of $80 (generating $30 of profit) and the distributor sells the

product to an unrelated customer outside of the United States for $100 (generating $20 of profit). 

If the distributor chooses to calculate its qualifying foreign trade income on the basis of 1.2 percent

of foreign trading gross receipts, then the manufacturer will be considered to have no qualifying

foreign trade income and, thus, would have no excluded income. The distributor’s qualifying

foreign trade income would be 1.2 percent of $100, and the manufacturer’s qualifying foreign trade

income would be zero. This limitation is intended to prevent a duplication of exclusions from

gross income because the distributor’s $100 of gross receipts includes the $80 of gross receipts of

the manufacturer. Absent this limitation, $80 of gross receipts would have been double counted

for purposes of the exclusion. If both persons were permitted to use 1.2 percent of their foreign

trading gross receipts in this example, then the related-person group would have an exclusion

based on $180 of foreign trading gross receipts notwithstanding that the related-person group

really only generated $100 of gross receipts from the transaction. However, if the distributor

chooses to calculate its qualifying foreign trade income on the basis of 15 percent of foreign trade

income (15 percent of $20 of profit), then the manufacturer would also be eligible to calculate its

qualifying foreign trade income in the same manner (15 percent of $30 of profit).6 Thus, in the

second case, each related person may exclude an amount of income based on their respective

profits. The total foreign trade income of the related-person group is $50. Accordingly, allowing

each person to calculate the exclusion based on their respective foreign trade income does not

result in duplication of exclusions.

Under the Senate amendment, a taxpayer may determine the amount of qualifying foreign

trade income either on a transaction-by-transaction basis or on an aggregate basis for groups of
7

 By reference to Standard Industrial Classification codes, the provision is intended to

include industries as defined in the North American Industrial Classification System.

8

 The Taxpayer Relief Act of 1997, Public Law 105-34.

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transactions, so long as the groups are based on product lines or recognized industry or trade

usage. Under the grouping method, it is intended that taxpayers be given reasonable flexibility to

identify product lines or groups on the basis of recognized industry or trade usage. In general,

provided that the taxpayer’s grouping is not unreasonable, it will not be rejected merely because

the grouped products fall within more than one of the two-digit Standard Industrial Classification

codes.7 The Secretary of the Treasury is granted authority to prescribe rules for grouping

transactions in determining qualifying foreign trade income.

Qualifying foreign trade income must be reduced by illegal bribes, kickbacks and similar

payments, and by a factor for operations in or related to a country associated in carrying out an

international boycott, or participating or cooperating with an international boycott.

In addition, the Senate amendment directs the Secretary of the Treasury to prescribe rules

for marginal costing in those cases in which a taxpayer is seeking to establish or maintain a market

for qualifying foreign trade property.

Foreign trading gross receipts

Under the Senate amendment, “foreign trading gross receipts” are gross receipts derived

from certain activities in connection with “qualifying foreign trade property” with respect to which

certain "economic processes" take place outside of the United States. Specifically, the gross

receipts must be (1) from the sale, exchange, or other disposition of qualifying foreign trade

property; (2) from the lease or rental of qualifying foreign trade property for use by the lessee

outside of the United States; (3) for services which are related and subsidiary to the sale,

exchange, disposition, lease, or rental of qualifying foreign trade property (as described above);

(4) for engineering or architectural services for construction projects located outside of the United

States; or (5) for the performance of certain managerial services for unrelated persons. Gross

receipts from the lease or rental of qualifying foreign trade property include gross receipts from

the license of qualifying foreign trade property. Consistent with the policy adopted in the

Taxpayer Relief Act of 1997,8 this includes the license of computer software for reproduction

abroad.

Foreign trading gross receipts do not include gross receipts from a transaction if the

qualifying foreign trade property or services are for ultimate use in the United States, or for use by

the United States (or an instrumentality thereof) and such use is required by law or regulation. 

Foreign trading gross receipts also do not include gross receipts from a transaction that is

accomplished by a subsidy granted by the government (or any instrumentality thereof) of the

country or possession in which the property is manufactured.
9

 The foreign direct costs attributable to the transaction generally must exceed 50 percent

of the total direct costs attributable to the transaction, but the requirement also will be satisfied if,

with respect to at least two categories of direct costs, the foreign direct costs equal or exceed 85

percent of the total direct costs attributable to each category.

10 For this purpose, the receipts of related persons are aggregated and, in the case of passthrough entities, the determination of whether the foreign trading gross receipts exceed $5 million

is made both at the entity and at the partner/shareholder level. 

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A taxpayer may elect to treat gross receipts from a transaction as not foreign trading gross

receipts. As a consequence of such an election, the taxpayer could utilize any related foreign tax

credits in lieu of the exclusion as a means of avoiding double taxation. It is intended that this

election be accomplished by the taxpayer’s treatment of such items on its tax return for the taxable

year. Provided that the taxpayer’s taxable year is still open under the statute of limitations for

making claims for refund under section 6511, a taxpayer can make redeterminations as to whether

the gross receipts from a transaction constitute foreign trading gross receipts.

Foreign economic processes

Under the Senate amendment, gross receipts from a transaction are foreign trading gross

receipts only if certain economic processes take place outside of the United States. The foreign

economic processes requirement is satisfied if the taxpayer (or any person acting under a contract

with the taxpayer) participates outside of the United States in the solicitation (other than

advertising), negotiation, or making of the contract relating to such transaction and incurs a

specified amount of foreign direct costs attributable to the transaction.9 For this purpose, foreign

direct costs include only those costs incurred in the following categories of activities: (1)

advertising and sales promotion; (2) the processing of customer orders and the arranging for

delivery; (3) transportation outside of the United States in connection with delivery to the

customer; (4) the determination and transmittal of a final invoice or statement of account or the

receipt of payment; and (5) the assumption of credit risk. An exception from the foreign economic

processes requirement is provided for taxpayers with foreign trading gross receipts for the year of

$5 million or less.10

The foreign economic processes requirement must be satisfied with respect to each

transaction and, if so, any gross receipts from such transaction could be considered as foreign

trading gross receipts. For example, all of the lease payments received with respect to a multiyear lease contract, which contract met the foreign economic processes requirement at the time it

was entered into, would be considered as foreign trading gross receipts. On the other hand, a sale

of property that was formerly a leased asset, which was not sold pursuant to the original lease

agreement, generally would be considered a new transaction that must independently satisfy the

foreign economic processes requirement.

A taxpayer’s foreign economic processes requirement is treated as satisfied with respect to

a sales transaction (solely for the purpose of determining whether gross receipts are foreign
11 In addition, consistent with the policy adopted in the Taxpayer Relief Act of 1997,

computer software licensed for reproduction is considered as property held primarily for sale,

lease, or rental.

12 “United States” includes Puerto Rico for these purposes because Puerto Rico is

included in the customs territory of the United States.

13 For this purpose, the fair market value of any article imported into the United States is

its appraised value as determined under the Tariff Act of 1930. In addition, direct labor costs are

determined under the principles of section 263A and do not include costs that would be treated as

direct labor costs attributable to "articles," again applying principles of section 263A.

14 See, e.g., sections 927(a)(1)(B) and 993(c)(1)(B).

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trading gross receipts) if any related person has satisfied the foreign economic processes

requirement in connection with another sales transaction involving the same qualifying foreign

trade property.

Qualifying foreign trade property

Under the Senate amendment, the threshold for determining if gross receipts will be treated

as foreign trading gross receipts is whether the gross receipts are derived from a transaction

involving “qualifying foreign trade property.” Qualifying foreign trade property is property

manufactured, produced, grown, or extracted (“manufactured”) within or outside of the United

States that is held primarily for sale, lease, or rental,11 in the ordinary course of a trade or

business, for direct use, consumption, or disposition outside of the United States.12 In addition, not

more than 50 percent of the fair market value of such property can be attributable to the sum of (1)

the fair market value of articles manufactured outside of the United States plus (2) the direct costs

of labor performed outside of the United States.13

It is understood that under current industry practice, the purchaser of an aircraft contracts

separately for the aircraft engine and the airframe, albeit contracting with the airframe

manufacturer to attach the separately purchased engine. It is intended that an aircraft engine be

qualifying foreign trade property (assuming that all other requirements are satisfied) if (1) it is

specifically designed to be separated from the airframe to which it is attached without significant

damage to either the engine or the airframe, (2) it is reasonably expected to be separated from the

airframe in the ordinary course of business (other than by reason of temporary separation for

servicing, maintenance, or repair) before the end of the useful life of either the engine or the

airframe, whichever is shorter, and (3) the terms under which the aircraft engine was sold were

directly and separately negotiated between the manufacturer of the aircraft engine and the person to

whom the aircraft will be ultimately delivered. By articulating this application of the foreign

destination test in the case of certain separable aircraft engines, no inference is intended with

respect to the application of any destination test under present law or with respect to any other rule

of law outside the Senate amendment.14
15 The intangibles that are treated as excluded property under the Senate amendment are:

patents, inventions, models, designs, formulas, or processes whether or not patented, copyrights

(other than films, tapes, records, or similar reproductions, and other than computer software

(whether or not patented), for commercial or home use), goodwill, trademarks, trade brands,

franchises, or other like property. Computer software that is licensed for reproduction outside of

the United States is not excluded from the definition of qualifying foreign trade property.

16 Except as provided by the Secretary of the Treasury, tiered partnerships or pass-through

entities will be considered as partnerships or pass-through entities for purposes of this rule if each

of the partnerships or entities is directly or indirectly wholly-owned by persons described in (1),

(2), or (3) above.

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The Senate amendment excludes certain property from the definition of qualifying foreign

trade property. The excluded property is (1) property leased or rented by the taxpayer for use by a

related person, (2) certain intangibles,15 (3) oil and gas (or any primary product thereof), (4)

unprocessed softwood timber, (5) certain products the transfer of which are prohibited or curtailed

to effectuate the policy set forth in Public Law 96-72, and (6) property designated by Executive

order as in short supply. In addition, it is intended that property that is leased or licensed to a

related person who is the lessor, licensor, or seller of the same property in a sublease, sublicense,

sale, or rental to an unrelated person for the ultimate and predominate use by the unrelated person

outside of the United States is not excluded property by reason of such lease or license to a related

person.

With respect to property that is manufactured outside of the United States, rules are

provided to ensure consistent U.S. tax treatment with respect to manufacturers. The Senate

amendment requires that property manufactured outside of the United States be manufactured by (1)

a domestic corporation, (2) an individual who is a citizen or resident of the United States, (3) a

foreign corporation that elects to be subject to U.S. taxation in the same manner as a U.S.

corporation, or (4) a partnership or other pass-through entity all of the partners or owners of which

are described in (1), (2), or (3) above.16

Foreign trade income

Under the Senate amendment, “foreign trade income” is the taxable income of the taxpayer

(determined without regard to the exclusion of qualifying foreign trade income) attributable to

foreign trading gross receipts. Certain dividends-paid deductions of cooperatives are disregarded

in determining foreign trade income for this purpose.

Foreign sale and leasing income

Under the Senate amendment, “foreign sale and leasing income” is the amount of the

taxpayer’s foreign trade income (with respect to a transaction) that is properly allocable to

activities that constitute foreign economic processes (as described above). For example, a

distribution company’s profit from the sale of qualifying foreign trade property that is associated
17 For this purpose, such a lease includes a lease that gave rise to exempt foreign trade

income under the FSC provisions.

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with sales activities, such as solicitation or negotiation of the sale, advertising, processing

customer orders and arranging for delivery, transportation outside of the United States, and other

enumerated activities, would constitute foreign sale and leasing income.

Foreign sale and leasing income also includes foreign trade income derived by the

taxpayer in connection with the lease or rental of qualifying foreign trade property for use by the

lessee outside of the United States. Income from the sale, exchange, or other disposition of

qualifying foreign trade property that is or was subject to such a lease17 (i.e., the sale of the

residual interest in the leased property) gives rise to foreign sale and leasing income. Except as

provided in regulations, a special limitation applies to leased property that (1) is manufactured by

the taxpayer or (2) is acquired by the taxpayer from a related person for a price that was other than

arm’s length. In such cases, foreign sale and leasing income may not exceed the amount of foreign

sale and leasing income that would have resulted if the taxpayer had acquired the leased property

in a hypothetical arm’s-length purchase and then engaged in the actual sale or lease of such

property. For example, if a manufacturer leases qualifying foreign trade property that it

manufactured, the foreign sale and leasing income derived from that lease may not exceed the

amount of foreign sale and leasing income that the manufacturer would have earned with respect to

that lease had it purchased the property for an arm’s-length price on the day that the manufacturer

entered into the lease. For purposes of calculating the limit on foreign sale and leasing income, the

manufacturer’s basis and, thus, depreciation would be based on this hypothetical arm’s-length

price. This limitation is intended to prevent foreign sale and leasing income from including profit

associated with manufacturing activities.

For purposes of determining foreign sale and leasing income, only directly allocable

expenses are taken into account in calculating the amount of foreign trade income. In addition,

income properly allocable to certain intangibles is excluded for this purpose.

General Example

The following is an example of the calculation of qualifying foreign trade income.

XYZ Corporation, a U.S. corporation, manufactures property that is sold to unrelated

customers for use outside of the United States. XYZ Corporation satisfies the foreign economic

processes requirement through conducting activities such as solicitation, negotiation,

transportation, and other sales-related activities outside of the United States with respect to its

transactions. During the year, qualifying foreign trade property was sold for gross proceeds

totaling $1,000. The cost of this qualifying foreign trade property was $600. XYZ Corporation

incurred $275 of costs that are directly related to the sale and distribution of qualifying foreign

trade property. XYZ Corporation paid $40 of income tax to a foreign jurisdiction related to the

sale and distribution of the qualifying foreign trade property. XYZ Corporation also generated

gross income of $7,600 (gross receipts of $24,000 and cost of goods sold of $16,400) and direct
18 “QFTP” refers to qualifying foreign trade property.

19 Overhead expenses must be apportioned in a reasonable manner that does not result in a

material distortion of income. In this example, the apportionment of the $500 of overhead

expenses on the basis of gross income is assumed not to result in a material distortion of income

and is assumed to be a reasonable method of apportionment. Thus, $25 ($500 of total overhead

expenses multiplied by 5 percent, i.e., $400 of gross income from the sale of qualifying foreign

trade property divided by $8,000 of total gross income) is apportioned to qualifying foreign

trading gross receipts. The remaining $475 ($500 of total overhead expenses less the $25

apportioned to qualifying income) is apportioned to XYZ Corporation’s other income.

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expenses of $4,225 that relate to the manufacture and sale of products other than qualifying foreign

trade property. XYZ Corporation also incurred $500 of overhead expenses. XYZ Corporation’s

financial information for the year is summarized as follows:

Total Other Property QFTP18

Gross receipts .......... $25,000.00 $24,000.00 $1,000.00

Cost of goods sold ...... 17,000.00 16,400.00 600.00

Gross income .......... 8,000.00 7,600.00 400.00

Direct expenses ........ 4,500.00 4,225.00 275.00

Overhead expenses ...... 500.00

Net income ............ 3,000.00

Illustrated below is the computation of the amount of qualifying foreign trade income that is

excluded from XYZ Corporation’s gross income and the amount of related expenses that are

disallowed. In order to calculate qualifying foreign trade income, the amount of foreign trade

income first must be determined. Foreign trade income is the taxable income (determined without

regard to the exclusion of qualifying foreign trade income) attributable to foreign trading gross

receipts. In this example, XYZ Corporation’s foreign trading gross receipts equal $1,000. This

amount of gross receipts is reduced by the related cost of goods sold, the related direct expenses,

and a portion of the overhead expenses in order to arrive at the related taxable income.19 Thus,

XYZ Corporation’s foreign trade income equals $100, calculated as follows:

Foreign trading gross receipts ....... $1,000.00

Cost of goods sold ................ 600.00

Gross income .................... 400.00

Direct expenses .................. 275.00

Apportioned overhead expenses ...... 25.00

Foreign trade income .............. 100.00
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Foreign sale and leasing income is defined as an amount of foreign trade income

(calculated taking into account only directly-related expenses) that is properly allocable to certain

specified foreign activities. Assume for purposes of this example that of the $125 of foreign trade

income ($400 of gross income from the sale of qualifying foreign trade property less only the

direct expenses of $275), $35 is properly allocable to such foreign activities (e.g., solicitation,

negotiation, advertising, foreign transportation, and other enumerated sales-like activities) and,

therefore, is considered to be foreign sale and leasing income.

Qualifying foreign trade income is the amount of gross income that, if excluded, will result

in a reduction of taxable income equal to the greatest of (1) 30 percent of foreign sale and leasing

income, (2) 1.2 percent of foreign trading gross receipts, or (3) 15 percent of foreign trade income. 

Thus, in order to calculate the amount that is excluded from gross income, taxable income must be

determined and then “grossed up” for allocable expenses in order to arrive at the appropriate

gross income figure. First, for each method of calculating qualifying foreign trade income, the

reduction in taxable income is determined. Then, the $275 of direct and $25 of overhead

expenses, totaling $300, attributable to foreign trading gross receipts is apportioned to the

reduction in taxable income based on the proportion of the reduction in taxable income to foreign

trade income. This apportionment is done for each method of calculating qualifying foreign trade

income. The sum of the taxable income reduction and the apportioned expenses equals the

respective qualifying foreign trade income (i.e., the amount of gross income excluded) under each

method, as follows:
20 Note that XYZ Corporation could choose to use one of the other two methods

notwithstanding that they would result in a smaller exclusion.

21 The $300 of allocable expenses includes both the $275 of direct expenses and the $25

of overhead expenses. Thus, the $45 of disallowed expenses represents the sum of $41.25 of

direct expenses plus $3.75 of overhead expenses. If qualifying foreign trade income were

determined using 30 percent of foreign sale and leasing income, the disallowed expenses would

include only the appropriate portion of the direct expenses.

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1.2% 15% 30%

FTGR1 FTI2 FS&LI3

Reduction of taxable income

1.2% of FTGR (1.2% * $1,000) 12.00 

15% of FTI (15% * $100) 15.00 

30% of FS&LI (30% * $35) 10.50 

Gross-up for disallowed expenses

$300 * ($12/$100) 36.00 

$300 * ($15/$100) 45.00 

$275 * ($10.50/$100)4 28.88 

Qualifying foreign trade income 48.00 60.00 39.38

1

 “FTGR” refers to foreign trading gross receipts.

2

 “FTI” refers to foreign trade income.

3

 “FS&LI” refers to foreign sale and leasing income.

4

 Because foreign sale and leasing income only takes into account direct expenses, it is appropriate

to take into account only such expenses for purposes of this calculation.

In the example, the $60 of qualifying foreign trade income is excluded from XYZ

Corporation’s gross income (determined based on 15 percent of foreign trade income).20 In

connection with excluding $60 of gross income, certain expenses that are allocable to this income

are not deductible for U.S. Federal income tax purposes. Thus, $45 ($300 of related expenses

multiplied by 15 percent, i.e., $60 of qualifying foreign trade income divided by $400 of gross

income from the sale of qualifying foreign trade property) of expenses are disallowed.21
- 15 -

Other

Property QFTP

Excluded/

Disallowed Total

Gross receipts $24,000.00 $1,000.00

Cost of goods sold 16,400.00 600.00

Gross income 7,600.00 400.00 (60.00) 7,940.00

Direct expenses 4,225.00 275.00 (41.25) 4,458.75

Overhead expenses 475.00 25.00 (3.75) 496.25

Taxable income 2,985.00

XYZ Corporation paid $40 of income tax to a foreign jurisdiction related to the sale and

distribution of the qualifying foreign trade property. A portion of this $40 of foreign income tax is

treated as paid with respect to the qualifying foreign trade income and, therefore, is not creditable

for U.S. foreign tax credit purposes. In this case, $6 of such taxes paid ($40 of foreign taxes

multiplied by 15 percent, i.e., $60 of qualifying foreign trade income divided by $400 of gross

income from the sale of qualifying foreign trade property) is treated as paid with respect to the

qualifying foreign trade income and, thus, is not creditable.

The results in this example are the same regardless of whether XYZ Corporation

manufactures the property within the United States or outside of the United States through a foreign

branch. If XYZ Corporation were an S corporation or limited liability company, the results also

would be the same, and the exclusion would pass through to the S corporation owners or limited

liability company owners as the case may be.

Other rules

Foreign-source income limitation

The Senate amendment provides a limitation with respect to the sourcing of taxable income

applicable to certain sale transactions giving rise to foreign trading gross receipts. This limitation

only applies with respect to sale transactions involving property that is manufactured within the

United States. The special source limitation does not apply when qualifying foreign trade income

is determined using 30 percent of the foreign sale and leasing income from the transaction.

This foreign-source income limitation is determined in one of two ways depending on

whether the qualifying foreign trade income is calculated based on 1.2 percent of foreign trading

gross receipts or on 15 percent of foreign trade income. If the qualifying foreign trade income is

calculated based on 1.2 percent of foreign trading gross receipts, the related amount of foreignsource income may not exceed the amount of foreign trade income that (without taking into account

this special foreign-source income limitation) would be treated as foreign-source income if such

foreign trade income were reduced by 4 percent of the related foreign trading gross receipts.
22 The foreign-source income limitation provisions also apply when source is determined

solely in accordance with section 862 (e.g., a distributor of qualifying foreign trade property that

is manufactured in the United States by an unrelated person and sold for use outside of the United

States).

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For example, assume that foreign trading gross receipts are $2,000 and foreign trade

income is $100. Assume also that the taxpayer chooses to determine qualifying foreign trade

income based on 1.2 percent of foreign trading gross receipts. Taxable income after taking into

account the exclusion of the qualifying foreign trade income and the disallowance of related

deductions is $76. Assume that the taxpayer manufactured its qualifying foreign trade property in

the United States and that title to such property passed outside of the United States. Absent a

special sourcing rule, under section 863(b) (and the regulations thereunder) the $76 of taxable

income would be sourced as $38 U.S. source and $38 foreign source. Under the special sourcing

rule, the amount of foreign-source income may not exceed the amount of the foreign trade income

that otherwise would be treated as foreign source if the foreign trade income were reduced by 4

percent of the related foreign trading gross receipts. Reducing foreign trade income by 4 percent

of the foreign trading gross receipts (4 percent of $2,000, or $80) would result in $20 ($100

foreign trade income less $80). Applying section 863(b) to the $20 of reduced foreign trade

income would result in $10 of foreign-source income and $10 of U.S.-source income. 

Accordingly, the limitation equals $10. Thus, although under the general sourcing rule $38 of the

$76 taxable income would be treated as foreign source, the special sourcing rule limits foreignsource income in this example to $10 (with the remaining $66 being treated as U.S.-source

income).

If the qualifying foreign trade income is calculated based on 15 percent of foreign trade

income, the amount of related foreign-source income may not exceed 50 percent of the foreign

trade income that (without taking into account this special foreign-source income limitation) would

be treated as foreign-source income.

For example, assume that foreign trade income is $100 and the taxpayer chooses to

determine its qualifying foreign trade income based on 15 percent of foreign trade income. 

Taxable income after taking into account the exclusion of the qualifying foreign trade income and

the disallowance of related deductions is $85. Assume that the taxpayer manufactured its

qualifying foreign trade property in the United States and that title to such property passed outside

of the United States. Absent a special sourcing rule, under section 863(b) the $85 of taxable

income would be sourced as $42.50 U.S. source and $42.50 foreign source. Under the special

sourcing rule, the amount of foreign-source income may not exceed 50 percent of the foreign trade

income that otherwise would be treated as foreign source. Applying section 863(b) to the $100 of

foreign trade income would result in $50 of foreign-source income and $50 of U.S.-source income. 

Accordingly, the limitation equals $25, which is 50 percent of the $50 foreign-source income. 

Thus, although under the general sourcing rule $42.50 of the $85 taxable income would be treated

as foreign source, the special sourcing rule limits foreign-source income in this example to $25

(with the remaining $60 being treated as U.S.-source income).22
23 With respect to the withholding taxes that are paid or accrued (a prerequisite to the taxes

being otherwise creditable), the provision in the Senate amendment treats such taxes as not being

paid or accrued with respect to qualifying foreign trade income.

24 This also would apply to any withholding tax that is creditable for U.S. foreign tax

credit purposes under an applicable treaty.

25 The waiver of treaty benefits applies to the corporation itself and not, for example, to

employees of or independent contractors associated with the corporation.

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Treatment of withholding taxes

The Senate amendment generally provides that no foreign tax credit is allowed for foreign

taxes paid or accrued with respect to qualifying foreign trade income (i.e., excluded

extraterritorial income). In determining whether foreign taxes are paid or accrued with respect to

qualifying foreign trade income, foreign withholding taxes generally are treated as not paid or

accrued with respect to qualifying foreign trade income.23 Accordingly, the Senate amendment's

denial of foreign tax credits would not apply to such taxes. For this purpose, the term

“withholding tax” refers to any foreign tax that is imposed on a basis other than residence and that

is otherwise a creditable foreign tax under sections 901 or 903.24 It is intended that such taxes

would be similar in nature to the gross-basis taxes described in sections 871 and 881.

If, however, qualifying foreign trade income is determined based on 30 percent of foreign

sale and leasing income, the special rule for withholding taxes is not applicable. Thus, in such

cases foreign withholding taxes may be treated as paid or accrued with respect to qualifying

foreign trade income and, accordingly, are not creditable under the Senate amendment.

Election to be treated as a U.S. corporation

The Senate amendment provides that certain foreign corporations may elect, on an original

return, to be treated as domestic corporations. The election applies to the taxable year when made

and all subsequent taxable years unless revoked by the taxpayer or terminated for failure to qualify

for the election. Such election is available for a foreign corporation (1) that manufactures property

in the ordinary course of such corporation’s trade or business, or (2) if substantially all of the

gross receipts of such corporation are foreign trading gross receipts. For this purpose,

“substantially all” is based on the relevant facts and circumstances.

In order to be eligible to make this election, the foreign corporation must waive all benefits

granted to such corporation by the United States pursuant to a treaty.25 Absent such a waiver, it

would be unclear, for example, whether the permanent establishment article of a relevant tax treaty

would override the electing corporation’s treatment as a domestic corporation under this

provision. A foreign corporation that elects to be treated as a domestic corporation is not

permitted to make an S corporation election. The Secretary is granted authority to prescribe rules

to ensure that the electing foreign corporation pays its U.S. income tax liabilities and to designate
26 For example, the Secretary of the Treasury may prescribe rules to prevent “per se”

corporations under the entity-classification rules from making such an election.

27 The sourcing limitation described above would not apply to this example because the

property is manufactured outside of the United States.

- 18 -

one or more classes of corporations that may not make such an election.26 If such an election is

made, for purposes of section 367 the foreign corporation is treated as transferring (as of the first

day of the first taxable year to which the election applies) all of its assets to a domestic

corporation in connection with an exchange to which section 354 applies.

If a corporation fails to meet the applicable requirements, described above, for making the

election to be treated as a domestic corporation for any taxable year beginning after the year of the

election, the election will terminate. In addition, a taxpayer, at its option and at any time, may

revoke the election to be treated as a domestic corporation. In the case of either a termination or a

revocation, the electing foreign corporation will not be considered as a domestic corporation

effective beginning on the first day of the taxable year following the year of such termination or

revocation. For purposes of section 367, if the election to be treated as a domestic corporation is

terminated or revoked, such corporation is treated as a domestic corporation transferring (as of the

first day of the first taxable year to which the election ceases to apply) all of its property to a

foreign corporation in connection with an exchange to which section 354 applies. Moreover, once

a termination occurs or a revocation is made, the former electing corporation may not again elect

to be taxed as a domestic corporation under the provisions of the Senate amendment for a period of

five tax years beginning with the first taxable year that begins after the termination or revocation.

For example, assume a U.S. corporation owns 100 percent of a foreign corporation. The

foreign corporation manufactures outside of the United States and sells what would be qualifying

foreign trade property were it manufactured by a person subject to U.S. taxation. Such foreign

corporation could make the election under this provision to be treated as a domestic corporation. 

As a result, its earnings no longer would be deferred from U.S. taxation. However, by electing to

be subject to U.S. taxation, a portion of its income would be qualifying foreign trade income.27

The requirement that the foreign corporation be treated as a domestic corporation (and, therefore,

subject to U.S. taxation) is intended to provide parity between U.S. corporations that manufacture

abroad in branch form and U.S. corporations that manufacture abroad through foreign subsidiaries. 

The election, however, is not limited to U.S.-owned foreign corporations. A foreign-owned

foreign corporation that wishes to qualify for the treatment provided under the Senate amendment

could avail itself of such election (unless otherwise precluded from doing so by Treasury

regulations).

Shared partnerships

The Senate amendment provides rules relating to allocations of qualifying foreign trade

income by certain shared partnerships. To the extent that such a partnership (1) maintains a

separate account for transactions involving foreign trading gross receipts with each partner, (2)
- 19 -

makes distributions to each partner based on the amounts in the separate account, and (3) meets

such other requirements as the Treasury Secretary may prescribe by regulations, such partnership

then would allocate to each partner items of income, gain, loss, and deduction (including

qualifying foreign trade income) from such transactions on the basis of the separate accounts. It is

intended that with respect to, and only with respect to, such allocations and distributions (i.e.,

allocations and distributions related to transactions between the partner and the shared partnership

generating foreign trading gross receipts), these rules would apply in lieu of the otherwise

applicable partnership allocation rules such as those in section 704(b). For this purpose, a

partnership is a foreign or domestic entity that is considered to be a partnership for U.S. Federal

income tax purposes.

Under the Senate amendment, any partner’s interest in the shared partnership is not taken

into account in determining whether such partner is a “related person” with respect to any other

partner for purposes of the Senate amendment’s provisions. Also, the election to exclude certain

gross receipts from foreign trading gross receipts must be made separately by each partner with

respect to any transaction for which the shared partnership maintains a separate account.

Certain assets not taken into account for purposes of interest expense

allocation

The Senate amendment also provides that qualifying foreign trade property that is held for

lease or rental, in the ordinary course of a trade or business, for use by the lessee outside of the

United States is not taken into account for interest allocation purposes.

Distributions of qualifying foreign trade income by cooperatives

Agricultural and horticultural producers often market their products through cooperatives,

which are member-owned corporations formed under Subchapter T of the Code. At the

cooperative level, the Senate amendment provides the same treatment of foreign trading gross

receipts derived from products marketed through cooperatives as it provides for foreign trading

gross receipts of other taxpayers. That is, the qualifying foreign trade income attributable to those

foreign trading gross receipts is excluded from the gross income of the cooperative. Absent a

special rule, however, patronage dividends or per-unit retain allocations attributable to qualifying

foreign trade income paid to members of cooperatives would be taxable in the hands of those

members. It is believed that this would disadvantage agricultural and horticultural producers who

choose to market their products through cooperatives relative to those individuals who market

their products directly or through pass-through entities such as partnerships, limited liability

companies, or S corporations. Accordingly, the Senate amendment provides that the amount of any

patronage dividends or per-unit retain allocations paid to a member of an agricultural or

horticultural cooperative (to which Part I of Subchapter T applies), which is allocable to

qualifying foreign trade income of the cooperative, is treated as qualifying foreign trade income of

the member (and, thus, excludable from such member’s gross income). In order to qualify, such

amount must be designated by the organization as allocable to qualifying foreign trade income in a

written notice mailed to its patrons not later than the payment period described in section 1382(d). 
28 See, e.g., Treas. Reg. sec. 1.924(d)-1(c)(5) and (e); Temp. Treas. Reg. sec. 1.925(a)-

1T(c)(8); Temp. Treas. Reg. sec. 1.925(b)-1T. 

29 See Temp. Treas. Reg. sec. 1.927(a)-1T(f)(2)(i). The Senate amendment also provides

that oil or gas or primary products from oil or gas are excluded from the definition of qualifying

foreign trade property. It is intended that similar principles under present-law regulations apply

for these purposes. Thus, for this purpose, petrochemicals, medicinal products, insecticides, and

alcohols are not considered primary products from oil or gas and, thus, are not treated as excluded

property. See Temp. Treas. Reg. sec. 1.927(a)-1T(g)(2)(iv).

- 20 -

The cooperative cannot reduce its income (e.g., cannot claim a "dividends-paid deduction") under

section 1382 for such amounts.

Gap period before administrative guidance is issued

It is recognized that there may be a gap in time between the enactment of the Senate

amendment and the issuance of detailed administrative guidance. It is intended that during this gap

period before administrative guidance is issued, taxpayers and the Internal Revenue Service may

apply the principles of present-law regulations and other administrative guidance under sections

921 through 927 to analogous concepts under the Senate amendment. Some examples of the

application of the principles of present-law regulations to the Senate amendment are described

below. These limited examples are intended to be merely illustrative and are not intended to

imply any limitation regarding the application of the principles of other analogous rules or

concepts under present law.

Marginal costing and grouping

Under the Senate amendment, the Secretary of the Treasury is provided authority to

prescribe rules for using marginal costing and for grouping transactions in determining qualifying

foreign trade income. It is intended that similar principles under present-law regulations apply for

these purposes.28

Excluded property

The Senate amendment provides that qualifying foreign trade property does not include

property leased or rented by the taxpayer for use by a related person. It is intended that similar

principles under present-law regulations apply for this purpose. Thus, excluded property does not

apply, for example, to property leased by the taxpayer to a related person if the property is held for

sublease, or is subleased, by the related person to an unrelated person and the property is

ultimately used by such unrelated person predominantly outside of the United States.29 In addition,

consistent with the policy adopted in the Taxpayer Relief Act of 1997, computer software that is

licensed for reproduction outside of the United States is not excluded property. Accordingly, the

license of computer software to a related person for reproduction outside of the United States for
30 See Temp. Treas. Reg. sec. 1.924(a)-1T(a)(2).

31 Foreign trading gross receipts eligible for exclusion from the tax base do not include

gross receipts from a transaction if the qualifying foreign trade property is for ultimate use in the

United States.

32 See Temp. Treas. Reg. sec. 1.927(a)-1T(d)(4)(ii).

33 See Temp. Treas. Reg. sec. 1.927(a)-1T(d)(4)(iii), (iv), and (v).

34 See Temp. Treas. Reg. sec. 1.927(a)-1T(d)(4)(vi).

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sale, sublicense, lease, or rental to an unrelated person for use outside of the United States is not

treated as excluded property by reason of the license to the related person. 

Foreign trading gross receipts

Under the Senate amendment, foreign trading gross receipts are gross receipts from, among

other things, the sale, exchange, or other disposition of qualifying foreign trade property, and from

the lease of qualifying foreign trade property for use by the lessee outside of the United States. It

is intended that the principles of present-law regulations that define foreign trading gross receipts

apply for this purpose. For example, a sale includes an exchange or other disposition and a lease

includes a rental or sublease and a license or a sublicense.30 

Foreign use requirement

Under the Senate amendment, property constitutes qualifying foreign trade property if,

among other things, the property is held primarily for lease, sale, or rental, in the ordinary course

of business, for direct use, consumption, or disposition outside of the United States.31 It is

intended that the principles of the present-law regulations apply for purposes of this foreign use

requirement. For example, for purposes of determining whether property is sold for use outside of

the United States, property that is sold to an unrelated person as a component to be incorporated

into a second product which is produced, manufactured, or assembled outside of the United States

will not be considered to be used in the United States (even if the second product ultimately is

used in the United States), provided that the fair market value of such seller’s components at the

time of delivery to the purchaser constitutes less than 20 percent of the fair market value of the

second product into which the components are incorporated (determined at the time of completion

of the production, manufacture, or assembly of the second product).32

In addition, for purposes of the foreign use requirement, property is considered to be used

by a purchaser or lessee outside of the United States during a taxable year if it is used

predominantly outside of the United States.33 For this purpose, property is considered to be used

predominantly outside of the United States for any period if, during that period, the property is

located outside of the United States more than 50 percent of the time.34 An aircraft or other
35 Id.

36 Id.

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property used for transportation purposes (e.g., railroad rolling stock, a vessel, a motor vehicle, or

a container) is considered to be used outside of the United States for any period if, for the period,

either the property is located outside of the United States more than 50 percent of the time or more

than 50 percent of the miles traveled in the use of the property are traveled outside of the United

States.35 An orbiting satellite is considered to be located outside of the United States for these

purposes.36

Foreign economic processes

Under the Senate amendment, gross receipts from a transaction are foreign trading gross

receipts eligible for exclusion from the tax base only if certain economic processes take place

outside of the United States. The foreign economic processes requirement compares foreign direct

costs to total direct costs. It is intended that the principles of the present-law regulations apply

during the gap period for purposes of the foreign economic processes requirement including the

measurement of direct costs. It is recognized that the measurement of foreign direct costs under the

present-law regulations often depend on activities conducted by the FSC, which is a separate

entity. It is recognized that some of these concepts will have to be modified when new guidance is

promulgated as a result of the Senate amendment’s elimination of the requirement for a separate

entity.

Effective date

In general

The Senate amendment is effective for transactions entered into after September 30, 2000. 

In addition, no corporation may elect to be a FSC after September 30, 2000. 

The Senate amendment also provides a rule requiring the termination of a dormant FSC

when the FSC has been inactive for a specified period of time. Under this rule, a FSC that

generates no foreign trade income for any five consecutive years beginning after December 31,

2001, will cease to be treated as a FSC.

Transition rules

Winding down existing FSCs and binding contract relief

The Senate amendment provides a transition period for existing FSCs and for binding

contractual agreements. The new rules do not apply to transactions in the ordinary course of
37 The mere entering into of a single transaction, such as a lease, would not, in and of

itself, prevent the transaction from being in the ordinary course of business.

38 It is anticipated that ordering rules similar to those that have been applied in guidance

under section 953(d) would apply to distributions from the electing corporation. See Notice 89-

79, 1989-2 C.B. 392.

- 23 -

business37 involving a FSC before January 1, 2002. Furthermore, the new rules do not apply to

transactions in the ordinary course of business after December 31, 2001, if such transactions are

pursuant to a binding contract between a FSC (or a person related to the FSC on September 30,

2000) and any other person (that is not a related person) and such contract is in effect on

September 30, 2000, and all times thereafter. For this purpose, binding contracts include purchase

options, renewal options, and replacement options that are enforceable against a lessor or seller

(provided that the options are a part of a contract that is binding and in effect on September 30,

2000).

Old earnings and profits of corporations electing to be treated as

domestic corporations

A transition rule also is provided for certain corporations electing to be treated as a

domestic corporation under the Senate amendment. In the case of a corporation to which this

transition rule applies, the corporation’s earnings and profits accumulated in taxable years ending

before October 1, 2000 are not included in the gross income of the shareholder by reason of the

deemed asset transfer for section 367 purposes that the Senate amendment provides. Thus,

although the electing corporation may be treated as transferring all of its assets to a domestic

corporation in a reorganization described in section 368(a)(1)(F), the earnings and profits amount

that would otherwise be treated as a deemed dividend to the U.S. shareholder under the regulations

under section 367(b) will not include the earnings and profits accumulated in taxable years ending

before October 1, 2000. This treatment is similar to the treatment of earnings and profits of a

foreign insurance company that makes the election to be treated as a domestic corporation under

section 953(d), which election was a model for the election to be treated as a domestic

corporation under the Senate amendment. Under section 953(d), earnings and profits accumulated

in taxable years beginning before January 1, 1988 were not included in the earnings and profits

amount that would be a deemed dividend for section 367(b) purposes. 

Like the pre-1988 earnings and profits of a domesticating foreign insurance company under

section 953(d), the earnings and profits to which this transition rule applies would continue to be

treated as earnings and profits of a foreign corporation even after the corporation elects to be

treated as a domestic corporation. Thus, a distribution out of earnings and profits of an electing

corporation accumulated in taxable years ending before October 1, 2000 would be treated as a

distribution made by a foreign corporation.38 Rules similar to those applicable to corporations

making the section 953(d) election that prevent the repatriation of pre-election period earnings and

profits without current U.S. taxation apply for this purpose. Thus, for example, the earnings and
39 See the rules of section 953(d)(4)(ii), (iii) and (iv).

40 The ultimate owner must be an actual domestic corporation, not a corporation that elects

to be treated as a domestic corporation under the Senate amendment. In addition, although the

controlled foreign corporation must be wholly owned for this purpose, it is intended that the mere

nominal ownership of an insignificant number of shares of insignificant value (which may, for

example, be required by foreign law) by someone unrelated to the domestic parent would not

cause the controlled foreign corporation to fail to be wholly owned for these purposes.

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profits accumulated in taxable years beginning before October 1, 2000 would continue to be taken

into account for section 1248 purposes.39

The earnings and profits to which the transition rule applies are the earnings and profits

accumulated by the electing corporation in taxable years ending before October 1, 2000. The

transition rule will not apply to earnings and profits accumulated before that date that are

succeeded to after that date by the electing corporation in a transaction to which section 381

applies unless, like the electing corporation, the distributor or transferor (from whom the electing

corporation acquired the earnings and profits) could have itself made the election under the Senate

amendment to be treated as a domestic corporation and would have been eligible for the transition

relief.

The transition rule for old earnings and profits applies to two classes of taxpayers. The

first class is FSCs in existence on September 30, 2000 that make an election to be treated as a

domestic corporation because they satisfy the requirement that substantially all of their gross

receipts are foreign trading gross receipts. To be eligible for the transition relief, the election

must be made not later than for the FSC’s first taxable year beginning after December 31, 2001.

The second class of corporations to which this transition relief applies is certain

controlled foreign corporations (as defined in section 957). Notwithstanding other requirements

for making the election to be treated as a domestic corporation provided under the Senate

amendment’s general provisions, such controlled foreign corporations are eligible under the

transition rule to make the election to be treated as a domestic corporation and will not have the

resulting deemed asset transfer cause a deemed inclusion of earnings and profits for earnings and

profits accumulated in taxable years ending before October 1, 2000. To be eligible for the

transition relief, such a controlled foreign corporation must be in existence on September 30,

2000. The controlled foreign corporation must be wholly owned, directly or indirectly, by a

domestic corporation.40 The controlled foreign corporation must never have made an election to

be treated as a FSC and must make the election to be treated as a domestic corporation not later

than for its first taxable year beginning after December 31, 2001. In addition, the controlled

foreign corporation must satisfy certain tests with respect to its income and activities. For

administrative convenience, these tests are limited to the three taxable years preceding the first

taxable year for which the election to be treated as a domestic corporation applies. First, during

that three-year period, all of the controlled foreign corporation’s gross income must be subpart F

income. Thus, the income was subject to full inclusion to the U.S. shareholder and, accordingly,
41 It is intended that, if the controlled foreign corporation’s and related FSC’s taxable

years are still open under the statute of limitations for claims for refund under section 6511,

redeterminations with respect to sales or commissions paid to the FSC are permitted for this

purpose. See Temp. Treas. Reg. sec. 1.925(a)-1T(d)(4).

- 25 -

subject to current U.S. taxation. Second, during that three-year period, the controlled foreign

corporation must have, in the ordinary course of its trade or business, entered into transactions in

which it regularly sold or paid commissions to a related FSC (which also was in existence on

September 30, 2000).41 If an electing corporation in this second class ceases to be (directly or

indirectly) wholly owned by the domestic corporation that owns it on September 30, 2000, the

election to be treated as a domestic corporation is terminated.

Limitation on use of the gross receipts method

Similar to the limitation on use of the gross receipts method under the Senate amendment's

operative provisions, the Senate amendment provides a rule that limits the use of the gross receipts

method for transactions after the effective date of the Senate amendment if that same property

generated foreign trade income to a FSC using the gross receipts method. Under the rule, if any

person used the gross receipts method under the FSC regime, neither that person nor any related

person will have qualifying foreign trade income with respect to any other transaction involving

the same item of property.

Coordination of new regime with prior law

Notwithstanding the transition period, FSCs (or related persons) may elect to have the

rules of the Senate amendment apply in lieu of the rules applicable to FSCs. Thus, for transactions

to which the transition rules apply (i.e., transactions after September 30, 2000 that occur (1)

before January 1, 2002 or (2) after December 31, 2001 pursuant to a binding contract which is in

effect on September 30, 2000), taxpayers may choose to apply either the FSC rules or the

amendments made by this Senate amendment, but not both. In addition, a taxpayer would not be

able to avail itself of the rules of the Senate amendment in addition to the rules applicable to

domestic international sales corporations because the Senate amendment provides that the

exclusion of extraterritorial income will not apply if a taxpayer is a member of any controlled

group of which a domestic international sales corporation is a member.