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FENWICK, DAVIS & WEST SAYS TO ALLOW USE OF DISC SECOND STAGE APPORTIONMENT RULES IN MAKING DISC-TYPE COMPUTATION.

AUG. 30, 1988

FENWICK, DAVIS & WEST SAYS TO ALLOW USE OF DISC SECOND STAGE APPORTIONMENT RULES IN MAKING DISC-TYPE COMPUTATION.

DATED AUG. 30, 1988
DOCUMENT ATTRIBUTES
  • Authors
    Fuller, James P.
    Lanford, Jennifer L.
  • Institutional Authors
    Fenwick, Davis & West
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    gross income from sources within the United States
    source rules
    Domestic International Sales Corporation (DISC)
    Foreign Sales Corporation (FSC)
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 88-7513
  • Tax Analysts Electronic Citation
    88 TNT 184-30

 

=============== SUMMARY ===============

 

James P. Fuller and Jennifer L. Lanford of Fenwick, Davis & West, Palo Alto, Calif., have criticized proposed regulation sections 1.861-8(f) and (g) for their interaction with section 927(e)(1). Fuller and Lanford say that the regulation generally reaches the correct result, since the section 904(d) FSC dividend income category is usually reduced to zero as a result of the dividends received deduction under section 245(c).

Fuller and Lanford say that the DISC-like computation under proposed regulation section 1.861-8(g), example (23)(iv) "should start with gross foreign receipts and reflect the pre-DEFRA apportionment of expenses to the section 904(d) DISC dividend category." They say that under the proposed limitation, the section 927(e)(1) limitation is calculated using 50 percent of combined taxable income, without any expense apportionment to DISC dividends. They compute the limitation with respect to a particular fact pattern under the regulation and then compute the limitation as they say that Congress intended. Fuller and Lanford say, "Congress' intent was simply to prevent the U.S. parent of a FSC from obtaining more foreign source income under the FSC rules than it obtained under the pre-DEFRA DISC rules." They suggest that the regulation be modified to allow for the use of the DISC second stage apportionment rules in the section 927(e)(1) DISC-like computation.

 

=============== FULL TEXT ===============

 

August 30, 1988

 

 

Commissioner of Internal Revenue

 

Internal Revenue Service

 

1111 Constitution Avenue, N.W.

 

Washington, D.C. 20224

 

 

Attention: CC:LR:T (INTL-28-86)

 

 

Subject: Comments on Proposed Treasury Regulations sections 1.861-

 

8(f)(1)(iii), (vi)(C) and (g) Examples (22) and (23)

 

 

Dear Sir:

We are submitting comments on Prop. Treas. Reg. section 1.861- 8(f) and (g). We commend the Service for proposing this change, but believe that the regulation's example contains a significant error insofar as section 927(e) is concerned.

Present Treas. Reg. section 1.861-8(g) Examples (22) and (23) address expense apportionment in the case of a Domestic International Sales Corporation (DISC). The present regulation requires a two stage apportionment process. After allocating expenses to export sales for purposes of computing combined taxable income and the allowable DISC commission, these costs are allocated to export sales income and to the DISC dividend for purposes of section 904. We believe these examples generally produced the correct result under prior (pre- DEFRA) law.

The proposed regulation modifies Examples (22) and (23) of the present regulation with expense apportionment rules for Foreign Sales Corporations (FSCs). Expenses are not allocated to the section 904(d) FSC dividend income category for taxable years beginning after December 31, 1986. Thus, expenses which are apportioned to CTI reduce the parent company's export sales income for purposes of section 904(d).

We think that Prop. Treas. Reg. sections 1.861-8(f) and (g) generally produce the correct result. Unlike the pre-DEFRA DISC dividend income category, the section 904(d) FSC dividend income category is generally reduced to zero as a result of the dividends received deduction under section 245(c). Therefore, there is no need to further allocate expenses against this category of income.

We are concerned, however, about the proposed regulation insofar as it deals with section 927(e). Section 927(e)(1) provides that the foreign source income of the parent company of a FSC may not exceed the foreign source income that would result if the analogous DISC pricing rule applied.

The legislative history of the Tax Reform Act of 1984 indicates quite clearly that Congress' intent was simply to prevent the U.S. parent of a FSC from obtaining more foreign source income under the FSC rules than it obtained under the pre-DEFRA DISC rules. The DEFRA Senate Report states at page 655 that:

The Committee intends that this special rule governing the source of income, and thus the foreign tax credit limitation of parties related to a FSC, result in foreign source income that is comparable to the foreign source income on the same transaction under prior [pre-DEFRA] law.

In the DEFRA Blue Book at page 1062, the Joint Committee Staff stated similarly that Congress' intent was to achieve the same level of foreign source income for related parties of a FSC that would result in a similar transaction using a DISC under prior law.

Accordingly, the "as-if DISC" computation contained in Prop. Treas. Reg. section 1.861-8(g) Example (23)(iv) should start with gross foreign receipts and reflect the pre-DEFRA apportionment of expenses to the section 904(d) DISC dividend category. The proposed regulation's section 927(e)(1) limitation is calculated using 50% of combined taxable income, without any expense apportionment to DISC dividends.

Assume a U.S. exporter (R) derives export sales using a FSC as a commission agent with the following facts:

     Domestic sales income                        $300

 

     Gross income from exports                     100

 

     Total general and administrative expenses      60

 

 

The $60 of general and administrative expense is allocable $45 to domestic sales and $15 to export sales. Combined taxable income therefore is $85 ($100-$15). The transfer pricing rule under section 925(a)(2) is used and R pays the FSC a commission of approximately $20 (23% x $85 CTI).

R's section 863(b) taxable income without any second stage apportionment pursuant to the proposed regulations would be computed as follows:

     Gross income from exports                         $100

 

 

     Less: Allocable expenses           $15

 

           FSC commission                20             (35)

 

                                        ___            _____

 

 

     R's section 863(b) taxable income                 $ 65

 

                                                       ====

 

 

Under Treas. Reg. section 1.863-3, if title passes overseas, R's section 863(b) income of $65 may be sourced partly within and partly without the U.S. Thus, one-half of R's taxable income ($32.50) would qualify as foreign source income.

Section 927(e)(1), of course, will limit R's foreign source income by reference to the amount of foreign source income that R would have realized using the comparable DISC pricing rule.

Prop. Treas. Reg. 1.861-8(g) Ex. 23(iv) calculates the section 927(e)(1) "as-if DISC" limit by starting with CTI, without a second stage apportionment pursuant to existing Treas. Reg. section 1.861- 8(g) Ex. (22) and (23) as follows:

     CTI (net of $100 gross foreign receipts

 

       and $15 allocated expenses)                       $ 85.00

 

 

     DISC commission (50% of CTI)                          42.50

 

 

     R's section 863(b) income                             42.50

 

 

     Source of R's income:

 

 

          U.S. Source                                    $ 21.25

 

                                                         =======

 

 

          Foreign Source                                 $ 21.25

 

                                                         =======

 

 

This approach, however, fails to compute the section 927(e)(1) "as-if DISC" limit as was intended by Congress. By appropriately utilizing the expense apportionment procedure allowed under existing Treas. Reg. section 1.861-8(g) Ex. (22) and (23), the following result is reached:

STEP 1 -- Apportion expenses between the section 904(d) DISC dividend income category and the section 863(b) income category:

The ratio of        Expenses allocated       Expense

 

DISC taxable   x    to combined taxable  =   apportioned to

 

income to           income                   section 904(d) DISC

 

combined taxable                             dividend

 

income                                       category

 

 

= 42.5/85      x            15           =   $7.50

 

 

Balance of expense allocable to

 

R's section 863(b) taxable income = $7.50

 

 

STEP 2 -- Calculate R's section 863(b) taxable income and foreign source income:

Gross foreign receipts                            $100

 

 

Less: Apportioned foreign expenses       7.50

 

      DISC commission                   42.50      (50)

 

                                        ______    _____

 

 

R's section 863(b) taxable income                 $ 50

 

                                                  ====

 

Source of R's income:

 

 

     U.S. source                                  $ 25

 

                                                  =====

 

 

     Foreign source                               $ 25

 

                                                  =====

 

 

Thus, under the section 927(e)(1) "as-if DISC" computation, R's foreign source income of $32.50 would be limited to $25. Prop. Treas. Reg. section 1.861-8(g) Ex. 23(iv) would erroneously limit R's foreign source income to $21.25.

An example of the section 927(e)(1) "as-if DISC" computation was presented both in the DEFRA Blue Book and the DEFRA Senate Finance Committee Explanation. However, the examples did not focus on the section 927(e)(1) apportionment of expense issue. The DEFRA Blue Book and Senate Report employed a simple view by applying the section 927(e)(1) limitation to a NET, combined taxable income amount. The proposed regulation, on the other hand, does incorporate expenses. Thus, it should be modified to reflect the necessary expense apportionment in the section 927(e)(1) "as-if DISC" computation.

We believe that modifying the proposed regulation to allow for use of the DISC second stage apportionment rules in the section 927(e)(1) "as-if DISC" computation will reflect Congress' clear intent to maintain parity in the level of foreign source income whether the transaction involves a FSC or a pre-DEFRA DISC.

Congress simply wanted to cap foreign source income at the pre- DEFRA DISC level and not inadvertently allow taxpayers to obtain unintended additional foreign source income merely because the FSC rules use a different pricing methodology. The proposed regulation would erroneously cap foreign source income at a level lower than that which the DISC rules allowed. Thus, the regulation needs to be corrected.

Should there be any questions concerning our comments regarding the proposed regulation, please contact Jennifer L. Lanford at (415) 858-7284 or James P. Fuller at (415) 858-7205.

Sincerely,

 

 

James P. Fuller

 

Jennifer L. Lanford

 

Fenwick, Davis & West

 

Palo Alto, California

 

 

cc: Richard Chewning

 

Leonard B. Terr
DOCUMENT ATTRIBUTES
  • Authors
    Fuller, James P.
    Lanford, Jennifer L.
  • Institutional Authors
    Fenwick, Davis & West
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    gross income from sources within the United States
    source rules
    Domestic International Sales Corporation (DISC)
    Foreign Sales Corporation (FSC)
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 88-7513
  • Tax Analysts Electronic Citation
    88 TNT 184-30
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