Firm Seeks Clarification of Foreign Military Sales Treatment

February 22, 2018

Brenda Zent
Special Advisor on International Taxation
Office of Tax Policy
Department of the Treasury
1500 Pennsylvania Ave., N.W.
Washington, DC 20220

Re: Foreign-Derived Intangible Income and Foreign Military Sales

Dear Brenda,

Thank you for speaking with me several times recently about foreign sales. As we discussed, we believe guidance is needed that clarifies that foreign military sales (“FMS”), or sales made pursuant to the Arms Export Control Act of 1976 (22 U.S.C. 2751 et seq., as amended), the Foreign Assistance Act of 1961 (22 U.S.C. 2151 et seq., as amended), or similar legislation are treated as sales to a foreign government (a sale to a person other than a United States person) for purposes of section 250 of the Internal Revenue Code, as amended (the “Code”¹), enacted by section 14202 of P.L. 115-97 (the “Act”).

The U.S. Aerospace & Defense (“A&D”) industry accounted for 10% of all 2016 U.S. exports in domestic goods and was the nation's 2nd largest exporting industry.² The A&D industry's exports have grown more than 50% since 2011,³ FMS sales are an important component of these exports.

What Are FMS Sales?

United States defense contractors sell directly to foreign governments in arrangements referred to as direct commercial sales (“DCS”). They may also export through the FMS process, a government-to-government regulatory process in which the United States Government (“USG”) purchases defense articles, training, and services from a U.S. defense contractor on behalf of a foreign government (or agency). Under the FMS process, U.S. defense contractors are required, in form, to contract with the USG. The contractor works closely with the USG and the customer throughout the process. The specifications for the products and services, as well as timing and logistical matters, are ultimately agreed upon by the contractor and the foreign government. In substance, despite their form, these transactions are sales made to a foreign person.⁴

What Has Been the Historic Treatment of FMS Sales?

Historically, tax benefits for exports have been available for business-to-government sales, including FMS. This was true under the Domestic International Sales Corporation (“DISC”) regime, the Foreign Sales Corporation regime, and the Extraterritorial Income regime.⁵ Congress and Treasury have consistently recognized the unique requirements of the FMS process and have not used the USG's role in the transaction to bar exporters from equal treatment and entitlement to these export benefits. Treasury and the Internal Revenue Service have understood and reflected in guidance a recognition that the benefits to the United States are the same whether or not the exports are DCS or FMS.

The Act

While the language used in these prior tax regimes is somewhat different from the language in section 250, the differences should not be interpreted to restrict the benefits for FMS. The policy of encouraging manufacturing activities in the United States remains.

The Act includes a new requirement that a taxpayer make a sale to a person that is not a U.S. person. Section 250(a)(4) provides that “foreign-derived deduction eligible income” (“FDII”) is:

[A]ny deduction eligible income of such taxpayer which is derived in connection with (A) property (i) which is sold by the taxpayer to any person who is not a United States person, and (ii) which the taxpayer establishes to the satisfaction of the Secretary is for a foreign use, or (B) services provided by the taxpayer which the taxpayer establishes to the satisfaction of the Secretary are provided to any person, or with respect to property, not located within the United States.

Section 892(a)(3) provides that “[f]or purposes of this title, a foreign government shall be treated as a corporate resident of its country.” A corporation is a “person” as defined in section 7701(a)(1). Therefore, a foreign government is clearly a person who is not a U.S. person.

The manufacturing activities for goods exported under the DCS, FMS and similar programs are the same. They are each in substance sales to foreign persons, with the DCS sales also being in form sales to foreign persons. The unique contractual arrangement of an FMS transaction should not operate to deny a defense contractor the ability to claim the FDII benefit for sales under the FMS program. The FDII benefit for DCS is clear. The FDII benefit for FMS should be as clear.

In addition, there is no indication in the legislative history that Congress intended to exclude FMS from the FDII benefit. It appears that one of the objectives of the FDII provision is to discourage certain “round tripping” practices, in which goods are sold outside the United States, but are ultimately sold to customers in the United States. However, all FMS sales, by definition, are made for use or consumption by a foreign government or agency thereof outside the United States.

Moreover, while involving a different statute, the Second Circuit deemed it important in General Electric Company v. Commissioner⁶ that the U.S. seller (GE) seeking to satisfy the destination test under the DISC rules⁷ negotiated directly with ultimate customers/consumers (foreign airlines). GE sold its products (aircraft engines) to U.S. airframe manufacturers who then attached GE's products to airframes that were then delivered to the foreign purchasers. A similar situation exists in the case of FMS sellers, as FMS sellers are heavily involved in negotiating the commercial and technical terms of sales contracts with ultimate customers/consumers (foreign governments or agencies thereof).

Therefore, we request that guidance be issued clarifying that FMS are treated as sales to a foreign government for purposes of section 250. Moreover, time is of the essence because of the need to provide timely and accurate forecasts for financial reporting purposes and to pay appropriate estimated taxes. To facilitate the prompt issuance of guidance, please consider the following language:

Property sold by the taxpayer under the authority of the Arms Export Control Act of 1976 (22 U.S.C. 2751 et seq., as amended), the Foreign Assistance Act of 1961 (22 U.S.C. 2151 et seq., as amended), or similar legislation, shall be regarded as property sold to a person who is not a U.S. person.

Thank you for your consideration of this matter. Should you have any questions, please let me know.

Sincerely,

Philip R. West
Steptoe & Johnson LLP
Washington, DC

cc:
L.G. “Chip” I Harter, Deputy Assistant Secretary (International Tax Affairs)
Dana L. Trier, Deputy Assistant Secretary (Tax Policy)
Douglas L. Poms, International Tax Counsel