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New Domestic Production Incentive Legislation in Congress

    New tax incentive replaces existing FSC/ETI benefits with tax reduction for domestic manufacturing and production activities - how will U.S. manufacturers, film and software developers and construction companies benefit from this proposal?

    New ETI/FSC replacement legislation has been circulating in Congress and soon may become part of the American Jobs Creation Act of 2003 (H.R. 2896). This legislation was introduced in the House and the Senate during the summer to replace the WTO-censored ETI and FSC export tax incentive regimes. This proposal is designed to satisfy U.S. trading partners and meet WTO trade obligations while providing comparable tax benefits to U.S. manufacturers.

DISCLAIMER: The precise terms of the replacement legislation is not known at this time, but earlier versions of the bills and published updates from Congress give us an accurate picture of what is being considered today.

Benefits and Burdens for Exporters

The replacement legislation contains some good news and some bad news for exporters. The act itself is divided into two main parts:

1) Repeal and phase-out of ETI and FSC benefits (Transition Rules)

2) Deduction for income attributable to U.S. production activities

After a discussion of the transition rules, this article will examine how the new deduction for production activities is computed.

Bad News - Repeal and Phase-out of ETI/FSC Benefits
    The bad news for U.S. exporters is that the ETI provisions, which provide a direct tax savings to most U.S. exporters, would be repealed. The ETI rules under Sec. 114 exclude a portion of export income from U.S. tax. The WTO has been following closely the actions taken by the U.S. Congress in repealing the Extraterritorial Income Exclusion (ETI) under Sec. 114. For the WTO, including the EU and other U.S. trading partners, the repeal of the ETI provisions represents a victory.

    The ETI rules were enacted in 2000 in response to the WTO findings that the Foreign Sales Corporation (FSC) legislation violated the anti-subsidy rules in the WTO Agreement. In 2001, however, the WTO also found that the ETI legislation violated the same anti-subsidy provisions of the WTO Agreement. Recently, the WTO has been discussing how to impose the $4 billion in punitive tariffs sanctioned by the WTO Dispute Resolution Panel in 2002.

    The new legislation in Congress satisfies the WTO objections to the extent that it contains provisions repealing ETI, or Sec. 114 of the IRC of 1986. The 4-year phase-out or transition period, however, delays the final termination of ETI/FSC benefits, which may annoy our WTO trading partners.

Good News - Phase-out Rules for 2002 ETI/FSC Savings
    Under one proposal, the new domestic production incentive will be phased in over a transition period, or 2003-2007, before a full deduction is available. Prior to 2007, exporters who qualify as a current ETI/FSC beneficiary (2002 calendar year taxpayers claiming ETI and/or FSC benefits) can claim a deduction equal to their transition amount, or adjusted 2002 ETI/FSC benefits, multiplied by a phaseout percentage. These savings are calculated under a formula and appear to be available whether or not the company satisfies the ETI or FSC foreign economic presence (FEP) requirements after 2002.

Caution: Since the base period, or the 2002 tax year, provides the basis for the transition period relief, taxpayers must be sure that their FEP tests have been met for 2002. If the FEP tests are not met, then taxpayers could face a loss of ETI/FSC benefits in 2002 and all subsequent transition years!

How Transition Period Benefits are Computed - S. 1637
    Under the Grassley proposal (S. 1637), a "current" FSC/ETI beneficiary is any company that received FSC or ETI benefits in calendar 2002. The aggregate FSC/ETI benefits for calendar 2002 also constitute the Base Period Amount used for computing tax savings during the transition period. Companies appear to qualify for transition period relief even if their actual exports in post-2002 tax years are less than their base period benefits.
Transition period deductions are equal to the Base Period Amount, multiplied by the phase-out percentage. Table 1, below, illustrates the phaseout, as contained in S. 1637:

TABLE 1

Assuming X Corp. has an ETI/FSC deduction in 2002 of $100,000, its transition deductions are shown in Table 2, below, in dollars:

TABLE 2

    Under one proposal, exporters eligible for transition period relief get an inflation adjustment in 2005, so they can claim a higher benefit than claimed in 2001! Before this legislation is finalized, these provisions should be revised to permit exporters to determine their actual "hypothetical" ETI benefits during each transition year. This figure may be higher or lower than their Base Period Amounts.

Two reasons can be cited for this change:

1) first, actual results in the transition period (2002-2008) should be commensurate with the level of export sales, and
2) second, the FSC legislation was repealed already in 2000, so it does not make sense to base 2002-2008 tax benefits on old law.

    It is more equitable and reasonable to base the tax results on actual data, or at least a base period of years (i.e., 1999-2002) that is subject to documentation and audit. By picking an arbitrary result for only one tax year and/or claiming benefits from tax provisions that have been repealed, the legislation may not pass judicial review.

Summary of Benefits for Exporters
    Exporters should generate net tax savings from these transition period provisions. Not only do they get to keep their existing ETI benefits for 2003 and 2004, but also they receive an ongoing benefit in 2005 and 2006. Only in later years will the phase-out of the 2002 tax benefits be material. It is apparent that benefits should remain available for distributors and construction and engineering companies during the transition period, but it is not clear whether the domestic production incentive is available for companies other than the initial manufacturer. As a result, not all ETI/FSC beneficiaries may be eligible for the 9% production deduction in 2004.
    The Domestic Production Incentive, discussed below, also contains indirect tax benefits for exporters. By keeping manufacturing and software development activities in the United States, exporters may claim a deduction for up to 9% of their income from qualified production activities.
    Tax practitioners should take some time to analyze the effect of the new proposal on their company or clients. This analysis will vary for each client and from industry to industry.

Deduction Attributable to Domestic Production Activities
    The Job Replacement Act adds a new Sec. 250, which provides for a deduction equal to 9% of an eligible taxpayer's income from qualified domestic production activities. From recent discussions in Congress, it does appear that an individual, partnership, S corporation or LLC can claim a deduction under Sec. 250 for its qualified production activities.
The full tax benefits available under Sec. 250 only apply to tax years beginning after 2008. The transition rules, discussed above, will apply in computing the 2003 and 2004 tax benefits. Once the new law is effective in 2005, however, there is nothing in the new proposal that would prevent an export company from double dipping, or claiming ETI/FSC transition relief as well as a domestic production incentive in 2005 and 2006.

Income Attributable to Domestic Production Activities
    The amount of the Sec. 250 deduction is based on income attributable to domestic production activities. Income is computed by reducing the taxpayer's domestic production receipts by the cost of goods sold, as well as direct and indirect expenses allocable to these receipts. Presumably, the expense allocation rules under Reg. Sec. 1.861-8 would apply and treat domestic production receipts as a separate class of income.
    Domestic production receipts include sales, leases or licenses of qualifying production property that must be manufactured, produced grown or extracted in whole or significant part by the taxpayer within the United States. Qualified property includes tangible personal property, computer software and films, tapes, records or similar reproductions.
The statute does not define what constitutes manufactured or produced "in whole or significant part." Presumably, some interim or final foreign assembly will be permitted, but these foreign costs will reduce the overall benefit under the domestic/foreign factor discussed below.

    Gross income from qualifying production property must be allocated between domestic and worldwide production activities based on the Domestic/Foreign Fraction. The numerator of the fraction is equal to the value of the taxpayer's domestic production activities, and the denominator is equal to the value of the taxpayer's foreign or worldwide production activities. For purposes of determining the denominator, the affiliated group definition is reduced from 80 to 50%, so production values of CFCs and foreign-based group members would be attributed to the U.S. taxpayer.
    The statute as drafted does not contain any grouping rules for products or product lines, so some guidance from the IRS will be required for determining how taxpayers can allocate domestic and foreign manufacturing and production "values" to product or product line sales. In addition, the statute does not refer to intangible values.

Phase-In Period Relief
The new Sec. 250 deduction is not available until 2004. After 2004, moreover, the deduction is phased in over four years. Assuming X Corp. has $100,000 each year and all of its income is attributable to domestic production activities, it's Sec. 250 deduction is computed as follows:

TABLE 3

Assuming X Corp. has $100,000 of income each year and 50% of its income is attributable to domestic production activities (Domestic/Foreign Factor), its Sec. 250 deduction is computed as follows:

TABLE 4

Summary

    The latest ETI/FSC replacement proposals appears to meet two key political objectives: they satisfy U.S. WTO obligations and provide a replacement tax regime that offers comparable tax savings for U.S. multinationals as the former FSC and current ETI provisions. The new proposal will appeal primarily to U.S. exporters that maintain a significant U.S. production base, which includes Puerto Rico.
    The Act should include incentives for small exporters or companies operating as an S corporation, LLC or sole proprietorship. The latest versions of the bill also would extend the incentives to construction and engineering companies.
    The big losers under the domestic production deduction are non-manufacturing exporters, like distributors, export agents or middlemen. Finally, like its predecessors, the new proposal leaves the tax deferral benefits of the IC-DISC intact. Thus, most closely-held exporters organized as an S corporation or LLC will prefer to maximize their cash flow savings using an IC-DISC for export tax benefits.

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