U.S. Income Tax Return of a Foreign Sales Corporation

Changes To Note

• For tax years ending on or after December 31, 2001, certain corporations with average annual gross receipts of more than $1 million but less than or equal to $10 million may be able to adopt or change to the cash method of accounting for eligible trades or businesses. This rule does not apply to corporations prohibited from using the cash method under section 448. For more details, including change in accounting method requirements, see Notice 2001-76, 2001-52 I.R.B. 614.
• If the FSC wants to allow the IRS to discuss its 2001 tax return with the paid preparer who signed it, check the Yes box in the area where the officer of the FSC signed the return. See page 4 for details.

Photographs of
Missing Children

The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in instructions on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

Unresolved Tax Issues

If the FSC has attempted to deal with an IRS problem unsuccessfully, it should contact the Taxpayer Advocate. The Taxpayer Advocate independently represents the FSC's interests and concerns within the IRS by protecting its rights and resolving problems that have not been fixed through normal channels.

While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that the FSC's case is given a complete and impartial review.

The FSC's assigned personal advocate will listen to its point of view and will work with the FSC to address its concerns. The FSC can expect the advocate to provide:

• A fresh look at a new or on-going problem.
• Timely acknowledgment.
• The name and phone number of the individual assigned to its case.
• Updates on progress.
• Timeframes for action.
• Speedy resolution.
• Courteous service.

When contacting the Taxpayer Advocate, the FSC should provide the following information:

• The FSC's name, address, and employer identification number (EIN).
• The name and telephone number of an authorized contact person and the hours he or she can be reached.
• The type of tax return and year(s) involved.
• A detailed description of the problem.
• Previous attempts to solve the problem and the office that had been contacted.
• A description of the hardship the FSC is facing (if applicable).

The FSC may contact a Taxpayer Advocate by calling 1-877-777-4778 (toll free). Persons who have access to TTY/TDD equipment may call 1-800-829-4059 and ask for Taxpayer Advocate assistance. If the FSC prefers, it may call, write, or fax the Taxpayer Advocate office in its area. See Pub. 1546, The Taxpayer Advocate Service of the IRS, for a list of addresses and fax numbers.

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and Publications

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Buy the CD-ROM on the Internet at www.irs.gov/cdorders from the National Technical Information Service (NTIS) for $21 (no handling fee), or call 1-877-CDFORMS (1-877-233-6767) toll free to buy the CD-ROM for $21 (plus a $5 handling fee).

By phone and in person. You can order forms and publications 24 hours a day, 7 days a week, by calling 1-800-TAX-FORM (1-800-829-3676). You can also get most forms and publications at your local IRS office.

Purpose of Form

Use Form 1120-FSC to report income, gains, losses, deductions, credits, and to figure the income tax liability of a FSC.

FSC Repeal and Extraterritorial Income Exclusion

In general, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000:

• Repealed the FSC rules,
• Provides taxpayers with an exclusion, which is figured on Form 8873, Extraterritorial Income Exclusion, and
• Provides transition rules for existing FSCs (see Transition Rules below).

Transition Rules

In general, a FSC that was in existence on September 30, 2000, and at all times thereafter, will continue to use the FSC rules for qualifying transactions in the ordinary course of business before January 1, 2002. Furthermore, a FSC will continue to use the FSC rules after December 31, 2001, for transactions pursuant to a binding contract between the FSC (or a person related to the FSC) and a person other than a related person if that binding contract was in effect on September 30, 2000, and has remained in effect. A binding contract includes a purchase, renewal, or replacement option that is enforceable against a lessor or seller (provided the option is part of a contract that is binding and in effect on September 30, 2000, and has remained in effect).

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.

Election To Apply Exclusion Rules

Taxpayers may elect to apply the new extraterritorial income exclusion rules instead of the FSC rules for transactions occurring during the transition period. The election is:

• Made by checking the box on line 2 of Form 8873,
• Made on a transaction-by-transaction basis,
• Effective for the tax year for which it is made and for all subsequent tax years, and
• Revocable only with the consent of the IRS.

Taxpayers use Form 8873 to determine their extraterritorial income exclusion.

Election To Be Treated as a Domestic Corporation

A FSC that was in existence on September 30, 2000, and at all times thereafter, may elect to be treated as a domestic corporation if either:

• It manufactures, produces, grows, or extracts property in the ordinary course of its trade or business or
• Substantially all of its gross receipts are foreign trading gross receipts.

The election is made by checking the box on line 3 of Form 8873. An electing corporation files Form 1120, U.S. Corporation Income Tax Return, or Form 1120-A, U.S. Corporation Short-Form Income Tax Return. Once made, the election applies to the tax year made and remains in effect for all subsequent years unless the election is revoked or terminated. If the election is revoked or terminated, the corporation would be a foreign corporation that files Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. Furthermore, the foreign corporation would not be eligible to reelect to be treated as a domestic corporation for 5 tax years beginning with the first tax year for which the original election is not in effect as a result of the revocation or termination.

Effect of election. A FSC that elects to be treated as a domestic corporation ceases to be a FSC for any tax year for which the election applies (and for any subsequent tax year).

FSC Election

No corporation may elect to be a FSC or a small FSC (defined below) after September 30, 2000. However, a FSC election is considered to occur on the formation of an otherwise eligible electing corporation, provided the corporation was formed before October 1, 2000, and filed the election within 90 days of formation. For details, see Temporary Regulations section 1.921-1T(b)(1).

Termination of Inactive FSCs

If a FSC has no foreign trade income (see definition under Tax Treatment of a FSC below) for any 5 consecutive tax years beginning after December 31, 2001, the FSC will no longer be treated as a FSC for any tax year beginning after that 5-year period.

Additional Information

For additional information regarding the rules discussed above, see Rev. Proc. 2001-37, 2001-23 I.R.B. 1327.

FSC Rules

Definition of a Foreign
Sales Corporation (FSC)

Under section 922(a), a FSC is defined as a corporation that has met all of the following rules.

1. It must be a corporation created or organized under the laws of a qualifying foreign country or any U.S. possession other than Puerto Rico.

   Qualifying U.S. possessions include Guam, American Samoa, the Commonwealth of the Northern Mariana Islands, and the U.S. Virgin Islands.

   A qualifying foreign country is a foreign country that meets the exchange of information rules of section 927(e)(3)(A) or (B). All U.S. possessions other than Puerto Rico are also certified to have met these rules.

   The following countries are qualifying foreign countries that have met the exchange of information rules of section 927(e)(3)(A) or 927(e)(3)(B): Australia, Austria, Barbados, Belgium, Bermuda, Canada, Costa Rica, Cyprus, Denmark, Dominica, the Dominican Republic, Egypt, Finland, France, Germany, Grenada, Guyana, Honduras, Iceland, Ireland, Jamaica, Korea, Malta, the Marshall Islands, Mexico, Morocco, the Netherlands, New Zealand, Norway, Pakistan, Peru, the Philippines, St. Lucia, Sweden, and Trinidad and Tobago.

2. It had no more than 25 shareholders at any time during the tax year.
3. It had no preferred stock outstanding at any time during the tax year.
4. During the tax year, the FSC must maintain:
   • An office in one of the qualifying foreign countries or U.S. possessions listed above,
   • A set of permanent books of account (including invoices) at that office, and
   • The books and records required under section 6001 at a U.S. location to sufficiently establish the amount of gross income, deductions, credits, or other matters required to be shown on its tax return.
5. It must have at least one director, at all times during the tax year, who is not a resident of the United States.
6. It must not be a member, at any time during the tax year, of a controlled group of which a DISC is a member.
7. It must have elected to be a FSC or small FSC, and the election must have been in effect for the tax year.

Small FSC. Section 922(b) defines a small FSC as a corporation that:

• Elected small FSC status and has kept the election in effect for the tax year and
• Is not a member, at any time during the tax year, of a controlled group that includes a FSC (unless that other FSC is also a small FSC).

A small FSC is exempt from the foreign management and foreign economic process requirements. See the instructions for Foreign Management Rules and the Foreign Economic Process Rules on page 3.

$5 million limit. Generally, any foreign trading gross receipts of a small FSC for the tax year that exceed $5 million are not to be considered in determining its exempt foreign trade income. The $5 million limit is reduced if the small FSC has a short tax year. It may also be reduced if the small FSC is a member of a controlled group that contains other small FSCs. See Regulations section 1.921-2(b) for more information.

Tax Treatment of a FSC

A FSC is not taxed on its exempt foreign trade income. Section 923 defines foreign trade income as the gross income of a FSC attributable to foreign trading gross receipts (defined below).

The percentage of foreign trade income exempt from tax is figured differently for income determined under the administrative pricing rules (for details, see the instructions for Schedule P (Form 1120-FSC)) and income determined without regard to the administrative pricing rules. These percentages are computed on Schedule E, page 4, Form 1120-FSC, and carried over to lines 9a and 9b of Schedule B, page 3, Form 1120-FSC to figure taxable income or (loss).

See section 923(a)(4) for a special rule for foreign trade income allocable to a cooperative. See section 923(a)(5) for a special rule for military property.

Tax treaty benefits. A FSC may not claim any benefits under any income tax treaty between the United States and any foreign country.

Foreign Trading Gross Receipts

A FSC is treated as having foreign trading gross receipts (defined in section 924) only if it has met certain foreign management and foreign economic process requirements.

Foreign trading gross receipts do not include:

• Certain excluded receipts (defined in section 924(f)).
• Receipts attributable to property excluded from export property under section 927(a)(2).
• Investment income (defined in section 927(c)).
• Carrying charges (defined in section 927(d)(1)).

Note: Computer software licensed for reproduction abroad is not excluded from export property under section 927(a)(2). Therefore, receipts attributable to the sale, lease, or rental of computer software and services related and subsidiary to such transactions qualify as foreign trading gross receipts.

Foreign Management Rules

A FSC (other than a small FSC) is treated as having foreign trading gross receipts for the tax year only if the management of the FSC during the year takes place outside the United States. These management activities include:

• Meetings of the board of directors and meetings of the shareholders.
• Disbursing cash, dividends, legal and accounting fees, salaries of officers, and salaries or fees of directors from the principal bank account (see below).
• Maintaining the principal bank account at all times during the tax year.

Meetings of directors and meetings of the shareholders. All meetings of the board of directors of the FSC and all meetings of the shareholders of the FSC that take place during the tax year must take place outside the United States.

In addition, all such meetings must comply with the local laws of the foreign country or U.S. possession in which the FSC was created or organized. The local laws determine whether a meeting must be held, when and where it must be held (if it is held at all), who must be present, quorum requirements, use of proxies, etc.

Principal bank accounts. See Regulations section 1.924(c)-1(c) for information regarding principal bank accounts.

Foreign Economic Process Rules

A FSC (other than a small FSC) has foreign trading gross receipts from any transaction only if certain economic processes for the transaction take place outside the United States. Section 924(d) and Regulations section 1.924(d)-1 set forth the rules for determining whether a sufficient amount of the economic processes of a transaction takes place outside the United States.

Generally, a transaction will qualify if the FSC satisfies two requirements:

• Participation outside the United States in the sales portion of the transaction and
• Satisfaction of either the 50% or the 85% foreign direct cost test.

The activities comprising these economic processes may be performed by the FSC or by any other person acting under contract with the FSC.

Participation outside the United States in the sales portion of the transaction. Generally, the requirement of section 924(d)(1)(A) is met for the gross receipts of a FSC derived from any transaction if the FSC has participated outside the United States in the following sales activities relating to the transaction: (1) solicitation (other than advertising), (2) negotiation, and (3) making a contract.

1. Solicitation (other than advertising) is any communication (including, but not limited to, telephone, telegraph, mail, or in person) by the FSC, to a specific, targeted customer or potential customer.
2. Negotiation is any communication by the FSC to a customer or potential customer aimed at an agreement on one or more of the terms of a transaction, including, but not limited to, price, credit terms, quantity, or time or manner of delivery.
3. Making a contract refers to performance by the FSC of any of the elements necessary to complete a sale, such as making or accepting an offer.

Grouping transactions. Generally, the sales activities described above are to be applied on a transaction-by-transaction basis. However, a FSC may make an annual election to apply any of the sales activities on the basis of a group. To make the election, check the applicable box on line 11a, Additional Information, on page 2 of Form 1120-FSC. See Regulations section 1.924(d)-1(c)(5) for details.

Satisfaction of either the 50% or 85% foreign direct cost test. To qualify as foreign trading gross receipts, the foreign direct costs incurred by the FSC attributable to the transaction must equal or exceed 50% of the total direct costs incurred by the FSC attributable to the transaction.

Instead of satisfying the 50% foreign direct cost test, the FSC may incur foreign direct costs attributable to activities described in each of two of the section 924(e) categories. The costs must equal or exceed 85% of the total direct costs incurred by the FSC attributable to the activity described in each of the two categories. If no direct costs are incurred by the FSC in a particular category, that category is not taken into account for purposes of determining whether the FSC has met either the 50% or 85% foreign direct cost test.

Direct costs are costs that:

• Are incident to and necessary for the performance of any activity described in section 924(e);
• Include the cost of materials consumed in the performance of the activity and the cost of labor that can be identified or associated directly with the performance of the activity (but only to the extent of wages, salaries, fees for professional services, and other amounts paid for personal services actually rendered, such as bonuses or compensation paid for services on the basis of a percentage of profits); and
• Include the allowable depreciation deduction for equipment or facilities (or the rental cost for its use) that can be specifically identified or associated with the activity, as well as the contract price of an activity performed on behalf of the FSC by a contractor.

Total direct costs means all of the direct costs of any transaction attributable to activities described in any paragraph of section 924(e). For purposes of the 50% test of section 924(d)(1)(B), total direct costs are based on the direct costs of all activities described in all paragraphs of section 924(e). For purposes of the 85% test of section 924(d)(2), however, the total direct costs are determined separately for each paragraph of section 924(e).

Foreign direct costs means the portion of the total direct costs of any transaction attributable to activities performed outside the United States. For purposes of the 50% test, foreign direct costs are based on the direct costs of all activities described in all paragraphs of section 924(e). For purposes of the 85% test, however, foreign direct costs are determined separately for each paragraph of section 924(e).

For more details, see Regulations section 1.924(d)-1(d).

Check the applicable box(es) on line 11b, Additional Information, on page 2 of the form, to indicate how the FSC met the foreign direct costs requirement.

Grouping transactions. Generally, the foreign direct cost tests under Regulations section 1.924(d)-1(d) are applied on a transaction-by-transaction basis. However, the FSC may make an annual election (on line 11d, Additional Information, on page 2 of the form) to apply the foreign direct cost tests on a customer, contract, or product or product line grouping basis. Any grouping used must be supported by adequate documentation of performance of activities and costs of activities relating to the grouping used. See Regulations section 1.924(d)-1(e) for details.

Exception for foreign military property. The economic process rules do not apply to any activities performed in connection with foreign military sales except those activities described in section 924(e). See Regulations section 1.924(d)-1(f) for details.

Section 925(c) Rule

To use the administrative pricing rules to determine the FSC's (or small FSC's) profit on a transaction or group of transactions, the FSC must perform (or contract with another person to perform) all of the economic process activities relating to the transaction or group of transactions. All of the direct and indirect expenses relating to the performance of those activities must be reflected on the books of the FSC and on Form 1120-FSC.

Under Temporary Regulations section 1.925(a)-1T(b)(2)(ii), an election may be made to include on the FSC's books all expenses, other than cost of goods sold, that are necessary to figure combined taxable income for the transaction or group of transactions. The expenses must be identified on Schedule G on the applicable line.

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