[Senate Report 106-416]
[From the U.S. Government Publishing Office]



106th Congress                                                   Report
                                 SENATE
 2d Session                                                     106-416

======================================================================



 
      FSC REPEAL AND EXTRATERRITORIAL INCOME EXCLUSION ACT OF 2000

                                _______
                                

               September 20, 2000.--Ordered to be printed

                                _______
                                

    Mr. Roth, from the Committee on Finance, submitted the following

                              R E P O R T

                        [To accompany H.R. 4986]

      [Including cost estimate of the Congressional Budget Office]

    The Committee on Finance, to whom was referred the bill 
(H.R. 4986) to amend the Internal Revenue Code of 1986 to 
repeal the provisions relating to foreign sales corporations 
and to exclude extraterritorial income from gross income, 
having considered the same, report favorably thereon with an 
amendment and recommend that the bill as amended do pass.

                                CONTENTS

                                                                   Page
 I. Summary and Background............................................2
          A. Purpose and Summary.................................     2
          B. Background and Need for Legislation.................     2
          C. Legislative History.................................     2
II. Explanation of the Bill...........................................3
          A. Repeal of FSC Provisions and Exclusion for 
              Extraterritorial Income............................     3
III.Budget Effects of the Bill.......................................21

          A. Committee Estimates.................................    21
          B. Budget Authority and Tax Expenditures...............    23
          C. Consultation With the Congressional Budget Office...    23
IV. Votes of the Committee...........................................24
 V. Regulatory Impact and Other Matters..............................25
          A. Regulatory Impact...................................    25
          B. Unfunded Mandates Statement.........................    25
          C. Complexity Analysis.................................    25
VI. Changes in Existing Law Made by the Bill, as Reported............25

                       I. SUMMARY AND BACKGROUND


                         A. Purpose And Summary


                                Purpose

    The bill, H.R. 4986, the ``FSC Repeal and Extraterritorial 
Income Exclusion Act of 2000,'' repeals the foreign sales 
corporation provisions of the Internal Revenue Code to comply 
with decisions of a World Trade Organization dispute panel and 
Appellate Body regarding a dispute brought before the World 
Trade Organization (``WTO'') by the European Union. To retain a 
competitive balance for U.S. businesses that compete in the 
world market, the bill modifies the taxation of foreign trade 
income to comply with the standards set forth in the decisions 
of the WTO dispute panel and Appellate Body.

                                Summary

    H.R. 4986 repeals sections 921 through 927 of the Internal 
Revenue Code of 1986 (``the Code''). These sections of the Code 
relate to foreign sales corporations (``FSCs'').
    H.R. 4986 provides that gross income for U.S. tax purposes 
does not include extraterritorial income. Deductions allocated 
to such excluded income generally are disallowed. 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. An 
exception from this general rule is provided for 
extraterritorial income that is not qualifying foreign trade 
income.
    In general, H.R. 4986 is effective for transactions entered 
into after September 30, 2000, and no corporation may elect to 
be a FSC after September 30, 2000.

                 B. Background and Need for Legislation

    In July 1998, the European Union \1\ requested that a WTO 
dispute panel determine whether the FSC regime of sections 921 
through 927 of the Code complies with WTO rules, including the 
Agreement on Subsidies and Countervailing Measures. A WTO 
dispute settlement panel (``the Panel'') was established in 
September, 1998, to address these issues. On October 8, 1999, 
the Panel ruled that the FSC regime was not in compliance with 
WTO obligations.\2\ The Panel specified that ``FSC subsidies 
must be withdrawn at the latest with effect from 1 October 
2000.'' \3\ On February 24, 2000, the Appellate Body affirmed 
the lower panel's ruling.\4\
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    \1\ The European Union comprises Austria, Belgium, Denmark, 
Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, 
Netherlands, Portugal, Spain, Sweden and the United Kingdom. Canada and 
Japan made third-party submissions to the subsequently established 
dispute settlement panel in support of the European Union position.
    \2\ United States--Tax Treatment for ``Foreign Sales 
Corporations,'' Report of the Panel, October, 8, 1999 (``Panel 
Decision'').
    \3\ Panel Decision at 334.
    \4\ United States--Tax Treatment for ``Foreign Sales 
Corporations,'' Report of the Appellate Body, February 24, 2000 
(``Appellate Body Decision'').
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                         C. Legislative History

    The Committee on Finance marked up the provisions of the 
bill on September 19, 2000, and approved the provisions, with 
an amendment, on September 19, 2000, by a voice vote, with a 
quorum present.

                      II. EXPLANATION OF THE BILL


 A. Repeal of FSC Provisions and Exclusion for Extraterritorial Income


                              Present Law

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 any 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.\5\ 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.
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    \5\ A variety of anti-deferral regimes impose current U.S. tax on 
income earned by a U.S. person through a foreign corporation. 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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Foreign sales corporations

    The income of an eligible 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. 
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. 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. 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 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 
transactions 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.
    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. 
Any distribution made by a FSC out of earnings and profits 
attributable to foreign trade income to a 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.
    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.

                           Reasons for Change

    The Chairman and Ranking Member began a process of 
reviewing the international provisions of the Code with 
hearings early in the 106th Congress. Among the issues 
identified in the testimony was the need to reexamine the U.S. 
tax treatment of foreign income.
    In the interim, a dispute settlement panel of the WTO found 
that the FSC provisions conferred an export subsidy barred by 
WTO rules. That decision was affirmed by the WTO Appellate 
Body.
    This legislation addresses both the broader issue of U.S. 
taxation of income derived from foreign sales, i.e., 
``extraterritorial income,'' as well as complying with the WTO 
rulings. The legislation repeals the FSC provisions of the Code 
that the Panel and Appellate Body found to be prohibited export 
subsidies. At the same time, the legislation revises the Code 
in a manner that rationalizes tax treatment for 
extraterritorial income.
    The legislation modifies the general rule of U.S. taxation 
by fundamentally amending the definition of gross income. Under 
the Code, the definition of ``gross income'' defines the outer 
boundaries of U.S. income taxation. The bill excludes income 
derived from certain activities performed outside the United 
States, referred to as extraterritorial income, from the 
definition of gross income and, thus, modifies the extent to 
which the United States seeks to tax such income. This new 
general rule thus becomes the normative benchmark for taxing 
income derived in connection with certain activities performed 
outside the United States.
    The Committee believes that, in order to ensure WTO 
compatibility, it is important that the new regime not confer 
export-contingent benefits. Accordingly, the Committee has 
determined that it is appropriate to treat all foreign sales 
alike. The general exclusion, therefore, applies to foreign 
trade income, whether the goods are manufactured in the United 
States or abroad--a substantially broader category of income 
than that which was exempted from tax under the FSC provisions. 
A taxpayer would receive the same U.S. tax treatment with 
respect to its foreign sales regardless of whether it exports.
    The Committee notes that the extraterritorial income 
excluded by this legislation from the scope of U.S. income 
taxation parallels the foreign-source income excluded under 
most territorial tax systems, particularly those employed by 
European Union member states. Under neither the U.S. tax system 
as modified by this legislation nor many European tax systems 
is the income excluded from taxation limited to income earned 
through exporting. At the same time, under both systems, 
exporting is one way to earn foreign source income that is 
excluded from taxation, and exporters under both systems are 
among those who can avail themselves of the limitations on the 
taxing authority of both systems.
    The Committee believes that this legislation, which 
fundamentally changes the U.S. tax treatment of 
extraterritorial income, complies with the WTO decisions and 
honors U.S. obligations under the WTO.

                       Explanation of Provisions

Repeal of the FSC rules

    The bill repeals the present-law FSC rules found in 
sections 921 through 927 of the Code.

Exclusion of extraterritorial income

    The bill 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 bill 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 bill, 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,\6\ (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 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.\7\
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    \6\ The term ``transaction'' means (1) any sale, exchange, or other 
disposition; (2) any lease or rental, and (3) any furnishing of 
services.
    \7\ For an example of these calculations, see the General Example, 
below.
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    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.\8\ 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).\9\ 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.
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    \8\ 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).
    \9\ The manufacturer also could compute qualifying foreign trade 
income based on 30 percent of foreign sale and leasing income.
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    Under the bill, 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 
transactions, so long as the groups are based on product lines 
or recognized industry or trade usage. Under the grouping 
method, the Committee intends 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.\10\ The Secretary of the Treasury is 
granted authority to prescribe rules for grouping transactions 
in determining qualifying foreign trade income.
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    \10\ By reference to Standard Industrial Classification codes, the 
Committee intends to include industries as defined in the North 
American Industrial Classification System.
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    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 bill 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 bill, ``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,\11\ this 
includes the license of computer software for reproduction 
abroad.
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    \11\ The Taxpayer Relief Act of 1997, Public Law 105-34.
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    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.
    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 bill, 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.\12\ 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.\13\
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    \12\ 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.
    \13\ For this purpose, the receipts of related persons are 
aggregated and, in the case of pass-through 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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    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 multi-year 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 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 bill, 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,\14\ in the ordinary course of a trade or business, for 
direct use, consumption, or disposition outside of the United 
States.\15\ 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.\16\
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    \14\ 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.
    \15\ ``United States'' includes Puerto Rico for these purposes 
because Puerto Rico is included in the customs territory of the United 
States.
    \16\ 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.
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    The bill 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,\17\ (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 the intention of the Committee 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.
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    \17\ The intangibles that are treated as excluded property under 
the bill 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.
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    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 bill 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.\18\
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    \18\ 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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              Foreign trade income
    Under the bill, ``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 bill, ``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 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 lease \19\ (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.
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    \19\ 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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    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 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:

------------------------------------------------------------------------
                                                  Other
                                    Total       property      QFTP \20\
------------------------------------------------------------------------
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
------------------------------------------------------------------------
\20\ ``QFTP'' refers to qualifying foreign trade property.

    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.\21\ Thus, XYZ 
Corporation's foreign trade income equals $100, calculated as 
follows:
---------------------------------------------------------------------------
    \21\ 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.

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

    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:

------------------------------------------------------------------------
                                           1.2%     15%  FTI  30%  FS&LI
                                        FTGR \22\     \23\       \24\
------------------------------------------------------------------------
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) \25\.........                             28.88
                                       ---------------------------------
      Qualifying foreign trade income.      48.00      60.00       39.38
------------------------------------------------------------------------
\22\ ``FTGR'' refers to foreign trading gross receipts.
\23\ ``FTI'' refers to foreign trade income.
\24\ ``FS&LI'' refers to foreign sale and leasing income.
\25\ 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).\26\ 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.\27\
---------------------------------------------------------------------------
    \26\ Note that XYZ Corporation could choose to use one of the other 
two methods notwithstanding that they would result in a smaller 
exclusion.
    \27\ 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 was 
determined using 30 percent of foreign sale and leasing income, the 
disallowed expenses would include only the appropriate portion of the 
direct expenses.

----------------------------------------------------------------------------------------------------------------
                                                                 Other                   Excluded/
                                                                Property       QFTP      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 bill 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 foreign-source 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.
    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 foreign-source 
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).\28\
---------------------------------------------------------------------------
    \28\ 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).
---------------------------------------------------------------------------
              Treatment of withholding taxes
    The bill 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.\29\ Accordingly, the bill'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.\30\ It is 
intended that such taxes would be similar in nature to the 
gross-basis taxes described in sections 871 and 881.
---------------------------------------------------------------------------
    \29\ With respect to the withholding taxes that are paid or accrued 
(a prerequisite to the taxes being otherwise creditable), the provision 
in the bill treats such taxes as not being paid or accrued with respect 
to qualifying foreign trade income.
    \30\ This also would apply to any withholding tax that is 
creditable for U.S. foreign tax credit purposes under an applicable 
treaty.
---------------------------------------------------------------------------
    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 bill.
              Election to be treated as a U.S. corporation
    The bill 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 reasonably may be 
expected to be 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.\31\ 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 one or 
more classes of corporations that may not make such an 
election.\32\ 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.
---------------------------------------------------------------------------
    \31\ The waiver of treaty benefits applies to the corporation 
itself and not, for example, to employees of or independent contractors 
associated with the corporation.
    \32\ 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.
---------------------------------------------------------------------------
    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 bill 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.\33\ 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 bill could avail itself of such election 
(unless otherwise precluded from doing so by Treasury 
regulations).
---------------------------------------------------------------------------
    \33\ The sourcing limitation described above would not apply to 
this example because the property is manufactured outside of the United 
States.
---------------------------------------------------------------------------
              Shared partnerships
    The bill 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) 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 bill, 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 bill'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 bill 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 bill 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. The Committee believes 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 bill 
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). 
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
    The Committee recognizes that there may be a gap in time 
between the enactment of the bill 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 bill. 
Some examples of the application of the principles of present-
law regulations to the bill 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 bill, 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.\34\
---------------------------------------------------------------------------
    \34\ See, e.g., Treas. Reg. sec. 1.924(d)-1(c)(5) and (e); Treas. 
Reg. sec. 1.925(a)-1T(c)(8); Treas. Reg. sec. 1.925(b)-1T.
---------------------------------------------------------------------------
              Excluded property
    The bill 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.\35\ 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 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.
---------------------------------------------------------------------------
    \35\ See Treas. Reg. sec. 1.927(a)-1T(f)(2)(i). The bill 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 Treas. Reg. sec. 1.927(a)-1T(g)(2)(iv).
---------------------------------------------------------------------------
              Foreign trading gross receipts
    Under the bill, 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.\36\
---------------------------------------------------------------------------
    \36\ See Treas. Reg. sec. 1.924(a)-1T(a)(2).
---------------------------------------------------------------------------
              Foreign use requirement
    Under the bill, 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.\37\ 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).\38\
---------------------------------------------------------------------------
    \37\ 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.
    \38\ See Treas. Reg. sec. 1.927(a)-1T(d)(4)(ii).
---------------------------------------------------------------------------
    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.\39\ 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.\40\ An aircraft or other 
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.\41\ An 
orbiting satellite is considered to be located outside of the 
United States for these purposes.\42\
---------------------------------------------------------------------------
    \39\ See Treas. Reg. sec. 1.927(a)-1T(d)(4)(iii), (iv), and (v).
    \40\ See Treas. Reg. sec. 1.927(a)-1T(d)(4)(vi).
    \41\ Id.
    \42\ Id.
---------------------------------------------------------------------------
              Foreign economic processes
    Under the bill, 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. The Committee recognizes 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. The Committee is aware that some of 
these concepts will have to be modified when new guidance is 
promulgated as a result of the bill's elimination of the 
requirement for a separate entity.

                             Effective Date

In general

    The bill 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 bill 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

    The bill 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 business \43\ 
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).
---------------------------------------------------------------------------
    \43\ 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.
---------------------------------------------------------------------------
    Similar to the limitation on use of the gross receipts 
method under the bill's operative provisions, the bill provides 
a rule that limits the use of the gross receipts method for 
transactions after the effective date of the bill 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.
    Notwithstanding the transition period, FSCs (or related 
persons) may elect to have the rules of the bill apply in lieu 
of the rules applicable to FSCs. Thus, for transactions to 
which the transition rules apply, taxpayers may choose to apply 
either the FSC rules or the amendments made by this bill, but 
not both. It is also intended that a taxpayer would not be able 
to avail itself of the rules of the bill in addition to the 
rules applicable to domestic international sales corporations.

                    III. BUDGET EFFECTS OF THE BILL


                         A. Committee Estimates

    In compliance with paragraph 11(a) of rule XXVI of the 
Standing Rules of the Senate, the following statement is made 
concerning the estimated budget effects of the provisions of 
the bill, H.R. 4986, as reported.
    The bill, as reported, is estimated to have the following 
effects on budget receipts for fiscal years 2001-2010.

                      ESTIMATED BUDGET EFFECTS OF H.R. 4986, THE ``FSC REPEAL AND EXTRATERRITORIAL INCOME EXCLUSION ACT OF 2000,'' AS REPORTED BY THE COMMITTEE ON FINANCE
                                                                        [Fiscal Years 2001-2010, in millions of dollars]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                     Provision                                 Effective              2001     2002     2003     2004     2005     2006     2007     2008     2009     2010    2001-05   2001-10
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Extraterritorial Income Exclusion; FSC Repeal......          generally ta 9/30/00      -141     -305     -340     -378     -423     -466     -514     -566     -623     -687    -1,587    -4,443
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Legend for ``Effective'' column: ta = transaction after.

Note: Details may not add to totals due to rounding.

Source: Joint Committee on Taxation.

                B. Budget Authority and Tax Expenditures


Budget authority

    In compliance with section 308(a)(1) of the Budget Act, the 
Committee states that the provisions of the bill as reported 
involve no new or increased budget authority.

Tax expenditures

    In compliance with section 308(a)(2) of the Budget Act, the 
committee states that the revenue-reducing income tax 
provisions involve increased tax expenditures (See revenue 
table in Part III.A., above.)

          C. Consultation With the Congressional Budget Office

    In accordance with section 403 of the Budget Act, the 
committee advises that the Congressional Budget Office has 
submitted a statement on this bill.

                                     U.S. Congress,
                               Congressional Budget Office,
                                Washington, DC, September 20, 2000.
Hon. William V. Roth, Jr.,
Chairman, Committee on Finance,
U.S. Senate, Washington, DC.
    Dear Mr. Chairman: The Congressional Budget Office has 
prepared the enclosed cost estimate for H.R. 4986, the FSC 
Repeal and Extraterritorial Income Exclusion Act of 2000.
    If you wish further details on this estimate, we will be 
pleased to provide them. The CBO staff contact is Erin 
Whitaker.
            Sincerely,
                                          Barry B. Anderson
                                    (For Dan L. Crippen, Director).
    Enclosure.

H.R. 4986.--FSC Repeal and Extraterritorial Income Exclusion Act of 
        2000

    Summary: H.R. 4986 would repeal present-law foreign sales 
corporation (FSC) rules. Under current law, U.S. firms 
generally are subject to U.S. Tax on their worldwide income, 
but they are allowed tax credits for a portion of the income 
taxes they pay to foreign governments on that income. Within 
that general framework, U.S. law permits the use of FSCs, 
through which a portion of domestic firms' export income is 
characterized as foreign source and is exempted from U.S. tax. 
Under the proposal, U.S. firms could elect to exclude certain 
qualifying foreign trade income from their taxable income, with 
qualifying foreign trade income defined to include a portion of 
income attributable to sales by U.S. taxpayers. To be eligible 
for the exclusion, firms would not be allowed tax credits for 
income taxes paid to foreign governments on the qualifying 
foreign trade income. Qualifying foreign trade income would be 
calculated by using one of several formulas. The remaining 
portion of income earned from sources abroad would be taxed in 
a similar manner as under current law.
    The Joint Committee on Taxation (JCT) estimates that the 
bill would reduce revenues by $141 million in 2001, by about 
$1.6 billion over the 2001-2005 period, and by about $4.4 
billion over the 2001-2010 period. Because the bill would 
affect receipts, pay-as-you-go procedures would apply.
    H.R. 4986 contains no intergovernmental or private-sector 
mandates as defined in the Unfunded Mandates Reform Act (UMRA) 
and would not affect the budgets of state, local, or tribal 
governments.
    Estimated cost to the Federal Government: The estimated 
budgetary impact of H.R. 4986 is shown in the following table. 
Estimates of all provisions in the H.R. 4986 were provided by 
JCT.

----------------------------------------------------------------------------------------------------------------
                                                                   By fiscal year in millions of dollars--
                                                           -----------------------------------------------------
                                                              2000     2001     2002     2003     2004     2005
----------------------------------------------------------------------------------------------------------------
                                               CHANGES IN REVENUES

Estimated Revenues........................................        0     -141     -305     -340     -378     -423
----------------------------------------------------------------------------------------------------------------
Source: Joint Committee on Taxation.

    Pay-as-you-go consideration: The Balanced Budget and 
Emergency Deficit Control Act sets up pay-as-you-go procedures 
for legislation affecting direct spending or receipts. The net 
changes in governmental receipts that are subject to pay-as-
you-go procedures are shown in the following table. For the 
purposes of enforcing pay-as-you-go procedures, only the 
effects in the current year, the budget year, and the 
succeeding four years are counted.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                     By fiscal year in millions of dollars--
                                                        ------------------------------------------------------------------------------------------------
                                                          2000    2001     2002     2003     2004     2005     2006     2007     2008     2009     2010
--------------------------------------------------------------------------------------------------------------------------------------------------------
Changes in receipts....................................      0     -141     -305     -340     -378     -423     -466     -514     -566     -623     -687
Changes in outlays.....................................                                           Not applicable
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Intergovernmental and private-sector impact: H.R. 4986 
contains no intergovernmental or private-sector mandates as 
defined in UMRA and would not affect the budgets of state, 
local, or tribal governments.
    Previous CBO estimate: On September 13, 2000, CBO 
transmitted a cost estimate for H.R. 4986 as ordered reported 
by the House Committee on Ways and Means on July 27, 2000, with 
subsequent amendments provided on September 12, 2000. This 
estimate reflects the removal of a provision from the earlier 
version of H.R. 4986 which would allow domestic corporations to 
receive a tax deduction for certain dividends received from 
their foreign subsidiaries. This change would decrease the 
reduction in revenues, relative to the earlier version of H.R. 
4986, by $12 million in 2001, $36 million over the 2001-2005 
period, and $36 million over the 2001-2010 period.
    Estimate prepared by: Erin Whitaker.
    Estimate approved by: Roberton C. Williams, Deputy 
Assistant Director for Tax Analysis.

                       IV. VOTES OF THE COMMITTEE

    In compliance with paragraph 7(b) of rule XXVI of the 
Standing Rules of the Senate, the following statements are made 
concerning the rollcall votes in the Committee's consideration 
of the bill.

                       MOTION TO REPORT THE BILL

    H.R. 4986, the FSC Repeal and Extraterritorial Income 
Exclusion Act of 2000, was ordered favorably reported by voice 
vote, as amended.

                 V. REGULATORY IMPACT AND OTHER MATTERS


                          A. Regulatory Impact

    Pursuant to paragraph 11(b) of rule XXVI of the Standing 
Rules of the Senate, the Committee makes the following 
statement concerning the regulatory impact that might be 
incurred in carrying out the provisions of the bill as 
reported.

Impact on individuals and businesses

    The bill repeals the FSC provisions of the Code and 
provides an exclusion from gross income for certain 
extraterritorial income.

Impact on personal privacy and paperwork

    The bill should not have any adverse impact on personal 
privacy. Additional paperwork may be required with the respect 
to the application of the new regime to individuals.

                     B. Unfunded Mandates Statement

    This information is provided in accordance with section 423 
of the Unfunded Mandates Act of 1995 (P.L. 104-4).
    The Committee has determined that the bill does not contain 
Federal mandates on the private sector. The Committee has 
determined that the bill does not impose a Federal 
intergovernmental mandate on State, local, and tribal 
governments.

                         C. Complexity Analysis

    Section 4022(b) of the Internal Revenue Service Reform and 
Restructuring Act of 1998 (the ``IRS Reform Act'') requires the 
Joint Committee on Taxation (in consultation with the Internal 
Revenue Service and the Department of the Treasury) to provide 
a tax complexity analysis. The complexity analysis is required 
for all legislation reported by the House Committee on Ways and 
Means, the Senate Committee on Finance, or any committee of 
conference if the legislation includes a provision that 
directly or indirectly amends the Code and has ``widespread 
applicability'' to individuals or small businesses.
    The staff of the Joint Committee on Taxation has determined 
that a complexity analysis is not required under section 
4022(b) of the IRS Reform Act because the bill contains no 
provisions that amend the Code and that have widespread 
applicability to individuals or small businesses.

       VI. CHANGES IN EXISTING LAW MADE BY THE BILL, AS REPORTED

    In the opinion of the Committee, it is necessary in order 
to expedite the business of the Senate, to dispense with the 
requirements of paragraph 12 of Rule XXVI of the Standing Rules 
of the Senate (relating to the showing of changes in existing 
law made by the bill as reported by the Committee).

                                  
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