Section 925 and Its Administrative Pricing Rules

Section 925 of the Internal Revenue Code was part of the Foreign Sales Corporation (FSC) regime, which existed from 1984 until its repeal. The FSC rules offered a tax incentive for U.S. companies by exempting a portion of their export income from corporate income tax. The provision established administrative pricing rules to allocate income between a U.S. parent company and its FSC, which determined the amount of tax-exempt income. These rules were an alternative to the “arm’s-length” pricing standard required under Section 482 for transactions between related entities, providing a clearer method for determining taxable profit from foreign sales.

Qualifying as a Foreign Sales Corporation

To use these benefits, a company first had to meet several requirements to qualify as an FSC, ensuring it had a legitimate presence and conducted business outside the United States. Organizationally, the corporation had to be established under the laws of a qualified foreign country or a U.S. possession that had an information-sharing agreement with the U.S. Treasury. The FSC was also limited to 25 shareholders, could not have preferred stock, and was required to maintain a foreign office with a permanent set of books and records.

Beyond its structure, an FSC had to satisfy foreign management and economic process tests. Foreign management rules required all shareholder and board meetings to occur outside the U.S. and the principal bank account to be maintained abroad. The economic processes test demanded that the FSC or its contractor participate in activities like soliciting or negotiating contracts and bear a portion of foreign direct costs, such as advertising or arranging delivery.

Applying the Administrative Pricing Rules

The administrative pricing rules provided three methods for determining the transfer price on sales from a U.S. parent to its FSC. This price dictated the profit allocation and the amount of “foreign trade income” eligible for tax exemption. Companies could choose the method that resulted in the most favorable tax outcome for a given transaction.

The 1.83% of Foreign Trading Gross Receipts Method

The first rule allowed the transfer price to be set so the FSC earned a profit equal to 1.83% of the foreign trading gross receipts from the sale. This method was limited, as the FSC’s profit could not exceed 46% of the combined taxable income of the FSC and its supplier. For example, on a sale with $100,000 in foreign trading gross receipts, the FSC’s profit would be $1,830, provided this did not exceed the limit. This amount was the FSC’s income, with the remainder allocated to the U.S. parent.

The 23% of Combined Taxable Income Method

The second method allowed the transfer price to allocate 23% of the combined taxable income (CTI) of the FSC and its parent to the FSC. CTI was the total profit from the export sale, calculated by subtracting the parent’s cost of goods sold and other expenses from the final sales price. For instance, if a sale generated a CTI of $10,000, the FSC would be allocated a profit of $2,300, with the remaining profit attributed to the U.S. parent company.

The Section 482 Arm’s-Length Method

The third option was to use the standard “arm’s-length” transfer pricing rules. This method required the price between the U.S. parent and the FSC to be the same as what would be charged between two unrelated parties in a comparable transaction, which required a detailed economic analysis. This approach could be beneficial if the FSC performed significant functions or assumed substantial risks, potentially justifying a larger profit allocation to the FSC than the other two formulas allowed. If this method was used, 30% of the FSC’s foreign trade income was exempt from federal tax.

Repeal and Legacy of the FSC Regime

The FSC regime and its pricing rules were dismantled after the World Trade Organization (WTO) ruled in 2000 that the system was an illegal export subsidy. The WTO found the tax exemption was contingent on export performance, violating international trade agreements. This ruling forced the United States to repeal the FSC provisions to avoid retaliatory tariffs from its trading partners.

In response, Congress enacted the Extraterritorial Income (ETI) exclusion in 2000, designing it to be WTO-compliant by extending tax benefits to income from certain foreign transactions, not just exports. The WTO also ruled the ETI exclusion was an illegal subsidy, leading to its repeal in 2004.

Although the FSC and ETI regimes are defunct, they have a lasting legacy in U.S. international taxation. Tax professionals may still encounter these rules when dealing with audits of past tax years or analyzing corporate tax histories. The rise and fall of the FSC regime also serves as a case study on the conflict between domestic tax incentives and international trade obligations.