Rev. Rul. 89-93
1989-2 C.B. 133, 1989-32 I.R.B. 51.
Internal Revenue Service
Revenue Ruling
SPECIAL FSC SOURCING RULE
Published: August 7, 1989
Section 927. - Other Definitions and Special Rules, 26 CFR 1.927(e)-1T: Temporary regulations: special sourcing rule.
Special FSC sourcing rule. In determining the foreign source income of a related supplier of a FSC under section 927(e)(1) of the Code, the maximum amount of DISC commission must be determined.
ISSUE
In determining the foreign source income of a related supplier of a FSC under section 927(e)(1) of the Internal Revenue Code of 1986 and section 1.927(e)-1T of the Income Tax Regulations, must the maximum amount of DISC commission be determined?
FACTS
X, a domestic corporation that uses a June 30 taxable year, manufactures a product A within the United States for sale both within and without the Untied States. The items of product A sold within the United States were for use solely within the United States, and the items of product A sold without the United States were for use solely without the United States. With regard to the sales made without the United States after December 31, 1984, X paid Y, a foreign corporation owned by X that qualified as a foreign sales corporation ('FSC') under section 922(a) of the Code, a commission pursuant to an agreement between X and Y. The items of product A manufactured by X were 'export property' within the meaning of section 927(a) and the gross receipts from the sale of those items without the United States were 'foreign trading gross receipts' under section 924.
During X's taxable year ended June 30, 1987, its total gross receipts and gross income from the sale of product A without the United States were $7,700,000 and $1,700,000, respectively. X's and Y's combined taxable income on those sales, computed on a group basis, was $1,600,000. During that taxable year, all of X's assets were located within the United States. On September 15, 1987, X paid Y a commission in the amount of $468,000, which included a reimbursement of Y's expenses of $100,000 plus a profit of $368,000. The profit paid to Y of $368,000 was equal to 23% of X's and Y's combined taxable income, the maximum profit permitted under the administrative pricing rules of section 925 of the Code.
On September 15, 1987, X and Y filed their Federal income tax returns for their June 30, 1987, taxable years reflecting the payment of this commission. For purposes of computing its foreign tax credit limitation under section 904 of the Code, X determined its foreign source taxable income from the sale of product A without the United States to be $400,000, after applying EXAMPLE (2) of section 1.863-3(b)(2) of the regulations as limited by section 927(e)(1). Since the 23% of combined taxable income administrative pricing method was used to determine on Y's original return Y's taxable income form the export sales, EXAMPLE (1) of section 1.863-3(b)(2) is not applicable. See Notice 89-87, page 54, this Bulletin, which provides that EXAMPLE (2) of section 1.863-3(b)(2) must be used. Under EXAMPLE (2), X's foreign source gross income would have been $850,000 and its foreign source taxable income would have been $616,000. However, section 927(e)(1) operated to limit X's foreign source taxable income to $400,000. Under that section, X's income could not exceed the amount which would have been treated as foreign source taxable income had the comparable DISC pricing rule, in this case the 50% of combined taxable income method of section 994(a)(2), been used to compute Y's profit. The section 927(e)(1) limitation is computed as follows:
Combined taxable income
("CTI") ........................ $1,600,000
DISC income (50%
of CTI) ......................... 800,000
X's income (50% of
(CTI) ........................... 800,000
Source of X's taxable income
had the DISC pricing method
applied:
U.S. source .................. $400,000
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Foreign source ............... $400,000
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The $400,000 foreign source income is the maximum amount which may be treated as such by X even if Y received a profit on the sales of product A of less than 23% of combined taxable income. Under section 927(e)(1) of the Code, the limitation on the amount of X's foreign source income must be computed using the pricing rule under section 994 that is analogous to the pricing rule used under section 925. In addition, the maximum amount of DISC commission under the analogous method must be determined for purposes of computing the section 927(e)(1) limitation. Under the facts contained in this ruling, the DISC commission must equal 50% of the combined taxable income resulting in $800,000 in taxable income earned by X. Therefore, for purposes of the section 927(e)(1) limitation calculation, X's hypothetical income may never exceed 50% of combined taxable income, and, X's foreign source income may never exceed 25% of combined taxable income after applying EXAMPLE (2) of section 1.863-3(b)(2) of the regulations. See Notice 89-11, 1989-4 I.R.B. 11, which provides that EXAMPLE (2) of section 1.863-3(b)(2) must be used in the case of sales involving a FSC.
HOLDING
If a profit earned by FSC is determined under the combined taxable income method, the FSC's related supplier's foreign source taxable income after applying EXAMPLE (2) of the regulations of section 1.863-3(b)(2) as limited by section 927(e)(1) of the Code, may never exceed 25% of the related supplier's and FSC's combined taxable income since the maximum amount of DISC commission must be determined.
DRAFTING INFORMATION
The principal author of this revenue ruling is Richard Chewning of the Office of Associate Chief Counsel (International). For further information regarding the revenue ruling contact Mr. Chewning at (202) 566-6384 (not a toll-free call).
Rev. Rul. 89-93, 1989-2 C.B. 133, 1989-32 I.R.B. 51.