Under RR 98-14, could a South Carolina taxpayer deduct commissions paid to a foreign sales corporation instead of treating them as dividend-related expenses?

Plain-English summary

South Carolina Revenue Ruling 98-14 said commissions paid to a foreign sales corporation, or FSC, were deductible when the FSC had real economic substance and was properly incorporated and operated under IRC Sections 921 through 927. The Department did not treat those commissions as expenses related to dividends that had to be allocated under S.C. Code Section 12-6-2220.

The ruling distinguished a legitimate payment for sales services from a payment to a paper corporation. A qualifying commission FSC could sell a U.S. producer's goods in foreign markets and earn commissions for those services. If the FSC maintained the required foreign presence and activities and genuinely performed the work, the commission remained a business expense even if the commission income later funded a dividend to the FSC's shareholder.

Economic substance was the key limitation. The Department cited a South Carolina case that denied commissions paid to a DISC lacking substance, and contrasted decisions upholding FSC commissions where the foreign corporation had an office, business activity, expenses, or other evidence that it was more than a paper entity.

Conditions in the ruling

• The FSC had to have economic substance.
• It had to be properly formed and operated under IRC Sections 921-927.
• The commission had to compensate the FSC for actual services, such as selling the producer's products in foreign markets.
• A later dividend funded by commission income did not by itself convert the commission into a dividend-related expense.
• The ruling said the same substance-and-compliance principles applied to buy-sell FSCs and small FSCs, even though its main analysis addressed a commission FSC that was not a small FSC.

Common questions

Q: Did RR 98-14 allow every payment labeled an FSC commission? No. The FSC needed economic substance and proper formation and operation under the cited federal provisions.

Q: Why was the dividend issue important? S.C. Code Section 12-6-2220 allocated dividends, less related expenses, to a corporation's principal place of business or an individual's domicile. The Department concluded a legitimate commission for services was not a dividend-related expense merely because the FSC later paid dividends.

Q: What happened if the foreign corporation was only a paper entity? The ruling said substance mattered and discussed Lowenstein, where commission deductions were denied because the DISC lacked economic substance.

Q: Does this page state current international-tax law? No. It summarizes a 1998 ruling and the federal FSC provisions it applied. Current federal and South Carolina rules should be checked independently.

Citations and references

• S.C. Code Ann. § 12-6-580 (South Carolina corporate taxable income based on federal income with state modifications, allocation, and apportionment)
• S.C. Code Ann. § 12-6-2220 (allocation of dividends less related expenses)
• IRC §§ 162, 245, 482, and 921-927 (business-expense deduction, dividends-received deduction, pricing, and FSC requirements discussed)
• Lowenstein v. South Carolina Tax Commission, 277 S.C. 561, 290 S.E.2d 812 (1982) (commission payments to a DISC lacking economic substance)
• SLI International Corporation v. Crystal, 236 Conn. 156, 671 A.2d 813 (1996) (FSC commission deduction upheld in the circumstances described)
• Kimberly Clark Corporation as Successor to Kimtech, Ltd. v. Wisconsin Department of Revenue, 1994 WL 128957 (Wis. Tax App. Comm.) (FSC commissions upheld where the corporation had substantial business reasons and activities)

Subject

Deductibility of Commissions Paid to Foreign Sales Corporations

Source

• Landing page: https://dor.sc.gov/advisory-opinion-search
• Original PDF: https://dor.sc.gov/sites/dor/files/policies/RR98-14.pdf

Original ruling text

State of South Carolina

Department of Revenue
301 Gervais Street, P.O. Box 125, Columbia, South Carolina 29214

SC REVENUE RULING #98-14

SUBJECT:

Deductibility of Commissions Paid to Foreign Sales Corporations
(Income Tax)

EFFECTIVE DATE:

Applies to all periods open under the statute.

SUPERSEDES:

All previous documents and any oral directives in conflict
herewith.

REFERENCES:

S. C. Code Ann. Section 12-6-580 (Supp. 1997)
S.C. Code Ann. Section 12-6-2220 (Supp. 1997)

AUTHORITY:

S. C. Code Ann. Section 12-4-320 (Supp. 1997)
SC Revenue Procedure #97-8

SCOPE:

A Revenue Ruling is the Department of Revenue’s official
advisory opinion of how laws administered by the Department are
to be applied to a specific issue or a specific set of facts, and is
provided as guidance for all persons or a particular group. It is
valid and remains in effect until superseded or modified by a
change in the statute or regulations or a subsequent court decision,
Revenue Ruling or Revenue Procedure.

Question:
Are commissions paid to a foreign sales corporation (hereinafter referred to as an “FSC”)
deductible in determining South Carolina taxable income or are they treated as an expense
related to dividends requiring that the commission expense be allocated to the state of a
corporation’s principal place of business or to the domicile of an individual taxpayer pursuant to
Section 12-6-2220 of the South Carolina Code of Laws (“Code”)?
Conclusion:
Provided that the FSC has economic substance and is properly incorporated and in operation in
accordance with Sections 921 through 927 of the Internal Revenue Code (hereinafter referred to
as “IRC”), the commissions paid to the FSC will be deductible and will not be considered an
expense related to dividends.
1

Discussion:
Before the Tax Reform Act of 1984, U.S. businesses doing business in foreign markets used
Domestic International Sales Corporations (referred to as DISCs) to defer a portion of their
foreign income from taxation in the United States. However, the advent of the General
Agreement on Tariffs and Trade (commonly referred to as “GATT”) led many to believe that
DISC’s created an “illegal export subsidy” for companies that were in reality doing business in
the United States. In response to this criticism, Congress severely limited the use of DISCs and
created a new type of entity referred to as a foreign sales corporation (“FSC”). The creation and
governing rules concerning FSC’s are contained in Sections 921 through 927 of the IRC. 1
Typically, the FSC operates as a wholly owned subsidiary of a U.S. producer and sells products
supplied by the U.S. parent/producer in foreign markets. To qualify as an FSC, a corporation
must comply with numerous complex statutes and regulations that require FSCs to meet strict
guidelines for incorporation and operation. If a FSC meets all of the requirements, a portion of
its income will be exempt from federal tax and any dividends that it pays to its domestic
corporate shareholders out of earnings and profits attributable to “foreign trade income” will
receive a dividends received deduction under Section 245 of the IRC.
The FSC provisions contain a number of requirements and qualifications designed to insure that
an FSC has a presence outside the United States and that its income which is exempt from U.S.
tax is attributable to substantial commercial activity conducted outside the United States. See,
Gustafson, Peroni & Pugh, Taxation of International Transactions, pg. 666 (First Ed. 1997).
To qualify as an FSC the corporation must meet the requirements of Section 922(a) of the IRC.
These requirements are: (1) The FSC must be a corporation created or organized under the laws
of a foreign country (in order to be a qualifying foreign country the country must have a
Treasury approved exchange of information program) or a possession of the United States; (2)
The FSC must not have more than 25 shareholders at any time during the taxable year; (3) The
FSC must not have any preferred stock outstanding during the taxable year; (4) The FSC must
maintain an office in a foreign country or in a possession of the United States. At this office, the
FSC must maintain a set of permanent books and records of its own accounts (if the office is
located in a foreign country, it must be located in a country that has a Treasury approved
exchange of information program); (5)The FSC must maintain records sufficient to meet the
requirements of Section 6001 of the IRC in a location in the U.S.; (6) The FSC must have a
board of directors that includes at least one individual who is not a resident of the United States;
(7) The FSC must not be a member of any controlled group of corporations of which a DISC is a
member; and, (8) the corporation must have elected to be treated as an FSC.
If a corporation is eligible to be an FSC, a portion of the FSC’s “foreign trade income” is exempt
from U.S. income tax. Income qualifies as “foreign trade income” only if it is gross income
1

From a paper prepared by Ann N. Boyd presented for State and Local Tax Course at the South
Carolina University School of Law (April 3, 1997).
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attributable to “foreign trading gross receipts”. An FSC is treated as having “foreign trading
gross receipts” only if: (1) the management of the FSC is carried on outside the United States
and (2) the economic processes from which the income is derived takes place outside the United
States. See, Section 924 of the IRC. Excluded from the definition of “foreign trade receipts” are
certain types of income from property, as well as investment income (including dividends,
interest, royalties, annuities, and rent) and carrying charges. See, Sections 921 through 927 of
the IRC.
In addition, the income of the FSC must be determined on the basis of actual arm’s length prices
under Section 482 of the Internal Revenue Code or on the basis of special administrative
formulas provided for in the statutes. If the FSC uses the arm’s length Section 482 method, 30%
of the FSC’s “foreign trade income” will be exempt from federal income tax if the shareholder of
the FSC is a U.S. corporation (32% in all other cases). If the FSC uses the administrative pricing
methods set forth in the statute, 15/23rds of the “oreign trade income” will be exempt from
federal taxes if the shareholder is a U.S. corporation (16/23rds in all other cases). See, Section
923 and 291 of the IRC.
FSCs exist in one of two forms. A commission FSC usually contracts with a principal (often a
U.S. corporation) to sell the goods of the U.S. corporation in a foreign market. In turn, the
company that is producing the product will pay the FSC a commission for selling the product. A
buy-sell FSC actually buys the exported product from the U.S. corporation and then sells it in a
foreign market. 2
For example, assume that Corporation A, has a wholly owned FSC. Corporation A pays the FSC
a commission to sell Corporation A’s product overseas. Corporation A is entitled to deduct the
commission expense as an ordinary and necessary business expense under Section 162 of the
Internal Revenue Code. Additionally, assuming the FSC has met all the requirements for foreign
management and foreign economic processes, the commission expense received by FSC is
considered “foreign trade income”, 15/23rds of which is exempt from federal tax. The FSC pays
Corporation A a dividend out of the earnings and profits attributable to “foreign trade income”
and the dividend is 100% deductible under Section 245(c)(1) of the IRC. 3
2

Either a commission FSC or a buy-sell FSC may elect to be treated as a small FSC under
Section 922(b) of the IRC if they meet the requirements of the statute. An FSC that elects to be a
small FSC does not have to meet the foreign management or the foreign economic process
requirements set forth in Section 924 of the IRC in order to have foreign trading gross receipts.
However, in determining the small FSC’s foreign trade income, foreign trading gross receipts
that exceed $5 million are not taken into account. Additionally, a small FSC is only allowed to
use the administrative pricing rules set forth in IRC Section 925(1) and (2) and may not use the
arm’s length method of pricing. See, Taxation of International Transactions, supra at p. 690.
3

A domestic corporation is entitled to a 100% dividends received deduction for a distribution of
earnings and profits attributable to “foreign trade income”, other than Section 923(a)(2) nonexempt income. See, Section 245(c)(1)(A) of the IRC. Individuals do not receive a dividends
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South Carolina has adopted Section 245 and Sections 921-927 of the IRC. (See, Code Section
12-6-50 for those provisions of the IRC which have not been adopted by South Carolina).
Furthermore, Code Section 12-6-580 provides that a corporation’s South Carolina taxable
income and the unrelated business income of a corporation exempt from taxation under Internal
Revenue Code section 501, et. seq. is computed as determined under the Internal Revenue Code
with the modifications provided in Article 9 of this chapter and subject to allocation and
apportionment as provided in Article 17 of this chapter. For federal income tax purposes, the
commission expense is usually deductible as an ordinary and necessary business expense
pursuant to Section 162 of the IRC.
Section 12-6-2220 of the Code provides that :
The following items of income must be directly allocated and excluded from the
apportioned income and the apportionment factors:
“...(2) Dividends received from corporate stock owned, less all related expenses,
are allocated to the state of the corporation’s principal place of business as
defined in Section 12-6-20(9) or the domicile of an individual taxpayer.”
One salient point about commission FSCs is that in many instances, the primary source of an
FSC’s income is the commissions it receives. It is possible that this might be the only income
from which the FSC may pay dividends to its shareholders. The shareholder who is receiving
the dividend is also the company that is paying the commission to the FSC. (In some instances,
the commission may be being paid by another corporation such as a brother-sister corporation.)
This has lead some parties to question whether the commission expense which is deductible by
the party paying the commission, is an expense related to dividends and therefore, allocable to
the principal place of business of the corporation or to the domicile of the individual.
Thus, the question becomes whether the commission expense is an expense related to the
generation of the dividend or whether the commission expense is a legitimate business expense
in payment for services rendered by the FSC. The answer to this question, in part, hinges on
whether the FSC itself is a corporation of substance, such that the payment of an expense to the
corporation would be considered a legitimate business deduction. As a general rule, if a
corporation has substance, the corporate form will be upheld.
In Lowenstein v. South Carolina Tax Commission, 277 S.C. 561, 290 S.E. 2d 812 (1982), the
South Carolina Supreme Court refused to recognize the legitimacy of commission payments
made to a commission DISC, finding that in this particular instance, the DISC was a mere “paper
corporation” which lacked economic substance. Therefore, the court disallowed the deduction of
the commission expense finding that it was not an ordinary and necessary business expense.

received deduction.
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Recently, two separate tribunals have considered whether commissions paid to FSCs are
deductible. In SLI International Corporation v. Crystal, 236 Conn. 156, 671 A. 2d 813 (1996),
the Connecticut Supreme Court considered whether the commission paid by a brother-sister
corporation of an FSC was an expense related to dividends, when the parent corporation received
a dividend from the FSC. The Connecticut court in that instance found that the federally
qualified FSC was a corporation with economic substance because it had an office in a foreign
county, it had income other than the commissions received from its brother-sister corporation
and the FSC had legitimate business expenses. Furthermore, the commission expenses that were
paid by the brother-sister corporation to the FSC for its services were valid business expenses
and thus, these commission expenses were eligible to be deducted in determining the brothersister corporation’s Connecticut corporate business tax.
The Connecticut Supreme Court concluded that because FSCs in general, and the one in the case
before them in particular, have economic substance and necessarily had expenses and other
potential sources of income, the FSC could not be disregarded and the commission expense was
properly deductible.
In Kimberly Clark Corporation as Successor to Kimtech, Ltd. v. Wisconsin Department of
Revenue, 1994 WL 128957 (Wis. Tax App. Comm.), the Wisconsin Tax Appeals Commission
determined that the Kimberly Clark Sales Corporation (an FSC) was formed for substantial
business reasons and carried on substantial business activities. The commission further
determined that the FSC had earned the commissions paid to it and therefore there was no basis
to deny the corporation that paid the commission a deduction for that commission.
In both SLI International Corporation and Kimberly Clark Corporation, the tribunals took pains
to distinguish prior state court decisions involving DISCs where the corporate form of the DISC
was found to be a “mere paper corporation”. In their decisions, the tribunals noted that it was
clear, that unlike prior DISC law, in order for a corporation to properly qualify as a FSC it must
have economic substance because of the substantial requirements relating to a foreign presence.
In instances where an FSC has economic substance and performs the function of selling the U.S.
producer’s product in foreign markets and incurs expenses in connection with that function, the
commission expense is a legitimate business expense to compensate the FSC for its services.
The fact that the commission itself may constitute all, or part, of the earnings and profits of
which the FSC may pay dividends to its shareholders does not convert it into an expense related
to dividends. To hold otherwise, would subject every potentially deductible payment that is
made from a parent to a subsidiary to the possibility of being disallowed as an expense related to
dividends.
NOTE: While this document specifically deals with the deductibility of commissions paid to a
commission FSC that is not a small FSC, the legitimacy of transactions of buy-sell FSC’s will be
upheld if the buy-sell FSC has economic substance and is properly formed and operated in
accordance with IRC Sections 921- 927. Likewise, the legitimacy of transactions involving
small FSC’s will depend on whether the small FSC has economic substance and whether it is
properly formed and operated in accordance with Sections 921 - 927 of the IRC.
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SOUTH CAROLINA DEPARTMENT OF REVENUE

s/Burnet R. Maybank III
Burnet R. Maybank, III, Director
Columbia, South Carolina
, 19 98
June 22

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