If a U.S. company's export-sales subsidiary is a Foreign Sales Corporation (FSC) that properly uses the IRS's safe-harbor administrative pricing rules to set its commissions, does that automatically mean New York can't require a combined franchise tax report between the parent and the FSC?

Subject

Whether, for taxable years 1984, 1985, and 1986, United States Surgical Corporation is required to file a combined franchise tax report with its wholly owned subsidiary Auto Suture FSC Ltd. to properly reflect its Article 9-A franchise tax liability.

Plain-English summary

United States Surgical Corporation's wholly-owned subsidiary, Auto Suture FSC Ltd. ("FSC"), was incorporated in the U.S. Virgin Islands as a Foreign Sales Corporation — a structure Congress created in 1984 to give U.S. exporters a tax break on export income. FSC had no property, payroll, or sales in New York; its only income was commissions earned by participating in the parent's export sales, computed under IRC § 925's "administrative pricing rules" — a safe-harbor formula (either 1.83% of gross receipts or 23% of combined taxable income) that, once properly used, prevents the IRS from making further income reallocations under the general arm's-length rule of IRC § 482. Because New York generally follows federal income-tax concepts, the parent argued that FSC's proper use of this federal safe harbor meant a combined New York report with FSC wasn't necessary — that using the safe harbor was itself proof there was no distortion to fix.

The Department disagreed with that reasoning, though it didn't resolve the ultimate question. First, it noted the administrative pricing safe harbor only covers the commission FSC earns on qualifying export sales — it says nothing about other intercompany dealings, like fees the parent charges FSC for services, or amounts charged to related foreign purchasers (which remain governed by ordinary IRC § 482 arm's-length principles, treating FSC and the parent as a single seller). Citing prior state cases (Standard Manufacturing Co. and Digital Equipment Corp.), the Department emphasized that even where federal arm's-length pricing rules were followed, a combined report can still be required if actual evidence shows non-arm's-length prices produced distortion — merely showing that a federal safe harbor was available isn't the same as proving prices were actually adjusted to arm's-length levels for the years at issue. Under Tax Law § 211.4 and 20 NYCRR § 6-2.5(a), the Commissioner isn't precluded from requiring FSC's inclusion in a combined report if substantial intercorporate transactions exist that could distort the parent's reported New York tax liability — regardless of whether some federal safe harbor or informal understanding also happens to apply. Because whether that necessity actually exists is a factual question, the Department left the final combined-report determination to be resolved on audit.

What this means for you

Companies with a Foreign Sales Corporation (or similar) subsidiary

Properly using a federal transfer-pricing safe harbor (like the FSC administrative pricing rules) for one category of intercompany income doesn't automatically insulate you from a state combined-report requirement — especially for other categories of intercompany charges the safe harbor doesn't reach (service fees, allocations, etc.).

Multinational or multistate corporate groups relying on federal arm's-length compliance

Simply showing that federal transfer-pricing rules were available and used isn't the same, for New York purposes, as proving actual arm's-length prices were charged for the specific years at issue — expect the Department to want evidence, not just eligibility, before conceding no distortion occurred.

Accountants and tax professionals

This ruling reinforces the Standard Manufacturing / Digital Equipment line of state cases: a combined report determination turns on actual evidence of intercorporate transactions and pricing for the years under review, not on the mere existence of a federal compliance mechanism. Note that FSC-related combined-report questions are inherently fact-intensive and, per Tax Law § 171(24), can't be conclusively resolved in an advisory opinion — expect these disputes to play out at audit.

Common questions

Q: Does using the IRC's FSC administrative pricing safe harbor prevent New York from requiring a combined report?
A: Not automatically. The safe harbor covers only the commission on qualifying export sales; other intercompany transactions remain subject to ordinary scrutiny, and even safe-harbor compliance doesn't itself prove no distortion existed for the years at issue.

Q: What does New York actually require before mandating a combined report with a foreign subsidiary?
A: Under Tax Law § 211.4 and 20 NYCRR § 6-2.5(a), the Commissioner must determine that inclusion is necessary to properly reflect a taxpayer's tax liability because of substantial intercorporate transactions or an arrangement causing inaccurate reporting.

Q: Can another company with an FSC subsidiary rely on this ruling?
A: No. This advisory opinion binds the Department only for the taxpayer and facts presented, and cannot be relied on by anyone else — and even here, the Department did not make the final combined-report determination, leaving it to audit.

Citations and references

Statutes and regulations:

• Tax Law § 211.4 (Commissioner's discretion to require/permit combined reports)
• Tax Law § 211.5 (intercompany transactions/agreements justifying a combined report)
• 20 NYCRR § 6-2.1 (combined report requirements: capital stock, unitary business, other requirement)
• 20 NYCRR § 6-2.5(a) (foreign corporation inclusion in combined report; substantial intercorporate transactions)
• 26 U.S.C. § 924, § 925 (foreign sales corporation activities and administrative transfer pricing rules)
• 26 U.S.C. § 482 (arm's-length allocation of income between related parties)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1989.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a89_2c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-89 (2)C
Corporation Tax
January 31, 1989

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. C880726A

On July 26, 1988, a Petition for Advisory Opinion was received from United States Surgical
Corporation, 150 Glover Avenue, Norwalk, Connecticut 06856.
The issue raised is whether for taxable years 1984, 1985 and 1986, Petitioner is required to
file a combined franchise tax report with its wholly owned subsidiary, to properly reflect Petitioner's
franchise tax liability under Article 9-A.
Facts
Petitioner's subsidiary, Auto Suture FSC Ltd. (hereinafter "FSC") was incorporated in the
U.S. Virgin Islands on December 21, 1984. It filed an election to be taxed as a foreign sales
corporation for federal income tax purposes on March 20, 1985.
FSC has no property, payroll, or sales in New York State. Its income is derived from
commissions earned on its participation in export sales made by its related supplier, Petitioner. Its
expenses relate to the performance through its agents of substantive activities ("foreign economic
processes") relating to such export sales. All these activities take place offshore.
Pursuant to the requirements of section 922 of the Internal Revenue Code (hereinafter "IRC"),
and the regulations thereunder, FSC maintains an office in the Virgin Islands. This office is
administered by an unrelated management company to whom an annual fee is paid by FSC. As
required by the IRC, various records of FSC are maintained at this office. These records include
invoices, statements of accounts, quarterly income statements, and annual balance sheets. The Board
of Directors of FSC consists of three individuals. Two of the directors are officers of Petitioner. A
third director is an outside director who resides in the U.S. Virgin Islands. All board meetings are
held in the U.S. Virgin Islands pursuant to the foreign management requirements of section 924 of
the IRC.
In accordance with the rules prescribed by section 924 of the IRC, FSC performs various
activities relating to the solicitation of export sales as well as specified economic processes relating
to export sales. Since FSC has no employees, these activities are performed by others on behalf of
FSC. Accordingly, FSC has entered into a number of contracts that provide for the performance of
these activities.
The basic contract entered into between FSC and Petitioner provides for the participation of
FSC in transactions that give rise to "foreign trading gross receipts." The contract further provides
that various services may be provided for FSC in connection with such participation, either by
Petitioner or by third parties. The contract provides for payment to Petitioner for services rendered
by it.
TP-9 (9/88)

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Another contract entered into by FSC with Auto Suture U.K. Ltd. (hereinafter "U.K."), a
wholly owned subsidiary of Petitioner, provides for the performance of certain services by U.K.
relating to the export sales in which FSC participates. These services include the preparation of
invoices and statements of account. The agreement provides for the payment of fees by FSC to U.K.
FSC's income is earned in the form of commissions paid to it by Petitioner. The
commissions are based on export sales made by Petitioner. These sales include both sales to wholly
owned foreign subsidiaries and sales to unrelated foreign customers. The commissions are
determined pursuant to the administrative pricing rules prescribed by section 925 of the IRC. These
rules permit FSC to earn a "safe harbor" profit and provide that the Internal Revenue Service may
not make any further allocations of income under section 482 of the IRC.
New York State has not enacted any special provisions concerning the taxability of foreign
sales corporations. Petitioner contends that inasmuch as New York State generally accepts federal
income tax concepts, including those relating to allocation of income pursuant to section 482 of the
IRC, and inasmuch as FSC has properly availed itself of the administrative pricing rules provided
by section 925 of the IRC, a combined report would not be necessary in order to properly reflect
Petitioner's franchise tax liability. Petitioner also contends that the failure of the Legislature to enact
any specific provision relating to a foreign sales corporation evidences its intent that the
administrative pricing rules would be deemed to properly reflect Petitioner's tax liability.
Discussion
The foreign sales corporation provisions contained in sections 921 through 927 of the IRC
were added by P.L. 98-369 and are applicable to transactions after 1984 in tax years ending after
December 31, 1984.
Section 925 of the IRC provides that in the case of a sale of export property to a foreign sales
corporation by a related person, the taxable income of both the foreign sales corporation and the
related person is based upon a transfer price determined under an arm's-length approach.
Treasury Regulation section 1.925(a)-lT provides the transfer pricing rules. Such rules apply,
generally, only if a transaction gives rise to foreign trading gross receipts. However, such rules will
also apply if the foreign sales corporation is acting as commission agent for a related supplier with
regard to a transaction on which the related supplier is the principal, if the transaction would have
resulted in foreign trading gross receipts had the foreign sales corporation been the principal. The
allowable transfer price or commission a related party may charge or pay to a foreign sales
corporation is determined by one of three transfer pricing methods: the "1.83 percent" gross receipts
method and the "23 percent" combined taxable income method (these are described as the
administrative pricing rules and they may be used when certain conditions are met) and the section
482 method. Subject to the special no-loss rule, any or all of the transfer pricing methods may be
used in the same taxable year for separate transactions or groups of transactions. If either of the

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administrative pricing rules is applied to a transaction, the Commissioner of the Internal Revenue
Service may not make distributions, apportionments or allocations as provided by section 482 of the
IRC.
The transfer pricing rules only apply to the price of a sale to a foreign sales corporation (or
foreign sales corporation commissions). A foreign sales corporation, or a principal for which the
foreign sales corporation is acting as commission agent, must sell to a related purchaser on an arms­
length basis, under the provisions of section 482 (relating to the allocation of income and deductions
between related parties), viewing the foreign sales corporation and any related supplier as a single
entity which sells to the purchaser. S.Prt. No. 169, 98th ConE., 2d. Sess., Vol. 1, 649 (1984).
Section 211.4 of the Tax Law authorizes the Commissioner of Taxation and Finance
(hereinafter "Commissioner"), in his discretion, to require or permit a parent corporation and its
wholly-owned subsidiaries to file a franchise tax report on a combined basis. However, a combined
report embracing a corporation not a taxpayer (i.e., a foreign corporation not doing business in New
York) cannot be required unless the Commissioner deems such a report necessary, in order to
properly reflect the tax liability under Article 9-A because there are intercompany transactions or
some agreement, understanding, arrangement or transaction referred to in section 211.5.
Section 6-2.1 of the Business Corporation Franchise Tax Regulations (hereinafter
"Regulations") provides that the capital stock requirement, the unitary business requirement and the
other requirement set forth in section 6-2.3 or section 6-2.5(a), as the case may be, must be met
before the Commissioner may require a group of corporations to file on a combined basis. Herein,
it is clear that the capital stock and the unitary business requirement have been met. Thus, question
is whether the requirement of section 6-2.5 has been met.
Section 6-2.5 of the regulations provides that a foreign corporation not subject to tax in New
York will not be required to be included in a combined report unless the Commissioner determines
that inclusion of the corporation is necessary to properly reflect the tax liability of one or more
taxpayers included in the group either because of substantial intercorporate transactions or because
of some agreement, understanding, arrangement or transaction whereby the activity, business,
income or capital of any taxpayer is improperly or inaccurately reflected.
Herein, FSC operates in accordance with the extensive rules prescribed by section 924 of the
IRC. When certain conditions are met, the commissions earned by FSO may be determined pursuant
to the administrative pricing rules prescribed by section 925 of the IRC. Where the administrative
pricing rules are not used, the provisions of section 482 of the IRC are applied. Transfer pricing
rules apply to individual transactions or groups of transactions. Accordingly, in a taxable year the
administrative pricing rules could be applied to some transactions, while section 482 rules are
applied to other transactions. If the administrative pricing rules are applied to a transaction, the
Commissioner of the Internal Revenue Service may not make distributions, apportionments or
allocations as provided by section 482 of the IRC. However, the administrative pricing rules only
apply to the commissions earned by FSC on the sale of export property. The administrative pricing
rules do not apply to the amount Petitioner charges FSC for the services it performs for FSC. In
addition, section 482 rules will apply to the sales price charged to a related purchaser, viewing

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Petitioner and FSC as a single entity selling to the purchaser.
In Standard Manufacturing Co. Inc., v. State Tax Commission, 114 AD2d 138, aff'm 69
NY2d635, the court found sufficient evidence to support the determination that a combined report
should be filed notwithstanding the taxpayer's assertions that it had shown that distortion was
impossible since the taxpayer had entered into an agreement with the Internal Revenue Service to
adjust taxpayer's prices to reflect arm's-length transactions under section 482 of the IRC. The court
found such assertions flawed in light of the absence of proof that price adjustments pursuant to the
agreement were made for the years at issue.
It appears that Petitioner's contention that a combined report would not be necessary
inasmuch as FSC has properly availed itself of the administrative pricing rules provided by section
925 of the IRC is equally flawed in the absence of proof that price adjustments were made for the
years at issue.
Moreover, in the Matter of Digital Equipment Corporation, Decision of the State Tax
Commission, June 28, 1985, TSB-H-85(29)C, the Tax Commission determined that a combined
report was not required and it indicated that:
Unlike Matter of Standard Manufacturing Co., Inc. (State Tax Comm., May 2, 1984),
where the taxpayer unsuccessfully asserted that section 482 adjustments assured
arm's length prices between it and its Puerto-Rican- based subsidiary for subsequent
years not reviewed by the Service, Digital provided evidence of changes for the
taxable years at issue. The Audit Division then made no showing that such changes
did not result in arm's length prices. (Emphasis supplied).
It must be concluded from the last sentence of the above quotation that a combined report
would be appropriate even in a case where section 482 adjustment are made by the Internal Revenue
Service if non-arm's length prices (and hence distortion) are found to exist. (See also, Matter of
Boehringer Ingelheim Pharmaceuticals, Inc., Decision of the State Tax Commission, January 17,
1986, TSB-H-86(5)C).
Additionally, franchise tax regulation section 6-2.5(a) provides that a foreign corporation will
not be required to be included in a combined report unless inclusion is necessary to properly reflect
the tax liability of a taxpayer because of substantial intercorporate transactions or some agreement,
understanding, arrangement or transaction whereby the activity, business, income or capital of the
taxpayer is improperly or inaccurately reflected. Thus, based upon regulation section 6-2.5(a), a
foreign corporation may be required to be included in a combined report if it is necessary to properly
reflect the tax liability of a taxpayer if substantial intercorporate transactions exist whether or not
some agreement, understanding, arrangement or transaction results in a taxpayer's activity, business,
income or capital being inaccurately or improperly reflected.
Accordingly, for the taxable years at issue, it is determined that the Commissioner is not
precluded from requiring the inclusion of FSC in a combined report of Petitioner under the
circumstances described herein if the Commissioner determines that inclusion is necessary to
properly reflect the tax liability of Petitioner. In addition, it is noted that the foreign sales
corporation provisions contained in sections 921 through 927 of the IRC were applicable to

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transaction after 1984 in tax years ending after December 31, 1984.
Whether the inclusion of a corporation in a combined report is necessary is a question of fact
not susceptible of determination in an Advisory Opinion. An Advisory Opinion merely sets forth
the applicability of pertinent statutory and regulatory provisions to "a specified set of facts". Tax
Law, § 171, subd. twenty-fourth; 20 NYCRR 901.1(a). Therefore, a determination cannot be made
in an Advisory Opinion as to whether a combined report shall be permitted or required. Inasmuch
as the question of whether Petitioner and FSC will be required to file a combined report for taxable
years ending 1984, 1985 and 1986, arises within the context of an audit, the necessary factual
determination will be made within such context, in accordance with the principles outlined above.

DATED: January 31, 1989

s/FRANK J. PUCCIA
Director
Technical Services Bureau

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.