Tax Data Management - Second Issue 2002

This is a newsletter from J.D. Choi of Tax Technologies, Inc. to tax professionals whose interests are improving the tax management processes.

Table of Contents

1. FSC and EIE Optimization
2. Form Automation
3. AuditTracker^TM is marching on
4. Tax Software Backup Plans
5. Mark your calendar

Due to the challenges by the WTO, the US government has changed the rules on tax benefits for export sales. It is being changed from Foreign Sales Corporation (FSC) regime to Extraterritorial Income Exclusion (EIE). Despite the intent of WTO to eliminate tax benefits on export sales by US companies, this transition from FSC to EIE created an extraordinary opportunity for export companies. I explore this in detail in this newsletter. For many export oriented companies, this will provide an additional way to reduce their effective tax rate.

I also discuss form automation issues in this newsletter. Based on my experience dealing with large companies, in particular financial service companies, I know they suffer from significant form compliance issues. For example, companies have to prepare a large number of Forms 1099, 1041, and many other statutory forms. The issue is how to produce relatively simple forms in large numbers. This issue can be simply solved by using existing technology.

1. To FSC or to EIE? That is the question.

The transition of FSC to EIE offers an extraordinary opportunity to many export companies. Here is why.

Under the FSC regime, many companies have applied the transaction-by-transaction ("TbyT") method of computing the FSC commission. Under the TbyT method, the amount of profit to the FSC is maximized by separating transactions by groups of different profit percentages and applying different pricing methods such as foreign trading gross receipt method, marginal costing method and combined taxable income method. Of course the computation must take into account the product grouping and overall profit percentage (OPP) limitations.

As far as the calculation goes, there are no substantive changes between FSC and EIE. However, because a company can elect to have FSC benefit or EIE benefit for a given transaction, effectively, a company can have two product groupings in two different calculations thereby generating larger benefit. Here is an example:

Scenario 1, 1 Regime (OPP = .1)

Transaction	Sales	TI	OPPL	TI * 15%	OPPL * 15%	Exclusion
1	100	18	10	2.70	1.5	2.70
2	100	15	10	2.25	1.5	2.25
3	100	12	10	1.80	1.5	1.80
4	100	10	10	1.50	1.5	1.50
5	100	8	10	1.20	1.5	1.50
6	100	0	10	0.00	1.5	0.00
7	100	-1	10	-0.15	1.5	0.00
Total TbyT	700	62				9.75
Product Calc	700	62	70	9.30	10.5	10.50
Commission	10.5	(Maximum of TbyT or Product)

 
Scenario 2, Regime Optimization
 

Transaction	Sales	TI	OPPL	TI * 15%	OPPL * 15%	Exclusion
1	100	18	10	2.70	1.5	2.70
2	100	15	10	2.25	1.5	2.25
3	100	12	10	1.80	1.5	1.80
4	100	10	10	1.50	1.5	1.50
5	100	8	10	1.20	1.5	1.50
6	100	0	10	0.00	1.5	0.00
7	100	-1	10	-0.15	1.5	0.00
Total TbyT	700	62				9.75
Trans 1-3	300	45	30	6.75	4.5	6.75
Trans 4-7	400	17	40	2.55	6.0	6.00
Commission	12.75

 
 
Comparison of Scenarios
 

Scenario 1 Benefit	10.50
Scenario 2 Benefit	12.75
Difference	2.25
% Increase	21%

NOTE: For simplicity the separation between the regimes is shown as calculated in the same regime. In actuality, transactions four through seven would be calculated in the FSC regime and then multiplied by 15/23 to determine the comparable EIE benefit.

As shown above, using both the FSC and EIE regime may result in substantially higher tax benefit than using the FSC regime alone. It is particularly true when a company has a large number of transactions with significant variance in profitability. In our lab test with ideal fact patterns, we have shown as a much as a 30% optimization benefit over using the FSC regime alone.

Like all good things, there is a catch. Most importantly, a company has only one shot at getting it right. Under Code Section 943(e)(1), a company may elect extraterritorial income exclusion provisions in lieu of FSC provisions on a transaction-by-transaction basis. Once made, the election can only revoked with the consent of the Secretary of the Treasury. Also, even if the revocation is granted, it is only effective for the years after the year of election. Accordingly, if an election is made to include a transaction in either FSC or EIE regime, that election cannot be changed effectively for that year. As such, it is very important that a company get the optimization between FSC and EIE correctly the first time it files its tax return.

The question becomes then "how could a company optimize" the tax benefit between FSC and EIE. I believe that most companies that have been optimizing FSC benefits in the past would have little problem optimizing the benefit. For others, it may be possible to get the maximum benefit if the company takes charge in collecting transactional data and processing them in-house.

A) Do-it-yourself optimization:

Up to this point, most companies have contracted Big Four accounting firms to perform TbyT analysis. There are two primary reasons for these contractual relationships. First, up to this point, only the Big Four accounting firms have had access to the TbyT software. Second, TbyT analysis has been marketed by a small group of people in Big Four accounting firms as a rare technical commodity. Neither of these is true anymore.

Thus, I believe, it is very important that a company takes charge of the TbyT analysis and brings the work in-house. My proposition is based on cost, data sensitivity, timing, and audit support considerations.

1) Cost considerations

So far, many companies have contracted with accounting firms under contingent fee arrangements or fixed-fee consulting agreements to have the TbyT analysis performed. Even in the case of fixed fee arrangement, the fee generally ranges from 10 percent to 25 percent of the tax benefits from the TbyT calculations.

Although TbyT analysis can produce significant tax benefit, finalization of the benefit does not occur until many years later when the audit is concluded. There are many issues that may come up during the audit that can easily jeopardize the tax benefit. Further, in evaluating any issue during the audit, a company must also consider the cost on related tax issues such as utilization of foreign tax credit. Therefore, if possible, it would be better for a company to perform the analysis by itself rather than relying on outside consultants to take charge of the analysis.

2) Data sensitivity issues

The data required for TbyT is probably the most sensitive data from the company's perspective since it contains very detailed pricing and cost information for every product. Under ordinary circumstances, companies would have very difficult time justifying the data leaving the company.

Further, it is imperative that the person performing TbyT understand the products a company produces in order to maximize the benefits from product grouping. From the competitive market perspective, the product information is critical business information.

Given the fact that a company has all the information in-house, rather than providing all this information to a group of consultants in order to have them perform the TbyT analysis, I believe it would be more cost effective and more secure for a company to learn how to perform the TbyT calculation and the analysis in-house.

3) Timing issues

As noted earlier, the election for either FSC or EIE benefit with respect to each of the transactions must be made by the time the tax return is filed. Accordingly, companies have very little time to collect the transactional data and perform the optimization calculations.

In the bulk of TbyT projects, most of the time is spent on collecting data and understanding the products and related groupings. Relatively, it takes very little time to actually process the data through the software to compute the optimization calculation.

Since the company will be involved in producing the transactional data and have far better understanding of the products than any consultant would, it can save significant time by performing the TbyT analysis in-house. Thus, by keeping the work in house, the FSC EIE compliance effort can be expedited.

4) Audit support

Finalization of the tax benefit occurs when a company successfully defends all of its positions with respect to TbyT analysis. There are few practical issues with having outside consultants driving the TbyT calculations with respect to audit.

First, there are a number of assumptions that need to be made during the TbyT analysis. These assumptions may make significant difference in transactional profitability as well as in the amount of US Tax benefit. Obviously, if a company’s fee arrangement with its consultant for the TbyT analysis is on contingent basis, as in many cases, it raises the possibility that the consulting company could take an aggressive position in making decisions with regard to the assumptions for the TbyT calculations. Although most contingent fee arrangements provides audit defense of TbyT analysis as part of the agreement, it does not help the company to have to take the aggressive stand on the TbyT that may jeopardize its positions with respect to other issues.

B) How can you do it yourself?

1) FSC EIE Processes

There is no myth about the TbyT analysis anymore. In fact, the first large-scale TbyT calculations was done by a company in-house with very little help from the outside. Many years ago, technology to analyze large numbers of transactions was virtually non-existent. In addition, most of the processing and scrubbing of data was done manually. After that, large accounting firms began marketing the service as a high-tech tax project.

Over time, however, the technology advanced and most of the TbyT analysis is done as part of the software. So, how can a company perform the TbyT analysis in-house? The following is a summary of processes to perform TbyT analysis:

A) Data collection of transactional data

The collection of data is in large part where most of the work is performed. Companies need to collect detailed data for sales and cost of sales. Generally, the more detail a company has the better the analysis will be since the tax benefit hinges primarily on the variability in gross profit percentage of each of the transactions. Most of companies that have been performing TbyT in the past already have a list of the data attributes required for the TbyT analysis. If your company needs a list of data attributes, contact us at info@TaxTechnologies.com.

B) Data cleansing

Most of the sales and cost transactional data require matching of credit memos and unallocated costs against the original transactions. Remaining unmatched transactions are allocated to all transactions using various allocation methods. In the past, this had been performed manually. Today, however, software applications have incorporated this strategy into their offerings requiring very little manual processing.

C) Reconciliation of transactional detail to tax return amounts

The transactional detail support for sales and cost data needs to be reconciled to tax return amounts.

D) Product grouping

This is an extremely important step since it will determine the overall profit percentages (OPP). In turn, OPP determines the limitation of tax benefits from either FSC or EIE regime. The product grouping is based on SIC code or standard industry or trade practices. Thus, it is best performed by the people in a company since they have the detailed knowledge required to group the products properly and may have alternative groupings that would be acceptable. Again, TbyT software provides various ways to import and make changes to the product grouping information.

E) Expense allocation and apportionment

Similar to foreign tax credit computations by basket, TbyT requires allocation of expenses to compute combined taxable income by transactions. Again, today’s software performs these tasks.

F) FSC/EIE optimization

This process determines which regime would produce maximum tax benefit for a company. This is purely done by software.

G) Verification of calculation

Companies must review the calculated results since they will ultimately be responsible to support the calculation in audit. I suspect that IRS has its own TbyT application and will be able to process the transactions using the data collected through IDR. Thus it is important that a company maintain the original data and reports to be able to support the calculations and show clear audit trail between the transactional data and calculated results.

H) Production of forms and schedule

Because TbyT analysis requires large volumes of reports to be produced, producing the forms and schedules can be a time consuming process even though it is simple and mechanical. Although IRS accepts tabular report filing of transactional information, it still requires production of large volume reports. Fortunately, all the reports are generated as part of today’s software. All you need to do is wait by the printer, review the reports, and file them with the IRS.

So, what's it going to be? FSC or EIE?

As described above, there is no magic in either FSC or EIE transactional analysis. Most of the processing is done through software. In fact, Tax Technologies, Inc. licenses one software package that would perform the TbyT and optimization calculations. If needed, TTI also provide services to assist companies with its efforts to perform TbyT analysis in-house. Remember, you only have one shot at getting it right.

2. Form automation  » Return top

Did you know you can map the data in your database, spreadsheets, or data warehouses to most of the forms available with very little effort?

Based on current PDF technology, most of the data from the company database can be directly mapped into PDF based forms. What it means is that millions of Forms 1099, 1041 and other large volume forms can be automated. Based on our experience, some of the data from database can be mapped to forms in the matter of hours.

Based on this database-to-PDF form mapping technique, millions of forms can be generated as soon as the database can produce the query results. Basically, companies need to create a database script that generates text files that can be read by PDF files. Thus, this technique may apply to any forms that are available through PDF. Since any form can be turned into PDF with very little efforts, any form can be mapped directly from an existing database.

This approach departs significantly from the traditional form and software development model. Under the old model, companies were dependent on the software vendor to develop the software application, transfer data from various data sources to the application and produce the forms. Under this new approach, the form can be attached to existing data sources and very little application development is required. It is particularly helpful if a company is required to produce large volume of simple forms based on single data source.

For example, if a company is required to produce five million Form 1099 based on customer data, instead of having a software vendor produce software that requires import of data to populate the form, companies can produce files from the existing database and produce the forms without ever requiring additional software be implemented. I say it is cool!

Furthermore, companies can modify the forms and the data mapping as the requirement changes over time. The maintenance for this is very little. Under this approach, companies can have total control over the form generation.

This approach also removes the need for data reconciliation since it does not require separate database be maintained for the form application. For example, while the conventional approach requires installation of software application and import of data from existing customer database to tax form application, the new approach does not require data import since the forms are generated directly from the customer database. This is particularly helpful since most of the customer database changes all the time.

I suggest however, the use of this approach be limited to simple forms with large volume of transactions. The benefit is great and maintenance is low. I would not use this approach on complex forms requiring calculations primarily because the original implementation and maintenance costs would outweigh the benefits.

If you are interested in learning more about this technique, please contact us at info@TaxTechnologies.com.

3. AuditTracker^TM is marching on   » Return top

After our last newsletter, we have received numerous requests for our AuditTracker. We have a number of companies interested in the AuditTracker. As we discuss the implementation of AuditTracker with our clients, it is becoming very clear that companies need audit documentation management as well as a process management tool.

Most people who have seen the application agree that it is very easy to understand and easy to use the software. Further, they tend to agree that it is something that's been needed for a long time. Based on our discussions with our clients, the best time to implement AuditTracker is when an audit cycle is concluded and the next audit cycle is about to begin.

Let us know if you would like to explore the possibility of using AuditTracker as your audit defense tool.

4. TaxSeries^TM as your backup plan? Maybe for year-end foreign tax credit planning?   » Return top

A lot of things are happening in the tax software market. Is the future of your International tax software uncertain? Are you struggling to complete your compliance because of software limitations? Is your vendor sending you frequent fixes?

Many of the companies we talk to are having a rough year with their International tax compliance software -- they are experiencing problems and worrying about the stability of their software when they don't have to. Tax Technologies wants you to consider TaxSeries as your backup plan. And, we will convert your International data from your current system at no charge as well.

Companies may use our service as a standby in case your current solution becomes too troublesome or unsupported; or, you can begin using TaxSeries as your primary compliance and planning tool. Don't fret for no reason -- call us today at 866-239-iTTI (4884) to see how we can help simplify your compliance season.

5. Mark your calendar   » Return top

FINANCIAL REPORTING & DISCLOSURE June 19-20, 2002, Chicago, IL

TTI will present the audit transparency issue and how to boost investor confidence with increased transparency of financial data. This is an objective symposium that evaluates and quantifies the adequacy of the current financial reporting model.

If you mention Tax Data Management Newsletter, you will receive 25% off on registration fee.

For registration, call Maria Cianflone, 312-780-0700 ext.175

For additional details, visit http://www.acius.net/?cID=112

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Regards,

J.D. Choi
CEO, Tax Technologies, Inc.
201-387-9451