IC-DISC: Compliance Challenges in the Federal Tax...

IC-DISC: Compliance Challenges in the

Federal Tax Break for Exporters

TUESDAY, OCTOBER 21, 2014, 1:00-2:50 pm Eastern

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IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters

Oct. 21, 2014

Jim Loizeaux

CliftonLarsonAllen

[email protected]

Robert J. Misey, Jr.

Reinhart Boerner Van Deuren

[email protected]

mailto:[email protected]

mailto:[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

5

INTEREST CHARGE – DOMESTIC

INTERNATIONAL SALES

COMPANIES, PART I

Rob Misey, Reinhart Boerner Van Deuren

About Rob Misey

Robert Misey is Chair of the International Department for Reinhart

Boerner Van Deuren. He previously worked for the IRS Chief

Counsel (International) on their Athletes and Entertainers Industry

Program.

A graduate of the law schools at Vanderbilt University and

Georgetown University. He is also the author of the books A

Practical Guide to U.S. Taxation of International Transactions and

Federal Taxation: Practice and Procedure. Robert's practice

concentrates on the taxation of cross-border athletes and

entertainers.

Rob can be reached at either 312-207-5456

or 414-298-8135 or [email protected]

20346308 ©2014 All Rights Reserved

Reinhart Boerner Van Deuren s.c.

7

What is an IC-DISC?

• An IC-DISC is a legal entity that has elected –

for tax purposes – to be treated as an IC-

DISC. For tax purposes, an IC-DISC earns

income on qualified export sales or assets

and pays no tax on that income.



What is an IC-DISC?

• IC is for “interest charge”. One of the benefits of an

IC-DISC is that an operating company can currently

deduct payments to an IC-DISC, while the IC-DISC

defers the pass-through of the income to its

shareholders in exchange for an “interest charge”.

• DISC is for Domestic International Sales Corporation.

This reflects that a DISC is a domestic corporation

that handles income related to international sales.



Benefits of an IC-DISC

• IC-DISCs can provide benefits by:

– Utilizing the tax rate differential between (a) ordinary

deductions and (b) qualified dividend rates

– Deferring income using the interest charge benefit.

– Shifting income between an entity and its shareholders

– Shifting income from a shareholder and (a) his children

or (b) company officers



Benefits of an IC-DISC

• Assume $40,000 in IC-DISC commissions are paid by

an operating company to an IC-DISC and the IC-

DISC makes a dividend to its shareholders.

OpCo IC-DISC

Share holder

$40,000 Commission

$40,000 Dividend

Tax Savings on Commission = $40,000 * 39.6% = $15,840

Tax Cost on Dividend = $40,000 * 23.8% = $9,520



History of IC-DISCs

• 1971 – DISCs were enacted that allowed unlimited

deferral of income earned by a DISC (no interest

charge)

• 1976 – DISCs were challenged by the European

Union as there was unlimited deferral

• 1981 – As part of an ‘understanding’ with the WTO,

an interest charge was to be paid on deferred

income



History of IC-DISCs

• 1984 – Congress enacted the Foreign Sales Corporation

provisions that allowed for a partial exemption of income from

exports.

– FSCs paralleled an advantage enjoyed by countries with a

territorial income tax system.

• 1997 – the European Union challenged FSCs as a “prohibited

export subsidiary”

• 1999 – the WTO ruled in favor of the European Union

• 2000 – Congress repealed the FSC provisions



History of IC-DISCs

• 2000 – US enacted the Extraterritorial Income Exclusion

Act that allowed for an exclusion from gross income of

qualifying extraterritorial income (“ETI”)

• 2001 – The European Union challenged the EIEA

• 2001 – The WTO ruled in favor of the European Union

• 2004 – Congress repealed the EIEA with a phase-out of

benefits extending through 2006



History of IC-DISCs

• 2003 – Congress enacted a preferential qualified

dividend rate

• 2008 – Congress extends the preferential qualified

dividend rate

• 2010 - Congress extends the preferential qualified

dividend rate

• 2012 - Congress extends the preferential qualified

dividend rate “permanently”



Outlook for IC-DISCs

• IC-DISCs have been challenged by the European Union

for lack of an interest charge.

– They cannot – apparently – challenged based on the

differential in ordinary vs dividend rates

• IC-DISCs were the focus of a technical correction in

2006 that would have treated IC-DISC dividends as

non-qualified dividends

– An industry coalition defeated the technical

correction



Outlook for IC-DISCs

• IC-DISCs were targeted for termination in 2007 as they

would have been a revenue raiser to offset other tax cuts

– Again, an industry led coalition led to comments by

the Administration (first Bush, and later Obama’s) that

the IC-DISC was a favored export benefit

• Things have been quiet until…

• Max Baucus (Senate Finance Committee Chair) has

proposed the termination of IC-DISCs for years after

December 31, 2014, as part of comprehensive

international tax reform



Current Issues –

3.8% Medicare Tax

• Is an IC-DISC dividend subject to the 3.8% Medicare Tax?

– Prima facie, the answer is yes. IC-DISCs are a passive

investment entity that pays qualified dividends, so the

3.8% Medicare Tax should apply.

• Some practitioners are taking the position that an IC-DISC

is an extension of the operating company and, therefore,

the dividend could be treated as a distribution from a

company the shareholder materially participates in.

– Our advice? Be careful… no clear guidance on this.



QUALIFICATION OF IC-DISCS

AND QUALIFIED EXPORTS,

PART II

Rob Misey, Reinhart Boerner Van Deuren

IC-DISC: Basics, Recent Developments

And Compliance Issues • Overview of IC-DISCs

― Overview of “vanilla” IC-DISC basics, structure,

commission, requirements and terminology

• Recent events

― Impact of recent tax laws on IC-DISCs, e.g., fiscal cliff,

Medicare tax, etc. on tax benefits

• Compliance (Part I)

― Taxation of IC-DISCs when dividends are not distributed



20

IC-DISC Basics

• Interest charge - domestic international sales corporation

• U.S. corporation that has elected, for federal income tax

purposes, to be treated as an IC-DISC by filing IRS Form

4876-A (election to be treated as an interest charge DISC)

• An IC-DISC is not subject to federal income tax (IRC §991).

• Two types: Commission (most popular) or buy-sell

• IC-DISC pays an interest charge on DISC-related deferred

tax liability.



21

Typical IC-DISC Structure

• Exporter (typically organized as a pass-through entity and

owned by individuals) forms a commission IC-DISC as a

subsidiary.

• Exporter pays a “commission” to the IC-DISC, based on

exports.

• IC-DISC pays dividends to its parent.

― Dividend income passes through to IC-DISC parent’s

owners.



22

IC-DISC Commission

• Choice of methods:

― 4% of qualified export gross receipts, plus 10% of DISC export promotion expenses

― 50% of combined taxable income of DISC and exporter attributable to qualified export gross receipts, plus 10% of DISC export promotion expenses

― IRC §482 method



23

IC-DISC Commission (Cont.)

• Determine IC-DISC commission:

― Transaction-by-transaction

― By product

― By product line

• No-loss rule: The gross receipts method and the combined taxable income method cannot cause a taxable loss to the related supplier.



24

IC-DISC Requirements

Incorporate in U.S. State or D.C. Have a single class of stock with

a par or stated value of ≥ $2,500

Have same tax year as primary shareholder

Maintain its own books and

records

Makes election on IRS Form 4876-A* Cannot be a member of a

controlled group with a foreign

sales corp (FSC)

95% of its receipts must be “qualified export receipts”

95% of the adjusted basis of

DISC’s assets must be “qualified

export assets” at the end of its

tax year.



25

IC-DISC Qualified Export Receipts

• Qualified export receipts

― Sales of export property *

― Rental of export property *

― Services related to export sales and leases

― Sales of export assets

― Dividends from foreign subs

― Interest on qualified investments (e.g., producer’s loans)

― Engineering or architectural services

― Managerial services

* By a DISC or by any principal for whom such DISC acts as a commission agent



26

IC-DISC Qualified Export Property

Qualified export property is:

• Manufactured, produced, grown or extracted in the U.S. by a party other than a DISC

• Held primarily for sale, lease or rental, in the ordinary course of trade or business, by or to a DISC for direct use, consumption or disposition outside the U.S.

• ≤ 50% of the fair market value of which is attributable to articles imported into the U.S.

Made in the U.S. (of ≥ 50% U.S. articles) and held for export



27

IC-DISC Qualified Export Property

Foreign Content Tested Export Property

• To qualify as Export property, the property may not have

more than 50% foreign content

― Numerator is value of imported article when imported

― Numerator is direct labor costs (under unicap

principles) performed outside the USA

― Denominator is value (normally sale price) of export

property when exported

― Numerator may not exceed 50% of denominator

(export sales price)



28

IC-DISC Qualified Export Assets • U.S. corporation assembles computer in U.S. and sells to foreign customer

― Sales price $10,000

― CGS: Materials (domestic) $1,000

Materials (foreign) $4,000

Labor (domestic) $1,000

Labor (foreign) $1,000 $7,000

― Gross profit $3,000

• Materials (foreign) $4,000 + labor (foreign) 1,000/export sales price less

than or equal to 50% for DISC purposes

• Satisfies foreign content test – Yes

• Also satisfies 20% safe harbor manufacturing test labor (domestic) 1,000 +

labor (foreign) 1,000 = 2,000 >20% x 7,000



29

IC-DISC Qualified Export Assets

Qualified export assets

• Export property (i.e., inventory)

• Export property assets

• Accounts receivable

• Temporary investments of working capital

• Producer’s loans

• Stock or securities in a related foreign export corporation

• Export-Import Bank and Foreign Credit Insurance Association obligations

• Export sales finance obligations

• Temporary bank deposits in U.S.



30

Deemed Distributions

• IC-DISC shareholders generally are taxed only on

dividends actually distributed to them by the DISC.

• IC-DISC shareholders are also taxed on their pro rata share

of income from certain items received by the DISC, but not

actually distributed to the DISC shareholders.

― These are called “deemed distributions.”

― The distribution is deemed to be received on the last

day of the DISC tax year in which the income was

derived.



31

Deemed Distributions (Cont.) • Income items to which deemed distributions apply

1) Gross interest derived from producer’s loan;

2) Gain recognized by the DISC on the sale or exchange of property (other than qualified export assets) previously transferred to the DISC in a transaction in which gain was not recognized in whole or in part, but only to the extent that the transferor’s gain on the previous transfer was not recognized

3) The lower of the gain recognized by the DISC on sale or exchange of depreciable property that is a qualified export asset to the DISC and which was previously transferred to the DISC, in a transaction in which gain was not recognized to the transferor or the transferor’s gain on the transfer, which was not recognized to the transferor and which would have been includible in the transferor’s income as ordinary income (e.g., depreciation recapture situations) if its entire realized gain had been recognized on the transfer

4) 50% of DISC taxable income attributable to military property

5) Income attributable to qualified export receipts that exceed $10 million

6) 1/17th of the taxable income of the DISC in excess of the amounts deemed distributed under (1) through (5), above, if the shareholder is a C corporation

7) Income attributable to international boycott operations

8) Illegal payments to government officials

9) The amount of foreign investment attributable to producer’s loans of a DISC as of the end of the group tax year ending with the DISC’s year



32

“Vanilla” Commission IC-DISC

Structure



33

US

IC - DISC

U.S.

Foreign

Exports

commission

S Corp -

S Corp

IC-DISC Tax Benefits Following

Tax Law Changes of 2013



34

IC-DISC Tax Deferral



35

US

IC - DISC USAco

U.S.

Foreign

Exports

commission

US

IC - DISC USAco

U.S.

Foreign

Exports

commission

IC-DISC Tax Deferral Benefits • Deferral of federal income tax

• Acts like a loan

― Taxable income attributable to qualified export receipts up to $10 million

― Interest rate play: Each 1% difference between the IC-DISC interest charge and taxpayer’s cost of capital interest rate is worth up to $39,000.



36

The “Interest Charge” On

Deferring Tax In The IC-DISC • Payment of commission to IC-DISC defers tax on each owner’s income

until it is distributed via dividends.

• If IC-DISC earnings are retained and undistributed at the end of the taxable year, each IC-DISC shareholder (or owner of a pass-through entity shareholder), rather than pay tax on dividends distributed, pays an “interest charge” to the IRS.

“Interest charge” on retained IC-DISC income [≈ tax on retained earnings as IC-DISC], computed by reference to each shareholder

Interest charge = [Shareholder’s DISC-related deferred tax liability] x

[Bbase period T-bill rate]

2013 base period T-bill rate ≈ .14%

• No interest charge if all IC-DISC income is distributed via dividends by the end of the IC-DISC’s taxable year



37

IC-DISC Producer’s Loan



38

US

IC-DISC

U.S.

Foreign

Exports

commission

USAcoloan

US

IC-DISC

U.S.

Foreign

Exports

commission

USAcoloan

Producer’s Loan • Producer’s loan is a qualified export asset.

• Gross interest of producer’s loans is subject to deemed distribution.

• Requirements (Treasury Reg. 1.993-4):

― Written note with ≤ 5-year maturity, designated as a producer’s loan, at arm’s length interest rates and terms

― Made out of accumulated DISC income (producer’s loans ≤ accumulated DISC income)

― Made to a U.S. person engaged in manufacturing, growing, extracting or producing export property



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Compliance and Reporting By IC-DISCs – Part III

Presented by: Jim Loizeaux

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Master 2. Go to page three 3. Delete the image 4. Select Close Master

View

James D. (Jim) Loizeaux Technical Director

International Services, CliftonLarsonAllen LLP

612-397-3204

[email protected]

Jim is one of the national practice leaders in the International Services group for CliftonLarsonAllen. He has over 25 years of international tax experience focusing on cross-border transactions, reorganizations, repatriation of earnings and exports.

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Pricing Rules

• An IC-DISC can act as a buy-sell entity or a commission-based entity.

• The transfer price between the IC-DISC and related supplier must be calculated under one of the three following methods:

– 4 % gross receipts

– 50% combined taxable income (CTI)

– Section 482

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Pricing Rules

• Under both the 4% gross receipts and 50% CTI methods, the DISC does not need to perform any economic functions or have any employees.

• Under both the 4% gross receipts and 50% CTI methods, the DISC can increase its commission by 10% of its export promotion expenses (EPEs), if the DISC is a buy-sell DISC vs. a commission DISC [Reg. 1.994-1(a)(2) and Computervision Corp v. Comm (96 T.C. 652)].

• EPEs include general administrative and selling expenses, certain freight paid to U.S.-flagged carriers, packaging costs, and design and label costs for export products incurred by the DISC.

(Note: EPEs paid by a related party can qualify, if a contract existed between the related party earmarking the EPEs for the buy-sell DISC before the transaction

took place.)

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Pricing Rules

• The pricing method chosen may be based export on transactions using one of the following approaches:

– Aggregate

– Transaction by transaction

– Product groupings

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Pricing Rules

• When utilizing the CTI method, overhead costs generally are allocated and apportioned between export and domestic sales, based on detailed rules [Reg. 1.861-8].

• If the profit margin on export products is less than profit margin on worldwide sales of the same products, then marginal costing rules may be applied to allocate only marginal or variable costs against export receipts under the CTI method [Reg. 1.994-2].

• Overall, the CTI method generally produces a larger benefit than the gross receipts method, when exports have a greater-than-8% profit ratio.

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Sample Commission Calculation

Total Domestic Exports

Domestic Sales 400 300 100

Export Sales 200 150 50

Domestic COGS

Export COGS

GP 200 150 50

Overhead 100 75 25

Taxable Income 100 75 25

Profit Margin 25%

Related Supplier Income Statement Before IC DISC Commission

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Sample Commission Calculation continued

Total Domestic

Method 4% CTI

Export 100 100

COGS (50)

GP (50)

Overhead (25)

Net Income 25

Total Commission 4 12.50

DISC Commission Calculation

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No Loss Rule (Reg. 1.994-1(e)(1))

• No loss rule is a limitation on the DISC’s income if the computation of the commission under either the gross receipts method or the CTI method results in a loss to the related supplier

• There is an exception to the no loss rule that allows the computation of a commission under the 4% gross receipts method where the overall profit percentage (“OPP”) is positive limited to 4%

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No Loss Rule continued

Total Domestic

Method 4% CTI

Export 100 100

COGS (75)

GP 25

Overhead (40)

Net Income 0

Total Commission 0 0

DISC Commission Calculation – 1.994-1(e)(1)(i)

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No Loss Rule – Application of Special Rule (Reg. 1.994-1(e)(1)(ii))

• OPP = Taxable income of product or product line for domestic and export sales ________________

Total gross receipts of sales

– Taxable income = 100

– Gross receipts = 400

– OPP = 25%

– Export receipt = 100

– 4% method = 4

– Special rule = 25 ($100 x 25%)

– Commission = 4 (lesser of 4% method or special rule)

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Summary of Tax Filings

• Initial IC-DISC election is made on Form 4876-A within 90 days of the start of the taxable year (must be signed by all shareholders).

• A Form 1120 IC-DISC is required to be filed annually on or before the 15th day of the ninth month following the close of the tax year.

– Attached will be Schedule K, Shareholder’s Statement of IC-DISC Distributions (indicates actual and deemed distributions that are taxable)

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Summary of Tax Filings

• A Form 8404 must be filed by all IC-DISC shareholders on or before the original due date of their tax returns (no extensions are permitted).

– Form 8404 requires any deferred interest-related costs to be paid (estimated tax payments are not required on a quarterly basis).

– Deferred interest is calculated on hypothetical tax based on ordinary rates, not qualified dividend rates.

(Section 995(f)(2)(A)(i))

– Form 8404 anticipates that estimates are likely needed, and amended procedures are outlined in form instructions.

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Common Compliance Pitfalls

• The DISC must make an initial estimate of the commission at the end of the year, and the related supplier must pay the commission within 60 days of the close of the year [Reg. 1.994-1(e)(3)(i)].

– Reasonable estimate requires at least 50%

– Payment should generally be in cash to avoid non- compliance risk [TSI, Inc. v. US (977 F.2d 424) and Thomas Int’l Ltd v US (773 F.2d 300)].

– True-up commission requires payment in 90 days.

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Common Compliance Pitfalls

• Failure to clear DISC receivables by year end resulting in DISC disqualification under the 95% asset test

• Failure to property capitalize the DISC

• Failure to comply with corporate formalities

• Failure to maintain separate books and records

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CLAconnect.com


Interest Charge – Domestic International Sales Companies: Common Structures Part IV

Presented by: Jim Loizeaux

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Flow Through Entities

• This is the most common and easiest structure. Cash travels between the S Corporation and IC-DISC

• The shareholder receives

– Reduced ordinary income

– Increased qualified dividends

• As reported on a Schedule K-1

S Corp or

Partnership

IC-DISC

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C Corporations

• This structure gets additional income to a C Corp shareholder when wages are at a max or the shareholder is not active in the business.

• The C Corporation receives an ordinary deduction for commissions paid.

• The shareholder receives a Form 1120-IC-DISC Schedule K-1 reporting the qualified dividends.

C Corp

IC-DISC

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Officer Bonus Plan

• This structure gets additional income to a business’s officers.

• The C Corporation receives an ordinary deduction for commissions paid.

• The officers receives a Schedule K from the IC-DISC reporting the qualified dividends.

• Structuring consideration:

C Corp

IC-DISC

Officer

- Commissions paid cannot be direct replacement for incentive compensation the officers would otherwise be eligible to receive under other corporate bonus or incentive plans

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Foreign Owner • This structure gets tax favored

dividends to a foreign parent. • The C corporation receives an

ordinary deduction for commissions paid. (Rather than no deduction for a dividend paid)

• The foreign owner *may* receive a dividend subject only to withholding tax.

• Structuring Considerations:

C Corp

IC-DISC

Foreign

Corp

- Benefit based on treaty override of Section 996(g) - Foreign shareholder must file a Form 1120F with a Form 8833 - DISC also reports dividends on a Form 1042-S - Foreign country taxation of the dividend must be addressed

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Generation Transfer

• This structure gets income to an owner’s children or grandchildren

• Rev. Rul. 81-54

Children

C Corp,

S Corp or

Partnership

IC-DISC

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CLAconnect.com


Interest Charge – Domestic International Sales Companies: IRS Audit Issues Part V Presented by:

Jim Loizeaux, CliftonLarsonAllen LLP

Robert Misey, Reinhart Boemer Van Deuren S.C.

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IRS Audit Issues

• Until recently, the IRS has not seemed to focus on in-depth audits of IC-DISCs

• Many audits focused on formation or qualification issues

• Recently, the IRS *is* starting to audit more complex IC-DISCs

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Formation and Qualification Issues

• A standing IRS Information Document Request asks for documentation related to Formation and Qualification issues

• Support for valid IC-DISC election

• Formation issues include documentation regarding the formation of the corporation and capitalization

• Qualification issues include separate books and records

– Best Practice: Separate checking account to show all transactions, in-and-out of the IC-DISC

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Other Issues

• Commission Expense Computations

– Proper support should be in your file to support the Schedule Ps included with 1120-IC-DISC

– Cost Accounting records should support the gross margins

– Workpapers should support the SG&A computations

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Other Issues

• Coordination with DPAD Computations

– Both DPAD and DISC Commissions should rely on the methodology found in Reg § 1.861-8 (see Reg § 1.199-4(d)(i))

– This regulation requires that specifically identified costs of sales be deducted from classes of sales

– SG&A must be allocated using a “reasonable” methodology

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Other Issues

• Non-standard structures

– Treaty-based IC-DISCs

– IC-DISCs in Roth IRAs

– Factoring DISCs

– Generation transfers

• Be sure to document the support and review any current judicial rulings for the non-standard structures

IC-DISC: Compliance Challenges in the Federal Tax...

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