IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters
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Presenting a live 110-minute teleconference with interactive Q&A
IC-DISC: Compliance Challenges
in the Federal Tax Break for Exporters
Leveraging Benefits Arising From the Dividend Tax Solution
WEDNESDAY, DECEMBER 4, 2013
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
Today’s faculty features:
Jerry Ogle, President, Ogle International Tax Advisors, Bradenton, Fla.
Jerry Jonckheere, International Tax Partner, Plante Moran, Grand Rapids, Mich.
Jim Loizeaux, Director, Grant Thornton, Minneapolis
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PDF of the slides and the Official Record of Attendance for today's program.
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• Print the slides by clicking on the printer icon.IC-DISC: Mastering Intricacies of the Federal Tax Incentive for Exporters Seminar Dec. 4, 2013 Jerry Jonckheere, Plante Moran Jim Loizeaux, Grant Thornton Jerry.Jonckheere@plantemoran.comm James.Loizeaux@us.gt.com Jerry Ogle, Ogle International Tax Advisors jerry@ogleintltax.com
Today’s Program History, Recent Law Changes, and Current Legislative Environment Slide 7 – Slide 19 [Jerry Jonckheere] Qualification of IC-DISCs and Qualified Exports Slide 20 – Slide 41 [Jim Loizeaux] Compliance and Reporting Slide 42 – Slide 52 [Jerry Ogle] IC- DISC structures Slide 53 – Slide 59 [Jerry Jonckheere, Jim Loizeaux and Jerry Ogle] Strategies and IRS activity Slide 60 – Slide 67 [Jerry Jonckheere, Jim Loizeaux and Jerry Ogle]
Interest Charge – Domestic
International Sales Companies
What they are
Their History
The Outlook
Current Issues
Jerry Jonckheere
Int’l Tax Partner – Plante Moran8 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.
9 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.
10
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 officers11
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.
Tax Savings on Commission =
Share
$40,000 * 39.6% = $15,840 holder
$40,000
Tax Cost on Dividend =
$40,000 * 23.8% = $9,520 Dividend
$40,000
Commission
OpCo IC-DISC12 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
13
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 provisions14 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
15 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”
16
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 correction17
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 reform18
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.Slide Intentionally Left Blank
Jim Loizeaux, Grant Thornton QUALIFICATION OF IC-DISCS AND QUALIFIED EXPORTS, PART II
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 new 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
21IC-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.
22Typical 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.
23IC-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
24IC-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.
25IC-DISC Requirements
* NotIncorporate
a tax-exempt org., PHC, Have a single
corp. or insurance class of stock with
co. association, RIC, aSpar
in U.S. State or D.C.
or stated value of ≥ $2,500
Have same tax year as primary
Maintain its own books and records
shareholder
Cannot be a member of a controlled
Makes election on IRS Form 4876-A*
group with a foreign sales corp (FSC)
95% of the adjusted basis of DISC’s
95% of its receipts must be “qualified
assets must be “qualified export assets”
export receipts”
at the end of its tax year.
26IC-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
27IC-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
28IC-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)
29IC-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
30IC-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.
31Deemed 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.
32Deemed 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
33“Vanilla” Commission IC-DISC Structure 34
IC-DISC Tax Benefits Following
Tax Law Changes of 2013
35IC-DISC Tax Deferral 36
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.
37The “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]
2012 base period T-bill rate ≈ .16%
• No interest charge if all IC-DISC income is distributed via
dividends by the end of the IC-DISC’s taxable year
38IC-DISC Producer’s Loan: Example 39
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
40Slide Intentionally Left Blank
Jerry Ogle, Ogle Tax Advisors COMPLIANCE AND REPORTING BY IC-DISCs
Ogle International Tax Advisors
offers IC DISC consulting services. An IC-DISC can act as a buy-sell entity or a
In addition, our spectrum of commission-based entity.
international tax services can provide
assistance in the areas of :
In any event, the transfer price between the IC-DISC
Foreign business investments - and related supplier must be calculated under one of the
structure active business three following methods:
investments in offshore
subsidiaries to minimize U.S. and
host country taxation. Analysis of 4% gross receipts
the U.S. CFC and PFIC rules for
individual investors.
50% combined taxable income (CTI)
Offshore profits importing -
plan for the repatriation of active
foreign profits. Sect. 482
Foreign tax systems -
analyze host country deductions,
exemptions, and incentives,
including foreign tax credits with
host country tax advisors.
For more information on our services Corporate Office Miami Office
Please contact us at our offices
or visit us at our website
6801 Energy Court, Suite 201
Sarasota, Florida 34240
5201 Blue Lagoon Dr Suite 800
Miami, Florida 33126 43
www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552 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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Please contact us at our offices
or visit us at our website
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Miami, Florida 33126 44
www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F)305.402.0552 The pricing method chosen is required on a
transaction-by-transaction basis (TxT); however, an
annual election can be made to group transactions in
accordance with products or product lines.
Neither the gross receipts method nor the CTI
method may be applied in a way that causes, in any
taxable year, a loss to the related supplier. There is a
special rule that allows the 4% gross receipts
method to apply where the overall profit percentage
is not exceeded [Reg. 1.994-1(e)(1)(ii)].
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552 When utilizing the CTI method, overhead costs
generally are allocated between export and domestic
sales, based on detailed rules [Reg. 1.861-8].
However, 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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Please contact us at our offices
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552Related Supplier Income Statement Before IC DISC
Commission
Domestic Sales 300
Export Sales 100
Domestic COGS (150)
Export COGS (50)
GP 200
Overhead (100)
Taxable Income 100 25%
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552DISC Commission Calculation
Method 4% CTI
Export 100 100
COGS (50)
GP 50
Overhead (25)
Net Income 25
Total Commission 4 12.50
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552 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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Please contact us at our offices
or visit us at our website
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552 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 vs. qualified dividend rates.
Form 8404 anticipates that estimates are likely
needed, and amended procedures are outlined in
form instructions.
Various states have different state income tax filings
required.
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552 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.
Failure to optimize available methods such as TxT,
marginal costing, overhead allocation under CTI, EPE
and factoring of qualified export-related accounts
receivable [Rev. Rul. 75-430]
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www.ogleintltax.com (T) 941.361.1147 (F) 941.827.9929 (T) 305.671.3179 (F) 305.402.0552Slide Intentionally Left Blank
Interest Charge – Domestic
International Sales Companies
Common Structures
Jerry Jonckheere
Int’l Tax Partner – Plante Moran54
Flow-Through Entities
This is the most common
and easiest structure. Cash travels
Between the S Corporation and
IC-DISC.
The shareholder receives
(1) Reduced ordinary income
(2) Increased qualified dividends S Corp
Or P’ship
As reported on a Schedule K-1
IC-DISC55 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. C Corp IC-DISC The shareholder receives a Form 1120-IC-DISC Schedule K-1 reporting the qualified dividends.
56
Officer Bonus Plan Officer
This structure gets additional income
to a business’s officers. This typically
is part of a bonus plan.
The C Corporation receives an
ordinary deduction for commissions C Corp,
paid.
S Corp IC-DISC
The officers receives a Form Or P’ship
1120-IC-DISC Schedule K-1
reporting the qualified dividends.57
Foreign Owner
This structure gets tax favored dividends Foreign
to a foreign parent. Corp
The C Corporation receives an
ordinary deduction for commissions
paid. (Rather than no deduction for a
Dividend paid)
C Corp IC-DISC
The foreign owner *may* receive a
dividend subject only to withholding tax.58
Roth IRA Roth
IRA
This structure gets income into a Roth
IRA that *may* avoid future taxation.
C Corp,
S Corp IC-DISC
Or P’ship59
Generation Transfer Children
This structure gets income to an
owner‘s children or grandchildren.
C Corp,
S Corp IC-DISC
Or P’shipInterest Charge – Domestic
International Sales Companies
IRS Audit Issues
How to Pass an Audit with Flying Colors
Jerry Jonckheere
Int’l Tax Partner – Plante Moran61 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
62
Formation and Qualification Issues
• A standing IRS Information Document Request asks for
documentation related to Formation and Qualification
issues,
• 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-DISC63
Other Issues
• Transaction-by-Transaction 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 computations64
Other Issues
• Coordination with DPAD computations
▫ Both DPAD and DISC Commissions should rely on the
methodology found in Reg § 1.861-8.
▫ This regulation requires that specifically identified costs of
sales be deducted from classes of sales
▫ SG&A must be allocated using a ‘reasonable’ methodology65 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 these non-standard structures
66 Other Words of Wisdom • Pigs get fat • Hogs get slaughtered
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