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IC-DISC Strategies:

Mastering the Complex Operational Challenges Anticipating IRS Audit Risks, Calculating Commissions, and Tackling Computational Intricacies

THURSDAY, NOVEMBER 10, 2016, 1:00-2:50 pm Eastern

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Nov.10, 2016

IC-DISC Strategies

Neal J. Block, Senior Counsel

Baker & McKenzie, Chicago

[email protected]

Mark C. Gasbarra, CPA, National Managing Director

Forte International Tax, Evanston, Ill.

[email protected]

Randall Janiczek, CPA

Plante & Moran, Grand Rapids, Mich.

[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.

FUNDAMENTAL CONCEPTS OF IC-DISCs

Randall Janiczek, Plante Moran

6

Domestic International Sales

Corporations (DISCs)

Background and tax benefits of DISCs

General review of tax benefits of DISCs

How the DISC came to be

Common DISC structures

Requirements of a DISC

Initial requirements

Annual requirements

Export property

Other considerations

7

Domestic International Sales

Corporations (DISCs)

DISC benefit arises as follows:

Commissions paid to a DISC reduce taxable profit of related supplier

corporation deductions at ordinary rates

DISC is tax-exempt entity – Sect. 991 income can be deferred

DISC dividends received by individual shareholders are qualified

dividends taxed at the capital gains rate Income can be taxed at lower capital gain tax rates

8

How DISCs Came To Be

1971: Congress enacted DISC provisions

U.S. tax on DISC income was deferred until it was distributed

1970s – 1980s: Trading partners challenged DISCs as allegedly violating

General Agreement on Tariffs and Trade (GATT)

1984: Congress enacted foreign sales corporation (FSC) provisions

FSCs were foreign corporations which effectively allowed US taxpayers

to obtain benefits similar to the former DISC structure

DISC was modified to allow deferral of DISC income from annual

maximum of $10 million of export receipts and introduce interest

charges on deferral (the DISC became the IC-DISC)

9

How DISCs Came To Be (Cont.)

Late 1990s: European Union (EU) members complain to World Trade

Organization (WTO) that FSC represents an illegal export subsidy, but IC-

DISC was not challenged

2000: Congress repeals FSC tax scheme and enacts extraterritorial income

exclusion (ETI or EIE); EU immediately lodged complaints

2003: Congress enacts favorable dividend tax rates for individuals

Tax rate on qualified dividends drop from 35% to 15%, creating an

opportunity for permanent savings

10

How DISCs Came To Be (Cont.)

2004: Congress repealed ETI and replaces with Domestic Production

Activities Deduction

2006: IRS becomes aware of IC-DISC planning and is looking for revenue

raising provisions and proposes legislation to treat DISC dividends as not

qualified but the legislation is not passed

2007: Repeal of capital gain rate for DISC dividends is proposed but not

passed.

Dec 31, 2012: Favorable dividend tax rates were to sunset but legislation

extends favorable qualified dividend rate

Rate increased from 15% to 20%

11

Commission reduces taxable profit

passed through to S corporation

shareholder (up to 39.6% tax

savings).

DISC is not subject to tax.

S corporation shareholders pay

20% tax on DISC dividends (Plus

NIIT).

Shareholders may be subject to an

interest charge for the tax deferral

on DISC earnings not distributed

General Review Of DISCs:

Pass-Through Structure

Shareholders

S Corporation

DISC

Commission Dividend

12

General Review Of DISCs:

C Corporation Structure

Commission reduces taxable

profit of C corporation (up to

35% tax savings)

DISC is not subject to tax

C corporation shareholders pay

tax at 20% on DISC dividend

(Plus NIIT)

Shareholders are subject to an

interest charge for the tax

deferral on DISC earnings not

distributed

Shareholders

DISC

Commission

Dividend

C Corporation

13

DISC Initial Set-Up

Commission DISC vs. buy/sell DISC

Domestic corporation (C corporation)

Must be a domestic corporation incorporated under the laws of any

state or the District of Colombia

Determine state tax implications

Single class of stock

$2,500 of capital

14

DISC Initial Set-Up (Cont.)

Form 4876-A election

File within 90 days from the beginning of tax year or inception of entity

Establish books and records by the end of first year of operation

15

DISC Annual Maintenance

95% qualified gross receipts test

95% qualified export assets test

$2,500 capital on each day of tax year

Timely payment of commission to IC-DISC

File IC-DISC income tax return

Maintain IC-DISC books

International boycott reporting

16

DISC Annual Maintenance (Cont.)

95% qualified gross receipts test

Qualified gross receipts are at least 95% of IC-DISC gross receipts for the

year.

Qualified gross receipts:

Sale, exchange or other disposition of export property

Lease or rental of export property used outside of U.S.

Related and subsidiary services

Dividends from related foreign export corporation

Interest on obligations that are qualified export assets

E.g., producer’s loans

Engineering and architectural services

17

Export Property For DISC (1.993-3)

Manufactured, produced, grown or extracted in the U.S. by a person

other than a DISC

Held primarily for sale, lease or rental for direct use, consumption or

disposition outside the U.S.

Not more than 50% of fair market value of the export property can be

attributable to foreign content.

Consider qualified export property sold to U.S. distributors

18


95% qualified gross receipts test (Cont.)

Other receipts to consider

Sales made to U.S. distributors

Sales made to foreign disregarded entities

Excluded receipts

Export property is for ultimate use in the U.S.

The sale, lease, etc. is accomplished by a subsidy of the U.S. government.

The export property is for the use by the US government, where the use

is required by law or regulation.

19


95% qualified export asset test

At least 95% qualified export assets at year-end are qualified.

Categories of export assets

Export property

Working capital

Only amount necessary for required working capital

Commission receivable

Stock or securities of related foreign export corporation

Producer’s loans

20


Commission payment

Payment of initial commission estimate within 60 days of DISC’s year-

end (March 2, calendar year).

Any unpaid commission must be paid within 90 days of finalization.

Unpaid amount cannot be more than original estimate – i.e., estimate

must be at least 50% of final.

File IC-DISC return (Form 1120-IC-DISC)

Due within 8 ½ months of year-end

Maintain IC-DISC books and records

21

Other Considerations

DISC commission reduces QPAI deduction.

Relates to the deduction for domestic production activities

DISC commission reduces profit on foreign title transfer sales. [Sect.

863(b)]

May reduce foreign tax credit limitation

Provide for deferred tax on accumulated DISC income

State income tax considerations

22

Problems?

Failure to file Form 4876-A timely

9100 relief

Distribution needed to meet qualification requirements

Deficiency distribution

Failure to meet 95% qualified export asset test and 95%

qualified gross receipts test, as well as timely paying

commission

Equal to amount of taxable income attributed to the non-

qualified portion

Deemed reasonable cause if paid on or before 15th day of ninth

month after year or within 90 days of an IRS request

If paid after, interest in the amount equal to 4.5% of distribution

[§992(c)(2)(b)]

Baker & McKenzie LLP is a member firm of Baker & McKenzie International, a Swiss Verein with member law firms around the world. In accordance with the common

terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an

"office" means an office of any such law firm.

© 2016 Baker & McKenzie LLP

Updated IC-DISC Ownership

Structures

Neal J. Block

Baker & McKenzie LLP (Chicago)

November 10, 2016

©2016 Baker & McKenzie LLP - 24

Overview of Presentation

Structuring

– Privately-held company: C Corp, S Corp, partnership, LLC taxed as a

partnership

– Closely Held and Publicly-traded “C” corporation deferral

– Individual Retirement Account (IRA) and Roth IRA

– Estate planning, executive compensation

– Treaty benefits

– Sourcing benefits


IC-DISC Ownership Structures

Privately-Held Company

U.S. – C Corp

Exporter

(Related Supplier)

IC-DISC

Commission

35%

IC-DISC

Individual Shareholders

IC-DISC Dividend 23.8%



S Corporation and LLC

– Dividends pass through the corporation to the shareholders and are

deferred from taxes and receive dividends taxed at the 23.8% capital

gains rate

IC-DISC Commission

39.6%

IC-DISC

U.S. Exporter

(S Corp.)

Capital Gains Dividend – 23.8%

Individual Shareholders


Partnership Owned by LLC or S Corporation

– DISC Dividends pass through the partnership to the

partners and shareholders of the S corporations and taxed

at the 23.8% capital gains rate

IC-DISC

23.8% Div.

Partnerships

and/or S Corps


Individuals

39.6% Commission

Deduction Exporting

Partnership

Deemed Exporter

C Corp DPAD

Public Shareholders


Putting Supply Chain Activity

in One Exporting Partnership

BEFORE

A sells to B ($10 profit) B sells to C (10 Profit) C exports and pays rent to D

Only C’s Export Profit Less D Payment qualifies

for DISC benefits.

Manufacturing

A

B

C

D

Exports and pays

DISC a commission

Further

Manufacturing

Pays

Rent

Sale

Sale

Leases Space to C

DISC

AFTER

A

B

C

D


ABCD

Partnership

DISC

DISC

Commission

on Total Profit

of ABCD


Closely Held and Publicly-Traded

Corporation - Deferral

*Plus non-qualified receipts.

IC-DISC Receivables

& Commission

Up to $9.1 Million

Deferred*

C CORP

Up To $10 Million

Deduction


Publicly-Traded Corporation

– IC-DISC may defer from taxation 16/17 of best $10

million of gross receipts. The balance is deemed

distributed to its shareholders.

– Large exporters who generate substantial export

receivables can sell the receivables to the IC-DISC at a

discount. The discount income qualifies as qualified export

receipts.


Example I Assume: An IC-DISC owned by a “C” Corp. in 2016 receives

commissions for export sales and earns discount income from factoring export receivables of $8 million. It earns a 20% or $.4 million commission on the best $2 million of sales. The IC-DISC is tax exempt and is allowed to retain income attributable to the best $10 million of gross receipts. The balance of gross receipts over $10 million is deemed distributed to the IC-DISC’s shareholders as a dividend. Use of the IC-DISC results in a $2.77 million tax savings as follows:



Example I (cont.)

Discount income $ 8.00 million

Commission on best $2 million of sales .40 million

Total IC-DISC income before deemed

distribution $ 8.40 million

Less 1/17 deemed distribution .50 million

Total income to be retained $ 7.90 million

Tax Savings @ 35% $ 2.77 million



Example I (cont.)

Interest charge imposed on IC-DISC shareholder on tax

savings (based upon One Year Treasury Bill rate)

Assume tax savings in 2016 $ 2.77 million

Interest rate on One Year Treasury Bill

in Sept. 2017 1%*

Interest charge payable when IC-DISC

shareholder’s 2017 return due (2018) $ 27,700 Tax benefit from interest deduction -

$27,700 @ 35% 9,695

Net cost of interest charge $ 18,005

*Assumed Rate



Example II

MAXIMUM BENEFIT FROM DISCOUNT INCOME

Assume:

$10 million of discount income $10.00 million

Less 1/17 deemed distribution .85 million

Net $ 9.15 million

[Can be increased by non-qualifying receipts up to 5% of total receipts]



Example II (cont.)

Tax benefit $10 million @ 35% $ 3.20 million

Interest Charge:

$3.2 million saved at 1%* $ 32,000

Tax benefit from interest

deduction – $32,000 @ 35% 11,200

Net cost of interest charge $ 20,800

*Assumed



Beneficiary Regular IRA – Regular Tax

IRA

C CORP

C Corporate

Tax Rates on

IC-DISC Dividends

IC-DISC

Corporate Tax Rates

on IC-DISC Dividends

0 Tax

on C Dividends


IRA IC-DISC Benefits

Use of C Corp To Own IC-DISC Stock

– Allows dividends from IC-DISC to be taxed to C corporation at corporate rates of 15% - 35%

– Dividends from C corporation to IRA tax-free

– Assets invested by IRA tax-free

– Distributions taxed when distributed by regular IRA

– May be combined with IRA direct ownership of IC-DISC stock


IRA IC-DISC Benefits

IRA Ownership of IC-DISC

– Accumulated IC-DISC income taxed at corporate rates 15-35% when distributed

– Assets in IRA invested tax-free

– Multiple IRA structure could reduce total tax on IC-DISC dividends

– Use of LLC owned by IRA to avoid custodian involvement

– Tax Court held in Summa Holdings, Inc. v. Commissioner, T.C. Memo. 2015-119 that Service could reallocate DISC commissions to Roth IRA owned DISC to related supplier under substance v. form. Commissions to regular IRA distinguished. Summa case on appeal 6th Circuit. Related cases on appeal 1st and 2nd Circuits. Similar FSC case, Mazzei v. Commissioner, Docket #16702-09, pending in Tax Court.


Estate Planning and Executive

Compensation

– Estate Planning: Ownership of IC-DISC stock in different proportions

than exporting company stock can remove IC-DISC dividends from

estate. Rev. Rul. 81-54 may result in gift tax exposure, but Hellweg

decision effectively held Rev. Rul. 81-54 inapplicable. All gift tax cases

have been dismissed, but could be resurrected if the Service is

successful in pending cases.

– Executive Compensation and Succession: IC-DISC dividends can

be paid to designated employees who own IC-DISC stock but do not

have to be the same shareholders of the parent company. May avoid

safe harbor pricing requirements. Can be used as a type of employee

stock purchase plan.


Foreign International Sales Corporation

(FISC)

– FISC: Owned more than 50% by IC-DISC

– FISC Dividends: Qualified IC-DISC export receipts [count towards best $10 million of gross receipts]

– Generally same activities qualify as IC-DISC regarding export property and related and subsidiary services

– 95% qualified export assets and gross receipts tests

– No safe harbor pricing

– Recommend when qualifying activities subject to low tax and otherwise would be subpart F income

IC-DISC

FISC


Foreign Individual, Partnership, or

Trust* Structure [Must be disclosed on 1120 IC-DISC Returns]

Foreign Individual,

Partnership, or Trust

DISC Related Supplier

20%** Capital Gains

Rate***

Commission

35% deduction *Trust not taxed as a corporation.

**3.8% tax not applicable to non-resident aliens.

***Possible treaty rate.


Treaty Country Corporation Structure

Treaty Country

C Corp.

DISC Related Supplier

Div. @ Treaty

W/H Rate

(5% or less)

Commission

35% deduction


Treaty Benefits (Ownership of a DISC by a Treaty Country Corporation)

– Section 996(g) classifies IC-DISC dividends as effectively connected with the conduct of a trade or business in the U.S. through a permanent establishment. This would likely result in foreign corp. shareholder of a DISC being subject to tax on DISC dividends at up to 35% tax.

– Section 996(g) is in conflict with most treaties which prevent taxation of a treaty country corporation in the absence of an actual permanent establishment (i.e., the mere existence of a U.S. subsidiary is not sufficient for U.S. taxation of dividends to parent as effectively connected income through a permanent establishment).


Treaty Benefits (Ownership of a DISC by a Treaty Country Corporation)

(Continued)

– Under the later-in-time theory, treaties executed after June 1984, therefore, may prevent 996(g) from applying

– IC-DISC dividends may thus be taxed at treaty rate on dividends

– If foreign owner of DISC is an individual, the 20% tax rate on DISC dividends should apply even if no treaty benefit*

– Treaty Country taxation of DISC dividends must also be taken into account

*The 3.8% tax not applicable to non-residential aliens.


Sourcing Benefits

– Section 861(a)(1)(D) treats IC-DISC dividends attributable to qualified export receipts as foreign source income to U.S. shareholders.

– IC-DISC dividends are presently in a separate basket (Section 904(d) Passive Basket).

– Opportunity exists to put foreign taxes into IC-DISC to create and increase foreign source income limitations:

(a) From U.S. title passage

(b) From FISCs.

Baker & McKenzie LLP is a member firm of Baker & McKenzie International, a Swiss Verein with member law firms around the world. In accordance with the common

terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an

"office" means an office of any such law firm.

© 2016 Baker & McKenzie LLP

Saving the Disqualified DISC

Neal J. Block

Baker & McKenzie LLP (Chicago)

November 10, 2016

Saving the Disqualified DISC

1. A DISC will not qualify as a DISC if its election [form 4876-A] is not filed timely, generally within 90 days of incorporation date. Also capital stock of $2500 par stated value must be validly issued by the date the election is due.

2. 95% of the DISC’s assets on the last day of the taxable year must be qualified export assets or the DISC will be disqualified.

3. 95% of the gross receipts for the year must be qualified export receipts or the DISC will be disqualified. In the case of a Commission DISC the qualified export receipts are those of its related supplier’s sales. Generally this test is commonly met since the DISC commissions are virtually always based on qualified export receipts.


4. In addition, Treas. Reg. § 1.993-6(e)(2) provides that if the

DISC commission agreement excludes non-qualified gross

receipts, they will not be taken into account. The Tax Court in

a split decision has held that this provision may not be relied

upon where an actual commission has been paid on non-

qualifying gross receipts. See Hughes International Sales

Corporation v. Commissioner, 100 T.C. 293 (1993). The

Internal Revenue Service, however, has informally held that

the intent of the regulation was that the provision not allow for

non-qualified gross receipts to be taken into account and has

allowed them to be excluded.


CONSEQUENCES IF ELECTION NOT

TIMELY FILED

– If election is not timely filed, no DISC benefit in the year of

incorporation and until a valid election is timely filed.

– So-called section 9100 relief may allow for a late election if

granted by the Service for reasonable cause.

– 9100 Relief commonly granted, but filing fee can be

expensive (around $7,000).


If a DISC is disqualified, the accumulated DISC income

(deferred income) is deemed distributed over 2 times the

number of years the DISC has been in existence up to 10

years. See Section 995(b)(2). The first deemed distribution

is the year following the year of disqualification.


The DISC income for the year of disqualification, except as

discussed later, does not qualify for DISC benefits. It can

be either reallocated to the related supplier under section

482 or left in the DISC at the discretion of the Internal

Revenue Service. If left in the DISC the income is taxed as

ordinary corporate income at corporate rates. See Addison

Int’l., Inc. v. Commissioner, 90 T.C. 1207 (1988); aff’d 887

F.2d 660 (6th Cir. 1989); Jet Research, Inc. v.

Commissioner, T.C. Memo. 1990-463.

54©2016 Baker & McKenzie LLP - 54

If the qualified export assets are not substantially below the

95% amount, it may be possible to examine the underlying

transactions to find additional qualifying gross receipts or

additional DISC income in an amount which would make the

95% test met. This could be done by a redetermination of the

DISC income before the filing of the DISC’s return. Under

Treas. Reg. § 1.994-1(e)(5), the resulting additional

receivable generally would be a qualified export asset at the

end of the prior taxable year if paid within 90 days of the

redetermination.


Deficiency Distribution May Be Available

1. The rules for a deficiency distribution may be found at

Treas. Reg. § 1.992-3 and provide that (1) an otherwise

disqualified DISC under the 95% qualified gross receipts

test may distribute an amount equal to the income

attributable to the non-qualified gross receipts and (2) that a

DISC that is not qualified under the 95% qualified export

assets test may distribute an amount equal to the total

amount of the non-qualified assets for the taxable year. If a

deficiency distribution is made for a taxable year, the DISC

is qualified for that year. Deficiency distributions may be

made for more than one taxable year.


2. The distribution is taxed as a current year’s distribution, but

if made, will qualify the DISC year as a qualified DISC for

the year in which it missed either the 95% qualified export

assets test, the 95% gross receipts test, or both.

3. The deficiency distribution and the year for which it is

made must be labelled as such at the time it is made and

notification made to the Internal Revenue Service and

DISC shareholders that the distribution is a deficiency

distribution.

4. It may be made in cash or other property.


5. There must be reasonable cause for the failure to meet the 95% test, but the similar standard for failure to make the DISC election timely has been lax. Generally, it appears that lack of sufficient knowledge of the DISC rules and regulations or simple negligence will be considered as reasonable cause. Our experience has been that if a deficiency distribution is made before an audit has commenced, the deficiency distribution will not be challenged.

Prior agreement of the Service for a deficiency distribution is not required. Nor is there any fee to be paid to the Internal Revenue Service for the privilege of making a deficiency distribution.


a. So long as a deficiency distribution is made by the time

the DISC’s return for the year of disqualification is due,

there is no penalty attached to the deficiency distribution.

Rather, the distribution is taxed either as dividend income,

return of capital or capital gains depending on the DISC’s

earnings and profits for the year of the distribution.

b. After the first DISC return is due subsequent to the year of

disqualification, a 4-1/2% interest charge per year is

imposed upon the DISC making a deficiency distribution

for each year or partial year that the non-qualified assets

are retained in the DISC’s possession or the assets

attributable to non-qualified gross receipts are not

considered to be distributed.


c. Since the DISC is a tax exempt entity, the interest charge

will not reduce DISC taxes, but will reduce its accumulated

DISC income.

d. If the same asset remains on the DISC’s books for more

than one taxable year, only that amount will be required to

be distributed in qualifying the initial year and future years.

Further, only one 4-1/2% of the amount which remains on

hand in future years is required for each year the DISC

remains disqualified, i.e., if an amount is paid out, for

example, after the second consecutive year of

disqualification, the deficiency interest for the first year of

disqualification would be the three years of deficiency

interest for the original amount. The 4-1/2% amount will not

be again imposed on the same amount to qualify the

second year. ©2016 Baker & McKenzie LLP - 60

For example, if the only disqualified asset is $100 in years one and two, a $100 deficiency distribution and an interest charge of 4-1/2% on the $100 for three years can qualify the DISC for both the first and second year.

e. There is no tracing of assets required for the deficiency distribution. All that is required is an amount equal to the disqualified amount being distributed. This should allow for capital contributions to be made to the DISC for the purposes of allowing it to make the deficiency distribution. (Since the deficiency distribution is designed to remove non-qualified assets from the DISC’s balance sheet, allowing for the contribution of capital for the purpose of making a deficiency distribution is consistent with that result.)


f. If the statute of limitations has run for a year in which a

DISC has not been qualified, it may be desirable not to

make a deficiency distribution for that year.

i. A DISC does not lose its election to be treated as a

DISC unless it is not qualified as a DISC for five

consecutive years. A deficiency distribution in one

of those years should allow the DISC election to

remain in effect for all five years in that period. See

Treas. Reg. § 1.992-2(e)(3).


ii. Under section 992(a)(2), a DISC which is

disqualified which has not timely received a

statutory notice of deficiency is not allowed to take

the position that it was not a qualified DISC.

Further, if the Service does not attempt to disqualify

the DISC, it will remain as a qualified DISC for all

purposes of the Code. See Treas. Reg. § 1.992-

1(g). Unfortunately, the claims court and the

Federal Court of Appeals has held that the failure to

qualify can only be used by the Service against a

taxpayer, not by a taxpayer in its favor. See

Stokely-Van Camp, Inc. v. Commissioner, 974 F.2d

1319 (Fed. Cir. 1992).


Clean DISC/Dirty DISC

There are no limitations on the number of related DISCs.

If a DISC may have qualification problems, a new DISC

may be incorporated for future years. This may lessen

the audit risk for the prior years.


©2016 Baker & McKenzie LLP – 65

3815706

THANK YOU

Neal J. Block Baker & McKenzie LLP

300 East Randolph Street Suite 5000

Chicago, Illinois 60601 ( (312) 861-2937 7 (312) 698-2068

[email protected]

Baker & McKenzie LLP is a member of Baker & McKenzie International, a Swiss Verein

North American Tax Practice Group

Your Trusted Tax Counsel

Any tax advice included in this communication is not intended or written to be used, and it cannot be

used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.

© Forte International Tax, LLC All rights reserved. www.forteintax.com

Calculating IC-DISC Income

Strafford

Mark Gasbarra, CPA

September 8, 2015

67 67

Speaker Introduction

Mark Gasbarra, CPA

National Managing Director

Forte International Tax, LLC

Firm’s focus is delivering processes and tools, including

VantagePoint™, to help international businesses

minimize their global tax cost

Service areas include the full range of international tax

services including structuring, transfer pricing, foreign

tax credit utilization and U.S. manufacturing and export

tax incentives (“IC-DISC”)

Mark has worked with DISC’s since 1981 and has led

the export incentives practices of two of the Big-Four

accounting firms before forming Forte International Tax

Services in 2004

69 69

Topics of this Session

Maximizing IC-DISC Taxable Income

Related Supplier Methods

Administrative Pricing Rules

4% Gross Receipts

50% Combined Taxable Income

Arms Length Pricing - §482

Unrelated Supplier?

Calculating Combined Taxable Income

Commission versus Buy-Sell Transactions

Marginal Costing & No Loss Rules

Special topics

Case Study

70 70

IC-DISC History

1971: Domestic International Sales Corporation (DISC) regime

enacted

1984: DISCs are replaced with two separate provisions, Foreign Sales

Corporations (FSCs) and IC-DISCs

2000: FSCs repealed and replaced with Extraterritorial Income (ETI)

2004: ETI phased out and section 199 phased-in

71 71

Why Do We Care?

Bottom Line – Tax Savings!

Qualified DISC income is exempt from Federal income tax and

may be excluded from State income tax as well.

An IC-DISC is a domestic corporation so its dividends to qualified

shareholders are taxed at capital gains rates.

Goal: Maximize the DISC’s income and minimize the ordinary

taxable income of its related supplier.

72 72

DISC Income Options

Administrative pricing methods

– Available to allocate profits between a Related Supplier and an IC-DISC.

– This is the most common and will be the focus of our discussion.

Arm’s length profit calculation determined under IRC Section 482

– Applicable to transactions between related parties that are controlled by

the same interests.

Fully operational exporter of U.S. produced property entity

– Any supplier will do.

73 73

Related Party & Related Supplier

Related Party

– A person which is controlled directly or indirectly by the same interests as

the IC-DISC within the meaning IRC Section 482.

Related Supplier

– A related party which singly engages in a transaction directly the IC-

DISC.

Administrative Pricing Rules

– Only applicable to transactions between an IC-DISC and its related

supplier.

An IC-DISC may have different related suppliers with respect to

different transactions

74 74

Related Supplier Example

X owns all the stock of Y, a regular corporation, and of Z, an IC-

DISC

X sells a product to Y which is resold to Z

Only Y is the only related supplier of Z with respect to this

transaction and eligible for Administrative Pricing

If, however, X sells directly to Z and Y also sells directly to Z, then,

as to the transactions involving direct sales to Z, each of X and Y is

a related supplier of Z.

75 75

Administrative Pricing Methods

4% Gross Receipts Method(s)

– Regular no-loss rule

– Special no-loss rule

50% Combined Taxable Income Method(s)

– Full Costing Combined Taxable Income (“FC-CTI”)

– Marginal Costing Combined Taxable Income (“MC-CTI”)

MC-CTI only considers direct costs (think about gross profit)

Limited to the overall profitability

Note that combined taxable income must always be determined.

76 76

Buy/Sell vs. Commission DISC

The same amount of DISC taxable income results under either

approach.

In a buy-sell transaction you first determine DISC taxable income

and then back into the transfer price.

Selection of a Buy/Sell or Commission can be made at the

transaction level.

77 77

What is “CTI” Anyway?

CTI is the limiting factor in determining DISC taxable income.

CTI is the combined taxable income of an IC-DISC and its Related

Supplier with respect to each qualified export transaction.

In order to maximize the IC-DISC tax exempt income you first

maximize CTI.

In order to maximize CTI we must fully understand its

components.

78 78

CTI Components

Qualified Export Receipts

Directly Allocable Costs

Deductions Allocated and Apportioned in accordance with U.S.

Treasury Regulations (aka 861-8)

79 79

How to Maximize CTI

Qualified export gross receipts are maximized by making sure to

pick up all available sources, including:

– Direct and Indirect Exports

– Component Sale

– Other components of gross receipts (broadly defined)

Cost of Goods Sold – must be consistent with the Related Supplier

method of accounting

Deductions – Section 861-8 allocation and apportionment

– Interest Expense

– Research & Development

– Other – considerable leeway here, but ….

80 80

Example 1

Example 1 Total Non-Export Export Trans 1

Export Trans 2 Grouped

Sales 400 200 100 100 200

COGS 250 100 90 60 150

Gross Profit 150 100 10 40 50

Expenses 120 80 8 32 40

Taxable Income 30 20 2 8 10

Profit Percentage 7.50% 10.00% 2.00% 8.00% 5%

IC-DISC Income

- 4% x QER 4.00 4.00 8.00

- Regular No-Loss Rule 2.00 8.00 10.00

Net 4% Method 2.00 4.00 8.00

- 50% x FC-CTI 1.00 4.00 5.00

Best Result 2.00 4.00 8.00

Observations Application of the regular no-loss rule

Grouping is beneficial in this case

All expenses are apportioned on a gross income basis

Export transaction #2 - Export profit of 8% results are same

81 81

What is Marginal Costing

It is a subset of the 50% combined taxable income method

Only considers direct costs (no 861-8 burden)

But, limited to the Overall Profit Percentage (“OPP”) multiplied

the qualified export receipts

The OPP is the taxable income (both domestic and export)

– TI/Sales = OPP

You are deemed to be discounting your exports sales in order to

penetrate foreign markets

82 82

Example 2



Sales 400 200 100 100 200

COGS 250 100 90 60 150

Gross Profit (MC-CTI) 150 100 10 40 50

Expenses 120 80 8 32 40



IC-DISC Income

- 4% x QER 4.00 4.00 8.00


Net 4% Method 2.00 4.00 8.00

- 50% x FC-CTI 1.00 4.00 5.00

- 50% x MC-CTI 5.00 20.00 25.00

- OPP Limitation 3.75 3.75 7.50

Net 50% MC Method 3.75 3.75 7.50

Best Result 3.75 4.00 8.00

Observations Marginal Costing boosts Export Trans 1 up to the OPP limit

Grouping is still beneficial

All expenses are apportioned on a gross income basis

No help from marginal costing on Export Trans #2

83 83

What About TxT and Optimization?

The DISC regulations generally require the computation of DISC

taxable income individually for each export transaction

However grouping in accordance with industry trade or practice is

allowed (but generally not beneficial)

Best approach is a T x T pricing approach coupled with

Optimization by testing all available pricing and grouping

alternatives in addition to available allocation and apportionment

method using sophisticated software tools – this can make a big

difference where there is significant variability among the various

export transactions

84 84

Example 3

Example 3 Total Non-Export Export Trans 1 Export Trans 2 Grouped

Sales 400 200 100 100 200

COGS 250 100 90 60 150


Expenses 120 80 8 32 40



IC-DISC Income

- 4% x QER 4.00 4.00 8.00


- Special No-Loss Rule 7.50 7.50 15.00

Net 4% Method 4.00 4.00 8.00

- 50% x FC-CTI 1.00 4.00 5.00

- 50% x MC-CTI 5.00 20.00 25.00


Net 50% MC Method 3.75 3.75 7.50

Best Result 4.00 4.00 8.00

Observations Marginal Costing boosts Export Trans 1 up to the OPP limit

Application of the Special No-Loss Rule allows full 4% on Trans 1 > 100% CTI

85 85

Example 4



Sales 400 200 100 100 200

COGS 250 100 90 60 150


Expenses 120 60 30 30 60

Taxable Income 30 40 -20 10 -10

Profit Percentage 7.50% 20.00% -20.00% 10.00% -5%

IC-DISC Income

- 4% x QER 4.00 4.00 8.00

- Regular No-Loss Rule -20.00 10.00 -10.00

- Special No-Loss Rule 7.50 7.50 15.00

Net 4% Method 4.00 4.00 8.00

- 50% x FC-CTI -10.00 5.00 -5.00

- 50% x MC-CTI 5.00 20.00 25.00


Net 50% MC Method 3.75 3.75 7.50

Best Result 4.00 5.00 8.00

Observations Now expenses are apportioned on relative Sales

Sales base increases the variability of profit

Now T x T = 9 which is and increase of 12.5% over grouping

The loss for Export Trans 1 is inconsequential

86 86

Importance of 861-8

• Limiting factor impacting permanent cash and book tax

savings

• Consistency Rule for all operative sections of the Code

– Subpart F

– IC-DISC

– DPAD

– FTC

• Allocation and Apportionment rules (861-8)

– Interest Expense – Consolidated Assets

– R&D, exclusive apportionment, sales or gross income

– Stewardship – dividends

– Other Supportive Deductions – Reasonable relationship between

the deduction and the income to be generated

87 87

Statutory Authority

• IRC §864

– §864(e) Rules for allocating interest, etc.

• 864(e)(6) Allocation and apportionment of other expenses.

– Expenses other than interest which are not directly allocable or

apportioned to any specific income producing activity shall be

allocated and apportioned as if all members of the affiliated group

were a single corporation.

– §864(f) Election to allocate interest, etc. on worldwide

basis.

• Not applicable until the first taxable year beginning after

December 31, 2020.

– §864(g) Allocation of research and experimental

expenditures.

88 88

Key Definitions

• Factual Relationships – between deductions and the “class of gross”

income to which they relate

• Allocation – normally a definite relationship will exist, in which case a

deduction is allocated to one or more classes of gross income

• Classes of Gross Income – not pre-defined but would include items

listed in IRC §61, including income derived from business, interest,

rents, royalties, dividends

• Apportionment – the process of spreading a deduction between the

statutory and residual groupings within a class

• Statutory Grouping – defined with respect to an operative section of

the IRC

• Residual Grouping – everything except the statutory grouping

• Operative Section – taxable income from a particular source, e.g.

qualified production activity income for DPAD

89 89

R&E Example (GI vs. Sales)

• Geographic Exclusive apportionment percentage

– N/A for DPAD

– GI Method is 25% vs. 50% for Sales Method

• Sales method focuses on 3-digit SIC Codes

– Product orientation may favor FTC

– Inclusion of controlled sales (CFC’s) – favors DPAD

– Inclusion on non-controlled sales (royalty payors) –

favors DPAD

• Numeric Example

90 90

Interest Expense

• Under IRC §864(e) and Treas. Reg. §1.861-9T

– Affiliated groups: allocate and apportion interest expense of each

member as if all members of such group were a single corporation.

• Foreign corporation treated as a member of affiliated group if:

– more than 50 percent of the gross income is effectively connected with the

conduct of a trade or business within the United States, and

– at least 80 percent of either the vote or value of all outstanding stock is

owned directly or indirectly by members of the affiliated group.

– Asset method must be used. May elect to determine the value of its

assets on the basis of either the:

• tax book value method.

• the alternative tax book value method, or

• the fair market value method.

– Tax-exempt assets not taken into account.

– Basis of stock in nonaffiliated 10-percent owned corporations

adjusted for earnings and profits changes.

91 91

Interest Example

• Fair Market Value – tended to benefit FTC

– Depreciated U.S. asset base

– More recent foreign acquisitions

– No bump for accumulated E&P of foreign subsidiaries

– Favorable nuances and uncertainty resulting form

limited guidance

• Tax Book Value (tax basis) – may tend to favor

DPAD

• Alternative Tax Book Value – would tend to favor

FTC if the asset profile would have favored FMV

• Numeric Example

92 92

Other Prescribed Relationships

• §1-861-8(e) Allocation and apportionment of

certain deductions. – Stewardship and controlled services.

– Legal and accounting fees.

– Income Taxes.

– Losses on the sale, exchange, or other disposition of property.

– Net operating loss deduction.

– Deductions which are not definitely related.

– Special deductions.

– Personal exemptions.

– Deductions for certain charitable contributions.

93 93

Supportive Deductions

• Under IRC §861-8T(B)(3) – Deduction may relate to other deductions, which can be more

readily allocated to gross income.

– Deductions may be allocated to all gross income or another broad

class of gross income and apportioned within that class using any

reasonable apportionment base.

– Deductions not definitely related to any class of gross income,

allocated and apportioned to all classes on a relative gross income

basis.

– §864(e)(6) and §1.861-14T require affiliated group apportionment

base, unless less than all members of affiliated group have gross

income in that class, in which case the base can include only the

members that have income in that class as part of the base.

94 94

Optimization Levers

Allocation and Apportionment

– Other than the prescribed methods for specific deductions, such as interest

and R&D, any method that is reasonable should be accepted.

– For example, sales, gross receipts, gross income, gross profit, cost of

goods sold, time spent, square footage, etc.

Pricing methods

– 4% gross receipts limited by either the regular or special no-loss rule

– 50% full cost or marginal cost limited by marginal cost combined taxable

income or the overall profit percentage limitation (OPP x QER)

Grouping alternatives

– Grouping for pricing and grouping for OPP

OPP Grouping

– May be broader than the pricing level (transaction or group)

95 95

IRS Form 1120-IC-DISC

Schedule K vs. 1099

Schedule B - Gross Receipts

Number of Schedule P’s to support the income

Schedule E – IC-DISC Expenses

– Export Promotion Expenses

10% of Qualified Amount can increase IC-DISC Income

– Entitled to reimbursement of all expenses incurred by the IC-DISC

Schedule J – Complexity

– Deemed Dividends

– Accumulated DISC Income

Schedule L – Balance Sheet

Schedule O – Check Boxes Be Careful

Schedule Q – Producer’s Loans

96 96

Optimization Levers

Allocation and Apportionment

– Other than the prescribed methods for specific deductions, such as interest

and R&D, any method that is reasonable should be accepted.

– For example, sales, gross receipts, gross income, gross profit, cost of

goods sold, time spent, square footage, etc.

Pricing methods

– 4% gross receipts limited by either the regular or special no-loss rule

– 50% full cost or marginal cost limited by marginal cost combined taxable

income or the overall profit percentage limitation (OPP x QER)

Grouping alternatives

– Grouping for pricing and grouping for OPP

OPP Grouping

– May be broader than the pricing level (transaction or group)

97 97

Case Study - Data

CASESTUDY

TotalForm1120-S

QualifiedExport

Sales OtherSales

Sales 20,000,000 6,000,000 14,000,000

DirectCostofGoodSold 10,000,000 2,000,000 8,000,000

Overhead 2,000,000

Freight 1,000,000

TotalCostofGoodsSold 13,000,000

GrossProfit 7,000,000

InterestExpense 200,000

ResearchandDevelopment 200,000

OtherDeductions 5,000,000

TotalDeductions 5,400,000

OrdinaryBusinessIncome 1,600,000

ProductionAssets 10,000,000 3,000,000 7,000,000

AssetRatios 30% 70%

SalesRatios 100% 30% 70%

COGSRatios 100% 20% 80%

OverallProfitPercentage

-Salesrelatedtaxableincome - - -

-TotalSales 20,000,000

OverallProfitPercentage("OPP") 8.00%

98 98

Case Study – Transaction File

99 99 99

99

Case Study – Product Tree

100 100

Case Study – Sum by Batch Report

Sum By Batch ReportSubject: 1000 Agricultural COOP

Scenario: AG IC-DISC

Tax Year: 2012

Purpose: U.S. Tax

Date and Time: 6/9/13 14:15

Pricing Batch Sales Gross Profit CTI Benefit

1 - FC-CTI 4,429,000 2,164,577 1,205,067 671,157

2 - MC-OPP limit 1,323,000 335,019 (71,436) 93,958

4 - MC-CTI 50,000 (7,167) (30,154) 2,500

6 - FTGR 28,000 (6,062) (19,722) 1,120

7 - FTGR-RegNlr 170,000 53,633 5,476 5,476

Total 6,000,000 2,540,000 1,089,231 774,211

Optimization Benefit:

Gross Receipts Method 6,000,000 0 0 240,000

Full Cost CTI Method 1,089,231 544,616

Best Method without Optimization 544,616

Increase in Benefit from Optimization 229,595

101 101

Implementation Requirements

Key Data Elements

Legal Structure and Qualification Criteria

Product Hierarchy

Sales and COGS at the lowest level of detail available

This is referred to as transactional data

Variances and Schedule M’s can be apportioned

T x T benefits are driven by variability in profitability

Financial statements

Pro-forma income tax returns

Allocation and Apportionment of Deductions (“A&A”)

A&A Can enhance existing variability

T x T, Marginal Costing, Special No-loss rule all work together to

significantly boost DISC income!

102 102

Questions and Contact Information

For additional questions on topics related to this discussion, please

contact:

Mark Gasbarra, CPA

National Managing Director

Forte International Tax, LLC

[email protected]

(847) 733-0645

www.forteintax.com

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