ic-disc: compliance challenges in the federal tax break...

IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters Leveraging Benefits Arising From the Dividend Tax Solution

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WEDNESDAY, DECEMBER 4, 2013

Presenting a live 110-minute teleconference with interactive Q&A

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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IC-DISC: Mastering Intricacies of the Federal Tax Incentive for Exporters Seminar

Jim Loizeaux, Grant Thornton [email protected]

Dec. 4, 2013

Jerry Jonckheere, Plante Moran [email protected]

Jerry Ogle, Ogle International Tax Advisors [email protected]

Today’s Program

History, Recent Law Changes, and Current Legislative Environment [Jerry Jonckheere]

Qualification of IC-DISCs and Qualified Exports [Jim Loizeaux] Compliance and Reporting [Jerry Ogle]

IC- DISC structures

[Jerry Jonckheere, Jim Loizeaux and Jerry Ogle] Strategies and IRS activity [Jerry Jonckheere, Jim Loizeaux and Jerry Ogle]

Slide 7 – Slide 19

Slide 20 – Slide 41 Slide 42 – Slide 52 Slide 53 – Slide 59 Slide 60 – Slide 67

Interest Charge – Domestic International Sales Companies

What they are Their History The Outlook Current Issues

Jerry Jonckheere Int’l Tax Partner – Plante Moran

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.

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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.

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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

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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

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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

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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

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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

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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”

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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

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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

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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.

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Slide Intentionally Left Blank

QUALIFICATION OF IC-DISCS AND QUALIFIED EXPORTS, PART II

Jim Loizeaux, Grant Thornton

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

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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.

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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.

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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

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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.

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IC-DISC Requirements

* Not a tax-exempt org., PHC, corp. or insurance co. association, RIC, S

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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.

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

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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

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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)

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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

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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.

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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.

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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

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“Vanilla” Commission IC-DISC Structure

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IC-DISC Tax Benefits Following Tax Law Changes of 2013

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IC-DISC Tax Deferral

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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.

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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]

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

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IC-DISC Producer’s Loan: Example

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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

Jerry Ogle, Ogle Tax Advisors

Ogle International Tax Advisors offers IC DISC consulting services. In addition, our spectrum of international tax services can provide assistance in the areas of :

Foreign business investments - structure active business investments in offshore subsidiaries to minimize U.S. and host country taxation. Analysis of the U.S. CFC and PFIC rules for individual investors.

Offshore profits importing - plan for the repatriation of active foreign profits.

Foreign tax systems - analyze host country deductions, exemptions, and incentives, including foreign tax credits with host country tax advisors.

Miami Office 5201 Blue Lagoon Dr Suite 800 Miami, Florida 33126 (T) 305.671.3179 (F) 305.402.0552

Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida 34240 (T) 941.361.1147 (F) 941.827.9929

For more information on our services Please contact us at our offices or visit us at our website www.ogleintltax.com

An IC-DISC can act as a buy-sell entity or a commission-based entity. In any event, 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) Sect. 482

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Miami Office 5201 Blue Lagoon Drive, Suite 800 Miami, Florida 33126 (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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Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida 33126 (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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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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Related 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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DISC 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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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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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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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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Common Structures


Flow-Through Entities

IC-DISC

S Corp Or P’ship

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

As reported on a Schedule K-1

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C Corporations

IC-DISC C Corp

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.

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Officer Bonus Plan

IC-DISC

C Corp, S Corp

Or P’ship

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

Officer

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Foreign Owner

IC-DISC C Corp

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.

Foreign Corp

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Roth IRA

IC-DISC

C Corp, S Corp

Or P’ship

This structure gets income into a Roth IRA that *may* avoid future taxation.

Roth IRA

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Generation Transfer

IC-DISC

C Corp, S Corp

Or P’ship

This structure gets income to an owner‘s children or grandchildren.

Children

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IRS Audit Issues How to Pass an Audit with Flying Colors


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,

• 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 • 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 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. ▫ 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 these non-standard structures

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Other Words of Wisdom • Pigs get fat • Hogs get slaughtered

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ic-disc: compliance challenges in the federal tax break...

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