FOR LIVE PROGRAM ONLY IC-DISC Strategies: Mastering the...
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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
FOR LIVE PROGRAM ONLY
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FOR LIVE PROGRAM ONLY
Nov.10, 2016
IC-DISC Strategies
Neal J. Block, Senior Counsel
Baker & McKenzie, Chicago
Mark C. Gasbarra, CPA, National Managing Director
Forte International Tax, Evanston, Ill.
Randall Janiczek, CPA
Plante & Moran, Grand Rapids, Mich.
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
DISC Annual Maintenance (Cont.)
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
DISC Annual Maintenance (Cont.)
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
DISC Annual Maintenance (Cont.)
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
©2016 Baker & McKenzie LLP - 25
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%
©2016 Baker & McKenzie LLP - 26
Privately-Held Company
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
©2016 Baker & McKenzie LLP - 27
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
Privately-Held Company
Individuals
39.6% Commission
Deduction Exporting
Partnership
Deemed Exporter
C Corp DPAD
Public Shareholders
©2016 Baker & McKenzie LLP - 28
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
©2016 Baker & McKenzie LLP - 29
ABCD
Partnership
DISC
DISC
Commission
on Total Profit
of ABCD
©2016 Baker & McKenzie LLP - 30
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
©2016 Baker & McKenzie LLP - 31
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.
©2016 Baker & McKenzie LLP - 32
Publicly-Traded Corporation
©2016 Baker & McKenzie LLP - 33
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:
Publicly-Traded Corporation
©2016 Baker & McKenzie LLP - 35
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
Publicly-Traded Corporation
©2016 Baker & McKenzie LLP - 36
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
Publicly-Traded Corporation
©2016 Baker & McKenzie LLP - 37
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]
Publicly-Traded Corporation
©2016 Baker & McKenzie LLP - 38
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
Publicly-Traded Corporation
©2016 Baker & McKenzie LLP - 39
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
©2016 Baker & McKenzie LLP - 40
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
©2016 Baker & McKenzie LLP - 41
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.
©2016 Baker & McKenzie LLP - 42
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.
©2016 Baker & McKenzie LLP - 43
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
©2016 Baker & McKenzie LLP - 44
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.
©2016 Baker & McKenzie LLP - 45
Treaty Country Corporation Structure
Treaty Country
C Corp.
DISC Related Supplier
Div. @ Treaty
W/H Rate
(5% or less)
Commission
35% deduction
©2016 Baker & McKenzie LLP - 46
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).
©2016 Baker & McKenzie LLP - 47
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.
©2016 Baker & McKenzie LLP - 48
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.
©2016 Baker & McKenzie LLP - 50
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.
©2016 Baker & McKenzie LLP - 51
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).
©2016 Baker & McKenzie LLP - 52
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.
©2016 Baker & McKenzie LLP - 53
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.
©2016 Baker & McKenzie LLP - 55
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.
©2016 Baker & McKenzie LLP - 56
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.
©2016 Baker & McKenzie LLP - 57
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.
©2016 Baker & McKenzie LLP - 58
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.
©2016 Baker & McKenzie LLP - 59
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.)
©2016 Baker & McKenzie LLP - 61
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).
©2016 Baker & McKenzie LLP - 62
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).
©2016 Baker & McKenzie LLP - 63
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 - 64
©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
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
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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
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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
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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.
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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.
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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
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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.
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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.
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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.
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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.
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CTI Components
Qualified Export Receipts
Directly Allocable Costs
Deductions Allocated and Apportioned in accordance with U.S.
Treasury Regulations (aka 861-8)
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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 ….
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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
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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
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Example 2
Example 2 Total Non-Export Export Trans 1
Export Trans 2 Grouped
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
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
- 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
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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
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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
Gross Profit (MC-CTI) 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
- 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
- OPP Limitation 3.75 3.75 7.50
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
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Example 4
Example 4 Total Non-Export Export Trans 1
Export Trans 2 Grouped
Sales 400 200 100 100 200
COGS 250 100 90 60 150
Gross Profit (MC-CTI) 150 100 10 40 50
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
- OPP Limitation 3.75 3.75 7.50
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
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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
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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.
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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
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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
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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.
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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
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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.
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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.
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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)
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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
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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)
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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%
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Case Study – Transaction File
99 99 99
99
Case Study – Product Tree
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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
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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!
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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
(847) 733-0645
www.forteintax.com