Many small and middle market US exporters could realize significant US tax benefits by organizing an Interest Charge Domestic International Sales Corporation (an “IC-DISC”). This Client Advisory describes the tax benefits available under the IC-DISC tax regime and the requirements that have to be satisfied to qualify for such benefits.
In 1971, the Domestic International Sales Corporation (“DISC”) tax regime was introduced to stimulate US exports. US trading partners argued that the DISC tax regime constituted an illegal export subsidy, in violation of the General Agreement on Tariffs and Trade (“GATT”). In 1984, the DISC tax regime was changed and became the IC-DISC tax regime.
In 1984, Congress simultaneously created the Foreign Sales Corporation (“FSC”) tax regime, which was also designed to encourage US exports. The World Trade Organization (“WTO”) subsequently ruled that the FSC tax regime constituted an illegal export subsidy.
In 2000, Congress replaced the FSC tax regime with an extraterritorial income (ETI”) exclusion, also designed to stimulate US exports. Following the WTO’s ruling that the ETI tax regime constituted an illegal export subsidy, Congress abolished the ETI tax regime in 2004.
Thus, while the DISC, FSC and ETI export incentive tax regimes have all been repealed, the IC-DISC tax regime, which has not been attacked by US trading partners, remains the most significant export tax incentive in the Internal Revenue Code of 1986, as amended (the “Code”).
General Description of IC-DISC Benefits
In the typical case, a US exporter, which could be a C corporation, an individual or a tax passthrough entity owned by individuals or C corporations, would pay a commission to its IC-DISC, a US C corporation, in connection with US export activities.
Generally, the IC-DISC would not be subject to federal income tax with respect to income it derives in connection with US export transactions.
The US exporter would be allowed to deduct the commission it pays to the IC-DISC provided that the amount of the commission does not exceed the greater of (i) 50% of the overall taxable income attributable to the export transaction; or (ii) 4 % of the export receipts, plus 10% of certain expenses incurred by the IC-DISC.
The commission would be deductible even if it exceeds the fair market value of services rendered by the IC-DISC. (In most cases, the IC-DISC would not engage in any meaningful economic activities and it would not have employees.)
The deduction could thus give rise to a federal income tax benefit at a 35% rate, assuming the related US exporter is a C corporation, or at a 39.6% rate, assuming the related US exporter is an individual or a tax passthrough entity owned by individuals.
The IC-DISC would often use the cash proceeds to pay a dividend to its shareholders. If the IC-DISC is owned by individual shareholders, the individual shareholders would pay tax on the dividend distribution at preferential capital gain rates (20%, in the case of high-income taxpayers).
The IC-DISC structure thus creates a tax arbitrage opportunity, because the commission payment from the related US exporter to the IC-DISC gives rise to a federal tax saving at a 39.6% or a 35% rate, while the dividend distribution from the IC-DISC to its individual shareholders gives rise to a federal tax at a 20% rate.
In lieu of distributing the cash proceeds as a dividend to its shareholders, the IC-DISC could loan the cash proceeds to the related US exporter at a low interest rate. This structure would thus give rise to a US tax deferral opportunity.
: When originally created in 1984, the IC-DISC tax regime was intended solely to provide a US tax deferral opportunity to US exporters. In 2003, Congress changed the tax treatment of dividend income, by providing that “qualified dividend” income realized by individuals could be taxed at preferential capital gain rates, rather than ordinary income rates. By changing the tax treatment of dividend income in 2003, Congress unintentionally created the IC-DISC tax arbitrage opportunity, described above.
Requirements of an IC-DISC
To qualify as an IC-DISC, the entity must be organized as a C corporation in the US under the laws of any state or the District of Columbia.
Furthermore, it must satisfy the following requirements:
- At least 95% of its gross receipts during the year are “qualified export receipts,” defined below.
- At the end of the taxable year, the adjusted basis of its “qualified export assets,” defined below, is at least 95% of the sum of the adjusted basis of all of its assets.
- It must have only one class of stock and it must have capital of at least $2,500;
- It must have made an election to be treated as an IC-DISC; and
- It must not be an otherwise “ineligible” corporation, which would include certain financial institutions, a personal holding company or a tax-exempt corporation.
“Qualified Export Receipts”
“Qualified export receipts” include:
- Gross receipts from the sale or other disposition of “export property,” defined below;
- Gross receipts from the lease of “export property” that the lessee uses outside the US;
- Gross receipts from engineering or architectural services for construction projects outside the US; and
- Gross receipts from supporting services related to any qualified sale of lease or “export property.”
“Qualified Export Assets”
“Qualified export assets” include:
- “Export property”;
- Accounts receivable arising in connection with transactions giving rise to “qualified export receipts”;
- Obligations related to a so-called “producer’s loan” (i.e., a loan from the IC-DISC to its related US exporter that satisfies the requirements of Sections 993(d)(2) and (3) of the Code); and
- Temporary investments in an amount reasonable to meet the IC-DISC’s working capital needs.
“Export property” must be:
- Manufactured or extracted in the US by a person other than an IC-DISC;
- Held mainly for sale or lease for direct use, consumption or disposition outside the US; and
- Property not more than 50% of the fair market value of which is attributable to articles imported in the US.
Interest on US Tax-Deferred Tax
Each US shareholder of an IC-DISC is obligated to pay interest to the IRS with respect to any deferred US tax, in an amount equal to the product of (i) the shareholder’s deferred tax liability and (ii) the base-period Treasury bill rate (“Base-Period Treasury Bill Rate”).
The Base-Period Treasury Bill Rate is defined as the annual rate of interest equivalent to the average one-year constant maturity Treasury yields.
(Because the shareholder is obligated to pay an interest charge on the value of the deferred tax, the IC-DISC tax regime, unlike the DISC FSC and ETI tax regimes, has not been considered to be an illegal export subsidy.)
Taxation of Shareholder of IC-DISC
Shareholders of an IC-DISC are taxable with respect to the income of an IC-DISC when the income is actually (or deemed) distributed. Under a special rule, if an IC-DISC has made a “producer’s loan,” to its related US exporter, then the shareholder is deemed to receive annually interest derived by the IC-DISC with respect to the “producer’s loan.”
A shareholder is also deemed to receive annually taxable income of the IC-DISC attributable to “qualified export receipts” for the taxable year in excess of $10 million.
Because of this special rule, the IC-DISC structure is beneficial only to small and middle market US exporters, and not large US exporters.
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See Code Section 994(a).
The dividend distribution could also be subject to the Code Section 1411 “Net Investment Income” tax.
The Tax Technical Corrections Act of 2007 would have amended the Code to provide that dividend distributions from an IC-DISC would not qualify for preferential capital gain rates While this legislative amendment was not made in 2007, it is possible that similar legislation would be enacted at a future date to eliminate the tax arbitrage opportunity, described above.
See Code Section 992(a)(1).
See Code Section 992(a)(1)(A).
See Code Section 992(a)(1)(B).
See Code Section 993(a)(1).
See Code Section 993(b).
See Code Section 993(c).
See Code Section 995(f).
See Code Section 995(f)(4).
See Code Section 995(b)(1)(A).
See Code Section 995(b)(1)(E).