U.S. Exporters - Don’t Miss Out On A Substantial Tax Break
Kelley Drye Client Advisory
In today’s global economy, it is practically unheard of for a large, multinational corporation to not have an extensive export compliance program, along with a dedicated group to administer it. Small to midsize companies, however, frequently lag behind their larger competitors in systematizing their compliance efforts. They have no standards dictated by management, no policies and procedures, no auditing mechanism. Export compliance in these organizations often comes down to one or two people playing catch-as-catch-can in between fulfilling other responsibilities. This can lead to easily avoidable errors, which can cost real money should one of those errors result in an export control violation and consequent monetary penalties.
A similar dynamic is at play in another often-overlooked aspect of exporting: potential tax benefits to be had by organizing an Interest Charge Domestic International Sales Corporation, or IC-DISC. In the main, sophisticated exporters with lots of international business experience already take advantage of the vehicle to save significantly on their tax bills. By contrast, those with less experience and fewer resources to expend on finding and capitalizing on tax breaks commonly miss out on the opportunity. This Client Advisory describes the IC-DISC structure and outlines how you can avoid being in the latter category.
BackgroundFirst and foremost, the IC-DISC is not a loophole – it’s a tax regime that Congress introduced specifically to stimulate U.S. exports. Under the regime, a U.S. exporter – which can be a C corporation, an individual, or a tax passthrough entity owned by individuals or C corporations – establishes a C corporation in the U.S. That new C corporation is the exporter’s IC-DISC. When the exporter exports something, it pays a commission to its IC-DISC. Generally, the IC-DISC is not subject to federal income tax on this commission income. The exporter, in turn, is allowed to deduct the commission it pays to the IC-DISC from its federal income taxes, provided that the commission amount does not exceed the greater of set ceiling amounts. Meanwhile, the IC-DISC can use the cash proceeds to pay a dividend to its shareholders, who pay tax on the dividend distribution at preferential capital gain rates.
The difference between the exporter’s federal income tax rate and the shareholders’ preferential capital gain rates can be significant, leading to a lucrative tax arbitrage opportunity. Alternatively, in lieu of distributing the cash proceeds as a dividend to its shareholders, the IC-DISC can also loan its cash proceeds to the exporter at a low interest rate, allowing comparable tax deferral instead. However an exporter proceeds, the savings can be substantial – more than a 50% tax reduction on 50% of export income, in some cases.
Requirements of an IC-DISCOf course, with such large losses to its revenue at stake, the U.S. government does not make establishing an IC-DISC as easy as organizing a new C corporation and having it elect to be one (though both of those are requirements). A proper IC-DISC must also have only one class of stock; must have capital of at least $2,500; and must meet strict criteria regarding its “qualified export receipts” and “qualified export assets.” Other structural characteristics – such as being one of several types of financial institutions, a personal holding company, or a tax-exempt corporation – can also render an entity ineligible for IC-DISC treatment.
Establishing a valid IC-DISC may sound complicated, but just like an effective export compliance program, once the proper systems are in place, the effort required to maintain it are minimal, and far outweighed by the benefits. In fact, an export compliance program and an IC-DISC can be viewed as complementary halves of a larger cost-saving program. Both rely on the same data – information related to a company’s export transactions – to serve their purposes. The difference is that while the compliance program’s value is in prevention, and thus harder to quantify, the return on an investment in an IC-DISC is apparent year after year – and in some cases might be able to cover the costs for both of them.