Copyright(c) 2012 Dr. Chase C. Rhee CHAPTER XXXVII U.S. Tax Benefits on Exports: IC-DISC (Interest Charge-Domestic International Sales Corporation) Purpose of the IC-DISC Background of the IC-DISC Definition of the IC-DISC Operations of the IC-DISC Structure of the Parent Exporter and the IC-DISC Qualification Conditions of the IC-DISC U.S. Tax Benefits of the IC-DISC Copyright(c) 2012 Dr. Chase C. Rhee

Copyright(c) 2012 Dr. Chase C. Rhee Purpose of the IC-DISC The purpose of the IC-DISC is to provide a legal export incentive to exporters of U.S. products or services by the U.S. Government IC-DISC: a U.S. domestic corporation formed by a parent company (usually manfacturer) Provides tax benefits, either income tax deferral or income tax savings Copyright(c) 2012 Dr. Chase C. Rhee

Background of the IC-DISC In 1971, U.S. enacted DISC tax provisions, which allowed exporters to establish domestic subsidiary which would receive the tax deferral up to 50% of export earnings, reduced later 32.3% in 1979 & 15% in 1982. From 1972, the foreign countries, specially European Community (later European Union), waged a strong objection to the DISC as an illegal U.S. export subsidy In 1984, GATT ruled the DISC as an illegal export subsidy. Tax Reform Act of 1984 changed the DISC to the IC- DISC to provide an income tax deferral opportunity without being accused of an illegal export subsidy by charging an interest on deferred tax liability Copyright(c) 2012 Dr. Chase C. Rhee

Background of the IC-DISC In 1984, U.S. also created the Foreign Sales Corporation (FSC) to encourage U.S. exports allowing 15% income tax exemption In 2000, the FSC was subsequently ruled as an illegal export subsidy by the WTO (World Trade Organization) In 2000, U.S. replaced the FSC with an Extraterritorial Income (ETI) Exclusion Act which excluded extraterritorial income from gross income for U.S. tax purposes. The ETI Exclusion was also ruled later in 2002 as an illegal export subsidy by the WTO. Copyright(c) 2012 Dr. Chase C. Rhee

Background of the IC-DISC In 2004, the American Jobs Creation Act repealed the ETI Exclusion tax regime. The IC-DISC is the only export incentive program that has not been considered to be an illegal export subsidy, because the shareholder pays an interest charge on the deferred tax It has not been attacked by U.S. trading partners and remains the most significant export incentive in the Internal Revenue Code Copyright(c) 2012 Dr. Chase C. Rhee

Background of the IC-DISC In 2003, the Jobs and Growth Tax Relief Reconciliation Act created the “qualified dividend tax rates,” to stimulate investments. the same rates as capital gains rates that are much lower than ordinary dividend rates IC-DISC’s dividend is also inadvertently treated as a qualified dividend. Qualified Dividends: Must be issued by a U.S corporation or a foreign corporation whose stocks are traded on a U.S. exchange Must be meet the holding period of more than 60 days Copyright(c) 2012 Dr. Chase C. Rhee

Definition of the IC-DISC An IC-DISC is a domestic corporation that has filed the IRS Form 4876-A, Election To Be Treated as an Interest Charge DISC. A U.S. exporter’s subsidiary or sibling entity set up for income tax deferral or income tax savings on export earnings. An IC-DISC is not taxed on its income. It has two options in the disposal of its income. The IC-DISC can defer the income tax payment without distribution to its shareholders or It can distribute its income to its shareholders as dividends on which income tax is paid by its shareholders. Copyright(c) 2012 Dr. Chase C. Rhee

Definition of the IC-DISC If the IC-DISC’s income is not distributed but retained, the income tax is deferred and an interest charge (IC) is imposed on shareholders for their share of deferred tax liability at the Treasury-Bill rate with annual maturity. Interest charge is recently below 1 percent (0.76% Oct. 2016). The commission payment reduces the parent company’s ordinary income leading to a less income tax. Tax deferral can be indefinite: Indefinite tax deferral Tax deferral is only available to income earned from export sales not exceeding $10 million. Copyright(c) 2012 Dr. Chase C. Rhee

Definition of the IC-DISC If the IC-DISC’s income is distributed to its shareholders, Parent company’s payments to its IC-DISC like sales commission reduces its ordinary income at higher tax rates (mostly 35-39.6%) Individual shareholders of the IC-DISC are taxed on their share of dividend income when its commission income is actually (or deemed) distributed to them at lower tax rates (mostly15-20% as qualified dividend income (the same as capital gains tax rates). C corporation shareholder of the IC-DISC does not receive the same tax benefit. Their dividends are not treated as qualified dividends. Individuals or pass-through entities such as S corporation, LLC or Partnership should own the IC-DISC to get tax benefits. Copyright(c) 2012 Dr. Chase C. Rhee

Definition of the IC-DISC If 50% of combined export income of parent company and its IC-DISC is paid to the IC-DISC as commission, 10% tax saving on combined export income by multiplying 50% by 20% (difference between two tax rates). Net export income from qualified export receipts exceeding $10 million a year is deemed distributed. No tax deferral allowed. Mostly small and medium-sized U.S. exporters except really large U.S. exporters can get the income tax benefits. Copyright(c) 2012 Dr. Chase C. Rhee

Operations of the IC-DISC IC-DISC can buy from parent company (e.g. manufacturer) and export as a buy/sell IC-DISC. IC-DISC can receive a commission from parent company (parent exporter) as a commission IC-DISC In both cases, Intercompany Transfer Pricing Rules under Section 482 of the Internal Revenue Code are applied in determining the transfer price and commission. . Copyright(c) 2012 Dr. Chase C. Rhee

Operations of the IC-DISC IC-DISC’s taxable income may not exceed the greatest of (1) 50% of IC-DISC‘s & parent company’s combined taxable income from qualified export receipts plus 10% of the IC-DISC export promotion expenses under 50-50 combined export income method. (2) 4 % of the qualified export receipts of IC-DISC plus 10% of IC-DISC export promotion expenses under 4 % gross export receipts method. (3) Taxable income of IC-DISC based on actual transfer price or commission subject to arm’s length standard under Section 482 method. Copyright(c) 2012 Dr. Chase C. Rhee

Operations of the IC-DISC In calculating taxable export income. Commission IC-DISC can use either of 50-50 combined export income method or 4% gross export receipts method Buy/Sell IC-DISC uses Section 482 method Commission can be paid the IC-DISC within 60 days after the close of the tax year Copyright(c) 2012 Dr. Chase C. Rhee

Structure of the Parent Company and the IC-DISC When an IC-DISC is owned by a parent company which is a sole proprietorship or a income pass-through entity like S-Corporation, LLC, and Partnership) as a subsidiary. IC-DISC can distribute its commission income as a qualified dividend taxable at 15-20%, thus converting 35-39.60% ordinary income to 15-20% qualified dividend income for shareholders. Copyright(c) 2012 Dr. Chase C. Rhee

Structure of the Parent Company and the IC-DISC When the IC-DISC is owned by a C corporation as a subsidiary. Because the qualified dividend rate is available only to individuals, dividend paid to the parent C corporation by the IC-DISC is taxed at a higher ordinary dividend tax rate. No tax savings To effectively derive the tax benefit, the shareholders of a parent C corporation must also own the IC-DISC as a sibling (brother-sister) entity. The same ownership works best when the C corporation is closely held entity with a few shareholders Mostly small and medium exporters of a income pass-through entity get tax benefits Copyright(c) 2012 Dr. Chase C. Rhee

Structure of the Parent Company and the IC-DISC However, the ownership of the IC-DISC is not required to mirror the ownership of the parent company. Accordingly, shareholders of a parent C corporation and the IC-DISC can be different. Parents own a parent C corporation and children own an IC-DISC, of which dividends are paid to children. Copyright(c) 2012 Dr. Chase C. Rhee

Qualification Conditions of the IC-DISC At least 95 percent of its gross receipts during the tax year are qualified as export receipts At the end of the tax year, the adjusted basis of its qualified export assets is at least 95 percent of all its adjusted assets. It has one class of stock, and its outstanding stock has a par value of at least $2,500 on each day of the tax year. It keeps separate books and records. Copyright(c) 2012 Dr. Chase C. Rhee

Qualification Conditions of the IC-DISC Its tax year must conform to the tax year of the shareholder (or shareholder group) who has the highest voting power. Its election to be treated as an IC-DISC is in effect Copyright(c) 2012 Dr. Chase C. Rhee

U. S. Tax Benefits of the IC-DISC U.S. Income Tax Deferral Deferral of U. S. income taxes on export earnings indefinitely, if export receipts do not exceed $10 million. In such a case, export income is deemed distributed and no deferral allowed. Interest charge to shareholders on deferred income taxes at the U.S. Treasury Bill rate with annual maturities, which is much lower than commercial rates. 0.76% in October 2016 IC-DISC is a tax-exempt corporation. Its shareholders pay income tax. No double taxation. Copyright(c) 2012 Dr. Chase C. Rhee

U. S. Tax Benefits of the IC-DISC U.S. Income Tax Savings The parent company deducts payments to its IC-DISC from its ordinary income at the tax rate of 35%-39.6% in most cases. When dividends are distributed to individual shareholders of IC-DISC, they pay income tax on dividends at the tax rate of 15%-20% in most cases. As a result, IC-DISC creates a 20% income tax savings its allocated export income (50% of combined export income) by converting 35%-39.6% income tax into 15%-20% income tax in most cases. Copyright(c) 2012 Dr. Chase C. Rhee