IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters

Transcription

1 Presenting a live 110-minute teleconference with interactive Q&A IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters Leveraging Benefits Arising From the Dividend Tax Solution WEDNESDAY, DECEMBER 4, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: 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 The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 IC-DISC: Mastering Intricacies of the Federal Tax Incentive for Exporters Seminar Dec. 4, 2013 Jerry Jonckheere, Plante Moran Jim Loizeaux, Grant Thornton Jerry Ogle, Ogle International Tax Advisors

6 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

7 Interest Charge Domestic International Sales Companies What they are Their History The Outlook Current Issues Jerry Jonckheere Int l Tax Partner Plante Moran

8 8 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.

9 9 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.

10 10 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

11 11 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. Tax Savings on Commission = $40,000 * 39.6% = $15,840 Tax Cost on Dividend = $40,000 * 23.8% = $9,520 Share holder $40,000 Dividend $40,000 Commission OpCo IC-DISC

12 12 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

13 13 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 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

14 14 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

15 15 History of IC-DISCs 2003 Congress enacted a preferential qualified dividend rate 2008 Congress extends the preferential qualified dividend rate Congress extends the preferential qualified dividend rate Congress extends the preferential qualified dividend rate permanently

16 16 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 nonqualified dividends An industry coalition defeated the technical correction

17 17 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

18 18 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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20 Jim Loizeaux, Grant Thornton QUALIFICATION OF IC-DISCS AND QUALIFIED EXPORTS, PART II

21 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 21

22 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. 22

23 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. 23

24 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 24

25 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. 25

26 IC-DISC Requirements * Not a tax-exempt org., PHC, corp. or insurance Have a single Incorporate in U.S. State or D.C. co. association, class of stock with RIC, a S 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* 95% of its receipts must be qualified export receipts Cannot be a member of a controlled group with a foreign sales corp (FSC) 95% of the adjusted basis of DISC s assets must be qualified export assets at the end of its tax year. 26

27 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 27

28 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 28

29 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) 29

30 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 30

31 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. 31

32 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. 32

33 Deemed Distributions (Cont.) Income items to which deemed distributions apply 33 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) 1/17 th 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

34 34 Vanilla Commission IC-DISC Structure

35 35 IC-DISC Tax Benefits Following Tax Law Changes of 2013

36 36 IC-DISC Tax Deferral

37 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,

38 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 passthrough 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 38

39 39 IC-DISC Producer s Loan: Example

40 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 ): 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 40

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42 Jerry Ogle, Ogle Tax Advisors COMPLIANCE AND REPORTING BY IC-DISCs

43 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. 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 Foreign tax systems - analyze host country deductions, exemptions, and incentives, including foreign tax credits with host country tax advisors. For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr Suite 800 Miami, Florida (T) (F)

44 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 (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.) For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Drive, Suite 800 Miami, Florida (T) (F)

45 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 (e)(1)(ii)]. For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

46 When utilizing the CTI method, overhead costs generally are allocated between export and domestic sales, based on detailed rules [Reg ]. 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 ]. Overall, the CTI method generally produces a larger benefit than the gross receipts method, when exports have a greater-than-8% profit ratio. For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

47 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 % For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

48 DISC Commission Calculation Method 4% CTI Export COGS (50) GP 50 Overhead (25) Net Income 25 Total Commission For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

49 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 15 th 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) For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

50 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. For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

51 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 (e)(3)(i)]. Reasonable estimate requires at least 50% Payment should generally be in cash to avoid noncompliance 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 ] For more information on our services Please contact us at our offices or visit us at our website Corporate Office 6801 Energy Court, Suite 201 Sarasota, Florida (T) (F) Miami Office 5201 Blue Lagoon Dr, Suite 800 Miami, Florida (T) (F)

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53 Interest Charge Domestic International Sales Companies Common Structures Jerry Jonckheere Int l Tax Partner Plante Moran

54 54 Flow-Through Entities 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 S Corp Or P ship IC-DISC

55 55 C Corporations 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. C Corp IC-DISC

56 56 Officer Bonus Plan Officer 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. C Corp, S Corp Or P ship IC-DISC

57 57 Foreign Owner This structure gets tax favored dividends to a foreign parent. Foreign Corp 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. C Corp IC-DISC

58 58 Roth IRA This structure gets income into a Roth IRA that *may* avoid future taxation. Roth IRA C Corp, S Corp Or P ship IC-DISC

59 59 Generation Transfer Children This structure gets income to an owner s children or grandchildren. C Corp, S Corp Or P ship IC-DISC

60 Interest Charge Domestic International Sales Companies IRS Audit Issues How to Pass an Audit with Flying Colors Jerry Jonckheere Int l Tax Partner Plante Moran

61 61 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

62 62 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

63 63 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

64 64 Other Issues Coordination with DPAD computations Both DPAD and DISC Commissions should rely on the methodology found in Reg This regulation requires that specifically identified costs of sales be deducted from classes of sales SG&A must be allocated using a reasonable methodology

65 65 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

66 66 Other Words of Wisdom Pigs get fat Hogs get slaughtered