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

Transcription

1 IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters TUESDAY, OCTOBER 21, 2014, 1:00-2:50 pm Eastern IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection and phone line (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Respond to verification codes presented throughout the seminar. If you have not printed out the Official Record of Attendance, please print it now. (see Handouts tab in Conference Materials box on left-hand side of your computer screen). To earn Continuing Education credits, you must write down the verification codes in the corresponding spaces found on the Official Record of Attendance form. Complete and submit the Official Record of Attendance for Continuing Education Credits, which is available on the program page along with the presentation materials. Instructions on how to return it are included on the form. To earn full credit, you must remain on the line for the entire program. WHOM TO CONTACT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Program: - On the web, use the chat box at the bottom left of the screen - On the phone, press *0 ( star zero) If you get disconnected during the program, you can simply call or log in using your original instructions and PIN.

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4 IC-DISC: Compliance Challenges in the Federal Tax Break for Exporters Oct. 21, 2014 Jim Loizeaux CliftonLarsonAllen Robert J. Misey, Jr. Reinhart Boerner Van Deuren

5 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. 5

6 Rob Misey, Reinhart Boerner Van Deuren INTEREST CHARGE DOMESTIC INTERNATIONAL SALES COMPANIES, PART I

7 About Rob Misey Robert Misey is Chair of the International Department for Reinhart Boerner Van Deuren. He previously worked for the IRS Chief Counsel (International) on their Athletes and Entertainers Industry Program. A graduate of the law schools at Vanderbilt University and Georgetown University. He is also the author of the books A Practical Guide to U.S. Taxation of International Transactions and Federal Taxation: Practice and Procedure. Robert's practice concentrates on the taxation of cross-border athletes and entertainers. Rob can be reached at either or or rmisey@reinhartlaw.com All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 non-qualified dividends An industry coalition defeated the technical correction All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

19 Rob Misey, Reinhart Boerner Van Deuren QUALIFICATION OF IC-DISCS AND QUALIFIED EXPORTS, PART II

20 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 recent 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

21 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

22 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

23 Choice of methods: IC-DISC Commission 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

24 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

25 IC-DISC Requirements Incorporate in U.S. State or D.C. Have same tax year as primary shareholder Makes election on IRS Form 4876-A* 95% of its receipts must be qualified export receipts Have a single class of stock with a par or stated value of $2,500 Maintain its own books and records 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

26 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

27 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

28 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) All Rights Reserved Reinhart Boerner Van Deuren s.c.

29 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, All Rights Reserved Reinhart Boerner Van Deuren s.c.

30 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

31 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

32 Deemed Distributions (Cont.) Income items to which deemed distributions apply 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

33 Vanilla Commission IC-DISC Structure US S Corp commission IC - DISC U.S. Foreign Exports All Rights Reserved Reinhart Boerner Van Deuren s.c.

34 IC-DISC Tax Benefits Following Tax Law Changes of All Rights Reserved Reinhart Boerner Van Deuren s.c.

35 IC-DISC Tax Deferral US USAco commission IC - DISC U.S. Foreign Exports All Rights Reserved Reinhart Boerner Van Deuren s.c.

36 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, All Rights Reserved Reinhart Boerner Van Deuren s.c.

37 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 pass-through 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] 2013 base period T-bill rate.14% No interest charge if all IC-DISC income is distributed via dividends by the end of the IC-DISC s taxable year All Rights Reserved Reinhart Boerner Van Deuren s.c.

38 IC-DISC Producer s Loan US USAco commission loan IC-DISC U.S. Foreign Exports All Rights Reserved Reinhart Boerner Van Deuren s.c.

39 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 All Rights Reserved Reinhart Boerner Van Deuren s.c.

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41 2014 CliftonLarsonAllen LLP Compliance and Reporting By IC-DISCs Part III Presented by: Jim Loizeaux CLAconnect.com 41

42 2014 CliftonLarsonAllen LLP James D. (Jim) Loizeaux Technical Director International Services, CliftonLarsonAllen LLP Jim is one of the national practice leaders in the International Services group for CliftonLarsonAllen. He has over 25 years of international tax experience focusing on cross-border transactions, reorganizations, repatriation of earnings and exports. 42

43 2014 CliftonLarsonAllen LLP Pricing Rules An IC-DISC can act as a buy-sell entity or a commissionbased entity. 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) Section

44 2014 CliftonLarsonAllen LLP Pricing Rules 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.) 44

45 2014 CliftonLarsonAllen LLP Pricing Rules The pricing method chosen may be based export on transactions using one of the following approaches: Aggregate Transaction by transaction Product groupings 45

46 2014 CliftonLarsonAllen LLP Pricing Rules When utilizing the CTI method, overhead costs generally are allocated and apportioned between export and domestic sales, based on detailed rules [Reg ]. 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 greaterthan-8% profit ratio. 46

47 2014 CliftonLarsonAllen LLP Sample Commission Calculation Total Domestic Exports Domestic Sales Export Sales Domestic COGS Export COGS Related Supplier Income Statement Before IC DISC Commission GP Overhead Taxable Income Profit Margin 25% 47

48 2014 CliftonLarsonAllen LLP Sample Commission Calculation continued DISC Commission Calculation Total Domestic Method 4% CTI Export COGS (50) GP (50) Overhead (25) Net Income 25 Total Commission

49 2014 CliftonLarsonAllen LLP No Loss Rule (Reg (e)(1)) No loss rule is a limitation on the DISC s income if the computation of the commission under either the gross receipts method or the CTI method results in a loss to the related supplier There is an exception to the no loss rule that allows the computation of a commission under the 4% gross receipts method where the overall profit percentage ( OPP ) is positive limited to 4% 49

50 2014 CliftonLarsonAllen LLP No Loss Rule continued DISC Commission Calculation (e)(1)(i) Total Domestic Method 4% CTI Export COGS (75) GP 25 Overhead (40) Net Income 0 Total Commission

51 2014 CliftonLarsonAllen LLP No Loss Rule Application of Special Rule (Reg (e)(1)(ii)) OPP = Taxable income of product or product line for domestic and export sales Total gross receipts of sales Taxable income = 100 Gross receipts = 400 OPP = 25% Export receipt = 100 4% method = 4 Special rule = 25 ($100 x 25%) Commission = 4 (lesser of 4% method or special rule) 51

52 2014 CliftonLarsonAllen LLP Summary of Tax Filings 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) 52

53 2014 CliftonLarsonAllen LLP Summary of Tax Filings 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, not qualified dividend rates. (Section 995(f)(2)(A)(i)) Form 8404 anticipates that estimates are likely needed, and amended procedures are outlined in form instructions. 53

54 2014 CliftonLarsonAllen LLP Common Compliance Pitfalls 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. 54

55 2014 CliftonLarsonAllen LLP Common Compliance Pitfalls Failure to clear DISC receivables by year end resulting in DISC disqualification under the 95% asset test Failure to property capitalize the DISC Failure to comply with corporate formalities Failure to maintain separate books and records 55

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57 2014 CliftonLarsonAllen LLP Interest Charge Domestic International Sales Companies: Common Structures Part IV Presented by: Jim Loizeaux CLAconnect.com 57

58 2014 CliftonLarsonAllen LLP Flow Through Entities This is the most common and easiest structure. Cash travels between the S Corporation and IC-DISC The shareholder receives Reduced ordinary income Increased qualified dividends As reported on a Schedule K-1 S Corp or Partnership IC-DISC 58

59 2014 CliftonLarsonAllen LLP 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 59

60 2014 CliftonLarsonAllen LLP Officer Bonus Plan This structure gets additional income to a business s officers. The C Corporation receives an ordinary deduction for commissions paid. The officers receives a Schedule K from the IC-DISC reporting the qualified dividends. Structuring consideration: C Corp Officer IC-DISC - Commissions paid cannot be direct replacement for incentive compensation the officers would otherwise be eligible to receive under other corporate bonus or incentive plans 60

61 2014 CliftonLarsonAllen LLP Foreign Owner This structure gets tax favored dividends to a foreign parent. 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. Structuring Considerations: C Corp Foreign Corp - Benefit based on treaty override of Section 996(g) - Foreign shareholder must file a Form 1120F with a Form DISC also reports dividends on a Form 1042-S - Foreign country taxation of the dividend must be addressed IC-DISC 61

62 2014 CliftonLarsonAllen LLP Generation Transfer This structure gets income to an owner s children or grandchildren Rev. Rul C Corp, S Corp or Partnership Children IC-DISC 62

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64 2014 CliftonLarsonAllen LLP Interest Charge Domestic International Sales Companies: IRS Audit Issues Part V Presented by: Jim Loizeaux, CliftonLarsonAllen LLP Robert Misey, Reinhart Boemer Van Deuren S.C. CLAconnect.com 64

65 2014 CliftonLarsonAllen LLP IRS Audit Issues Until recently, the IRS has not seemed to focus on indepth audits of IC-DISCs Many audits focused on formation or qualification issues Recently, the IRS *is* starting to audit more complex IC-DISCs 65

66 2014 CliftonLarsonAllen LLP Formation and Qualification Issues A standing IRS Information Document Request asks for documentation related to Formation and Qualification issues Support for valid IC-DISC election 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 66

67 2014 CliftonLarsonAllen LLP Other Issues Commission Expense 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 67

68 2014 CliftonLarsonAllen LLP Other Issues Coordination with DPAD Computations Both DPAD and DISC Commissions should rely on the methodology found in Reg (see Reg (d)(i)) This regulation requires that specifically identified costs of sales be deducted from classes of sales SG&A must be allocated using a reasonable methodology 68

69 2014 CliftonLarsonAllen LLP 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 the non-standard structures 69

70 2014 CliftonLarsonAllen LLP Other Words of Wisdom Pigs get fat Hogs get slaughtered 70