Tax Incentive for Exporters Overcoming Compliance Challenges to Maximize Tax Benefits

Transcription

1 Presenting a live 110 minute webinar with interactive Q&A IC DISC: Mastering Intricacies of the Federal Tax Incentive for Exporters Overcoming Compliance Challenges to Maximize Tax Benefits WEDNESDAY, DECEMBER 15, pm Eastern 12pm Central 11am Mountain 10am Pacific Td Today s faculty features: Tom Miller, Partner, BKD LLP, Indianapolis Jerry Ogle, President, Ogle International Tax Advisors, Bradenton, Fla. Neal Block, Senior Counsel, Baker & McKenzie, Chicago J Mark Loyd, Member, Greenebaum Doll & McDonald, Louisville, Ky. 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.

2 FINANCIER WORLDWIDE corporatefinanceintelligence W O R L D WAT C H AMERICAS TAX Using DISCs to reduce US tax on US exporting companies and their foreign shareholders FW M A G A Z I N E R E P R I N T E D F R O M A p r i l I s s u e

3 WORLDWATCH UNITED STATES Using DISCs to reduce US tax on US exporting companies and their foreign shareholders BY NEAL J. BLOCK Since 1971, the US Tax Code (Sections ) has reduced US tax on US exports through a US company called a Domestic International Sales Corporation (DISC). The DISC reduces US taxation on exports of US property manufactured, produced, grown or extracted in the United States for direct use outside the United States. Certain engineering and architectural services for construction projects located outside the United States, along with certain related and subsidiary services, also qualify. The income which a DISC earns reduces the taxable income of a related US exporting company. The DISCs income is exempt from tax until it is distributed or deemed distributed (under the DISC provisions, DISC income attributable to gross receipts over $10m is deemed distributed. However as discussed below, the amounts deemed and actually distributed possibly can be taxed at no greater than 15 percent). A DISC can be an arm s-length company which earns income in accordance with normal arms-length principles. However it can also receive so-called safe-harbour income from qualified transactions with a related supplier. The DISC safe-harbour income DISC dividends to foreign shareholders considered to be individuals or individual partners of a partnership, should be taxed at a maximum of 15 percent on the DISC dividends. REPRINT FW April generally is the greater of 4 percent of gross receipts or 50 percent of combined taxable income from qualifying transactions (generally the DISC safe-harbour income cannot create a loss in a related supplier. However, there are exceptions where the export transactions are less profitable than domestic transactions). The DISC originally was intended to be a deferral of tax, i.e., the DISC income deferred from tax eventually would be subjected to dividend income treatment at ordinary rates to its shareholders. Commencing in 2004, however, amendments to the Code taxed dividends from qualified corporations, including DISCs, at capital gains rates at a maximum of 15 percent to non-corporate shareholders (see Section 1(h)(11)(B)). This allows taxation of an unlimited amount of export profits to be permanently reduced from an effective rate of approximately 35 percent to an effective rate as low as 15 percent. Generally shareholders of DISCs who may benefit from the 15 percent capital gains rate are either trusts or individuals which are entitled to the 15 percent rate on capital gains. Socalled C corporation shareholders generally are not eligible for the 15 percent rate. Rather for those corporations the capital gains rate is the same as on ordinary income. As discussed below, however, some foreign corporations may be entitled to claim reduced US tax rates on DISC dividends. Taxation of DISC foreign shareholders under Section 996(g) When the DISC provisions were passed, Congress anticipated that certain non-resident aliens of the United States would be acquiring DISC stock. Because Congress intended for DISC shareholders to be taxable at ordinary dividend rates on DISC distributions, it included section 996(g) in the Code. That section provides that dividends received by non-resident alien individuals, foreign corporations, trusts or estates are to be treated as income effectively connected with a US trade or business conducted through a permanent establishment in the United States. Rather than applying the treaty rate on dividends related to portfolio investments, DISC dividend distributions are treated as if the recipient received the dividend from engaging in a US trade or business. When the DISC provisions were first passed and amended in 1984, the 996(g) provisions generally were considered to prevail over any contrary treaty provisions. Even though there was no treaty override in the Code provisions, the later in time of a Code provision or a treaty provision will prevail where the Code and the treaty have inconsistent provisions (see Whitney v. Robertson, 124 U.S. 190, 194 (1888)). Thus, for a number of years, DISC dividends were treated as effectively connected income because most tax treaties did not post-date the 1984 amendments to section 996(g). Foreign shareholders, therefore, commonly were subject to taxation on DISC dividends at normal tax rates of percent or even higher. Impact of capital gains treatment to foreign shareholders The 2004 Code amendments to make dividends from a qualified corporation to its shareholders subject to capital gains treatment should also benefit DISC dividends by being taxed at the same 15 percent rate. Thus foreign entities which are individuals or entities treated as partnerships of individuals for federal income tax purposes appear to be eligible for 15 percent maximum capital gains rate. Since the Code provisions were designed to retain the treatment of DISC dividends in the hands of foreign shareholders, the same as fully taxable dividend income in the hands of US shareholders, applying the 15 percent rate is consistent with the intent of the DISC provisions. Consequently, DISC dividends to foreign shareholders considered to be individuals or individual partners of a partnership, should be taxed at a maximum of 15 percent on the DISC dividends. The same would appear to be applicable to foreign trusts which are not for US income tax purposes treated as business associations taxed as corporations. 8

4 This article first appeared in Financier Worldwide s April 2010 Issue Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher. For further information on Financier Worldwide and its publications, please contact James Lowe on +44 (0) or by james.lowe@financierworldwide.com WORLDwatch Check-the-box election to deem foreign corporations to be US partnerships As discussed above foreign entities, treated as corporations for US income tax purposes do not appear eligible for the 15 percent capital gains rate since US corporations are taxed on capital gains at the 35 percent ordinary income rate. One way for a foreign corporation to take advantage of the 15 percent rate would be for it to elect to convert itself for US income tax purposes from a corporation to a partnership with individual shareholders. Under the socalled check-the-box elections under Treas. Reg , a foreign business entity which is not a so-called default corporation (see Treas. Reg (b)(8)) is eligible to elect partnership treatment. If it elects to be treated as a partnership, its partners who are individuals would be deemed to receive DISC dividends at the 15 percent capital gains rate. Before an eligible foreign entity does a checkthe-box election, however, it should determine whether or not the change in its US status from a corporation to a partnership or in some cases a disregarded entity would have other federal income tax consequences. If, however, there are no further adverse tax consequences, the check-the-box election may be a convenient way for a foreign corporation to achieve 15 percent taxation on DISC dividends. Another alternative would be for the individual shareholders of the foreign corporation who control the corporation to form a limited liability company (LLC) treated as a partnership for US income tax purposes. The LLC would then hold the stock of the DISC. In that manner the individual shareholders would have limited liability and still be able to treat the DISC dividends as dividend income subject to the 15 percent rate. Tax treaty provisions to reduce dividend taxation may be applicable Despite the language of section 996(g) there are a number of treaties which have come into effect subsequent to the last amendment to section 996(g) of the Code. Those treaties in many cases are inconsistent with the deemed permanent establishment which is found in section 996(g). Under those treaties, there can be no permanent establishment in the absence of an actual physical presence in the United States. Therefore, the language which deems a treaty country person to have a permanent establishment in the United States may be inconsistent with and thus overruled by the treaty. There is nothing in the Code or the legislative history to the Code which specifically states that the provisions of 996(g) are intended to override existing federal income tax treaties that are later in time to the 996(g) provisions. Consequently, if a treaty s language prevents a permanent establishment, the treaty provisions regarding normal dividends paid in the absence of a permanent establishment should result. To determine whether an existing treaty does override the provisions of section 996(g) of the Code requires an analysis of the specific treaty provisions. Perhaps more important is the treatment of DISC dividends under the laws of the DISC s foreign shareholders. If DISC dividends or deemed distributions to a foreign shareholder are subject to foreign tax at a high rate, the benefits of the lower US tax rate may be lost. If, however, foreign taxation of DISC dividends is relatively low, relying on the treaty could save substantial taxes in the context of having DISC commissions reduce taxable income of the US exporting company by 50 to 100 percent, while being distributed to the treaty company shareholder at an effective rate of 5 or 10 percent or less. Neal J. Block Partner Chicago, Illinois T: + 1 (312) E: Neal.J.Block@bakernet.com Neal J. Block has represented US clients on a broad range of domestic and international tax issues for more than 40 years. He is listed among Illinois Superlawyers for 2008 and 2009, and has been consistently named a leading Illinois attorney by the Law Bulletin since Baker & McKenzie defined the global law firm in the 20th century, and we are redefining it to meet the challenges of the global economy in the 21st. We bring to matters the instinctively global perspective and deep market knowledge and insights of 3900 locally admitted lawyers in 67 offices worldwide. We have a distinctive global way of thinking, working and behaving fluency across borders, issues and practices. We understand the challenges of the global economy because we have been at the forefront of its evolution. Since 1949, we have advised leading corporations on the issues of today s integrated world market. We have cultivated the culture, commercial pragmatism and technical and interpersonal skills required to deliver world-class service tailored to the preferences of world-class clients worldwide. Ours is a passionately collaborative community of 60 nationalities. We have the deep roots and knowledge of the language and culture of business required to address the nuances of local markets worldwide. And our culture of friendship and broad scope of practice enable us to navigate complexity across issues, practices and borders with ease. Our commitment to excellence and fluency are reasons why we have more lawyers listed in more countries in Chambers Global Directory of the World s Leading Lawyers than any other global firm. April 2010 FW REPRINT

5 LETTERS TO THE EDITOR tax notes Addressing DISC Cash Analysis of Robert Feinschreiber and Scott Beane To The Editor: In an article entitled Stripping Out the DISC s Earnings (Tax Notes, July 28, 2008, p. 331, Doc , 2008 TNT ), Robert Feinschreiber and Margaret Kent assert a DISC whose only asset on the last day of its tax year is cash in an amount which is no greater than $2,500 could be disqualified as a DISC by having failed the 95 percent qualified export assets test of section 992(a)(1)(B), 1 that is, the $2,500 amount would be a nonqualified asset. In a reply dated October 7, 2008 (Tax Notes, Oct. 6, 2008, p. 103, Doc , 2008 TNT ), Scott Beane rebutted the authors assertion primarily on the basis that because there is a de minimis exception with respect to cash, the $2,500 should be a qualified asset as a de minimis amount. The authors then countered in a response dated October 15, 2008 that in their opinion the risk was a realistic one because there was no authority directly on point for Mr. Beane s conclusion. Briefly my experience in DISC goes back as far as Robert Feinschreiber s, in that I have been practicing in the DISC area since the DISC provisions were first introduced. I have also lectured on various aspects of DISCs, published a number of articles regarding same, given expert testimony, and was awarded attorney s fees by the U.S. Tax Court in a DISC case. I have great respect for the authors. They raise an issue which is not directly covered by the code or regulations. However, in my opinion a DISC whose only asset on the last day of its tax year is cash in an amount which is less than or equal to $2,500 (stripped DISC) should not, because of the cash on hand, be disqualified as a DISC under the 95 percent qualified export assets test. My reasons are briefly summarized as follows: 1. The fact that under section 992(a)(1)(C) a DISC must have stock outstanding having a par or stated value of $2,500 provides strong support for the argument that $2,500 would be a de minimis amount. It is after all the amount needed to capitalize a DISC and therefore creates an initial need for cash. While it is true that the DISC s capital does not have to be in cash, or even paid in, the par value of stock generally does represent a corporation s shareholder liability to third parties under state 1 References to the code refer to the Internal Revenue Code of 1986 as amended. Under section 992(a)(1)(B) the 95 percent qualified export assets test is determined on the last day of the DISC s tax year. law. Since the shareholders contribution is for the benefit of third parties and must be $2,500 under the code, why it cannot be in cash and remain in cash is not evident. 2. Since the DISCs were first introduced, inflation has regularly eaten away at the value of a dollar. It is thus likely that whatever the de minimis amount other than $2,500 which the Service was considering in 1972, it should have increased more than five fold, i.e., the purchasing power of $2,500 today roughly would be the same as $500 in Cash falls into the category of temporary investments provided for in reg. section (e). Under that regulation, cash is considered as a part of the working capital of the DISC. Working capital is defined as the excess of a DISC s current assets over current liabilities. Reg. section (e)(2)(i). Assuming that the total current assets are the cash on hand, it would then be offset by current liabilities which are defined as obligations (or portion of obligations) due within the current normal operating cycle of the trade or business for the DISC whose satisfaction when due is reasonably expected to require the use of current assets. Reg. section (e)(2)(iii). In view of the fact that the DISC likely will have ongoing expenses (whether or not directly recoverable as commissions from a related supplier), consisting of accounting fees, state franchise taxes and other local taxes and even legal fees, it is likely that the anticipated expenditures for such fees and taxes could be equal to or greater than the $2,500 amount. This is especially true for accounting fees if the DISC has been actively earning commission income which it may have distributed before the end of the year. Since a DISC has no guaranty of any income for the following year under most commission agreements, the cash on hand at the end of the year is the only asset available for its future obligations. 4. Since under the 95 percent qualified export assets test, a DISC is allowed to have 5 percent of its assets nonqualified, 5 percent of the $2,500 amount or $125 could be on hand as a nonqualified asset as long as the remainder of the cash was qualified. 5. Considering the arguments in support of the propositions that $2,500 is reasonable working capital and that $2,500 is a de minimis amount, there should be allowed a deficiency distribution under reg. section for any non-qualified cash. Under the deficiency distribution procedures of reg. section , the DISC is allowed to make a deficiency distribution of the assets which are nonqualified assets. A distribution of those assets results 2 See U.S. Department of Labor, Bureau of Labor Statistics, Consumer Price Index. TAX NOTES, November 10,

6 COMMENTARY / LETTERS TO THE EDITOR in the DISC s becoming requalified for the year of disqualification. By definition the deficiency distribution in this case would involve a distribution of at most $2,500. There is a reasonable cause requirement under reg. section (c)(1) for a deficiency distribution which must be met. Reg. section (c)(2) specifically provides that reasonable cause includes reasonable uncertainty as to what constitutes a...qualified export asset. The strong reasons for treating the $2,500 as meeting the de minimis requirement for a qualified export asset plus the need for some working capital should provide the reasonable cause necessary for the deficiency distribution to be made. There is a cost to the deficiency distribution which is 4.5 percent per year of the amount required to disgorge the nonqualified assets from the DISC. Reg. section (c)(4). Assuming the full amount of the $2,500 is disqualified, the maximum amount which would be payable as interest each year is $ For most taxpayers this truly would be considered a de minimis amount. 6. Most important perhaps is that in the more than 35 years that I have been working in the DISC area as both a planner and a litigator, I have never seen a case where the DISC was disqualified solely because its total cash on hand at its year end was $2,500 and it had no other assets. While one can never predict the future with complete confidence, the fact that the Service apparently has never raised this issue in the more than 35 years of DISC further strengthens the arguments that such a risk is remote. As a result, I am comfortable in advising clients that if the only asset the DISC has at the end of the year is $2,500 in cash, (1) the DISC should not be considered to be non-qualified under the 95 percent qualified export assets test; and (2) in any event the DISC should be able to remain qualified by making a deficiency distribution. Specifically I am not advising clients to have their stripped DISCs spend their cash or convert it into other assets. 3 Sincerely, Neal J. Block Oct. 30, As pointed out in the Feinschreiber article, there are a number of ways the issue can be avoided, such as paying additional commissions for the year in question, creating a qualified commission receivable. I am only addressing the theoretical situation of a pure stripped DISC. 2 TAX NOTES, November 10, 2008