IC-DISC Strategies: Mastering the Complex Operational Challenges

Transcription

1 IC-DISC Strategies: Mastering the Complex Operational Challenges Anticipating IRS Audit Risks, Calculating Commissions, and Tackling Computational Intricacies TUESDAY, MAY 6, 2014, 1:00-3:00 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.

2 FINANCIER WORLDWIDEcorporatefinanceintelligence W O R L D W AT C H AMERICAS TAX Using DISCs to reduce US tax on US exporting companies and their foreign shareholders FW MAGAZINE REPRINTED FROM April 2010 Issue

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 DRAFT - FOR DISCUSSION PURPOSES ONLY Starting with the 2013 tax year, a new 3.8% net Investment Income tax (NIIT) was enacted for the following taxpayers: individuals, estates, and trusts. 1 For married filing joint taxpayers, the tax applies to the lesser of: net investment income, or the excess of modified adjusted gross income over $250, Net investment income is defined as the sum of the following three categories of income: 1. gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business and not considered a passive activity nor a trade or business of trading in financial instruments or commodities, 3 2. other gross income derived from a trade or business considered a passive activity or a trade or business of trading in financial instruments or commodities, 4 and 3. net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not considered a passive activity nor a trade or business of trading in financial instruments or commodities, 5 over the deductions which are properly allocable to such gross income or net gain. A passive activity should be determined within the meaning of Code In determining whether the NIIT applies, certain taxpayers subject to the NIIT need to determine if each source of their income is subject to the tax. The first step in that determination could be to acknowledge that portfolio income should be subject to the NIIT under category 1 since it is not derived from a trade or business. Next, non-portfolio income generally is derived from a trade or business. Trade or business income from a passive activity is subject to the NIIT. Therefore, trade or business income that is not from passive sources is not subject to the NIIT. In the following example, it will be helpful to determine whether the NIIT should apply to certain types of income. Example 1 US individual wholly owns an S Corporation that in turn wholly owns an IC DISC In this example, S Corporation manufactures widgets in the US and distributes the widgets worldwide. US individual materially participates in S Corporation. The IC DISC is a buy sell DISC and US individual is an employee of IC DISC and materially participates in that entity too. IC DISC pays a dividend to S Corporation. S Corporation provides US individual with a Schedule K-1 that includes ordinary income and also separately states the IC DISC dividend. There are two sources of income to analyze as to whether they are subject to the NIIT. With respect to the ordinary income reported on Schedule K-1, it should not meet the criteria of any of the three Code 1411 Code 1411(a)(1) Code 1411(c)(1)(A)(i) Code 1411(c)(1)(A)(ii) Code 1411(c)(1)(A)(iii) Code 1411(c)(2)(A)

6 categories listed above. If US individual did not materially participate in S Corporation, it would have been subject to the NIIT under category 2. With respect to the separately stated dividend arising from the IC DISC, a determination should be made if the dividend is derived in the ordinary course of a trade or business and not considered a passive activity under Category 1. The statue does not define derived in the ordinary course. However, final regulations were issued for Code 1411 on December 2, Section 5(B)(ii)b of the Comments in the Preamble to the final regulations does offer guidance with respect to derived in the ordinary course. Specifically, the Preamble provides: Within the context of section 469, income from interest, dividends, royalties, and annuities is classified as portfolio income unless such income is derived in the ordinary course of a trade or business. Section T(c)(3)(ii)(A) through (c)(3)(ii)(g), which implements section 469(e)(1)(B), identifies several situations where interest, dividends, royalties, or annuities are derived in the ordinary course of a trade or business, and therefore are not portfolio income. If the interest, dividends, royalties, or annuities do not fall into one of these situations, then they constitute working capital because they are not derived in the ordinary course of a trade or business. If the assets that generate the interest, dividends, royalties, and annuities are not held in a trade or business, however, then the classification of the income as working capital by reference to T(c)(3)(ii) is irrelevant. Code T(c)(3)(ii)(A) through (c)(3)(ii)(g) provides that the following items are considered derived in the ordinary course : T(c)(3)(ii)(A) Interest income on loans and investments made in the ordinary course of a trade or business of lending money; T(c)(3)(ii)(B) Interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business; T(c)(3)(ii)(C) Income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies; T(c)(3)(ii)(D) Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (but see paragraph (c)(3)(iii)(a) of this section); T(c)(3)(ii)(E) Royalties derived by the taxpayer in the ordinary course of a trade or business of licensing intangible property (within the meaning of paragraph (c)(3)(iii)(b) of this section); T(c)(3)(ii)(F) Amount included in the gross income of a patron of a cooperative (within the meaning of section 1381(a), without regard to paragraph (2)(A) or (C) thereof) by reason of any payment or allocation to the patron based on patronage occurring with respect to a trade or business of the patron; and T(c)(3)(ii)(G) 7 Treasury Decision 9644, 78 FR , December 2, 2013.

7 Other income identified by the Commissioner as income derived by the taxpayer in the ordinary course of a trade or business. As highlighted, Code T(c)(3)(ii)(D) provides that income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (but see paragraph (c)(3)(iii)(a) of this section). Code T(c)(3)(iii)(A) provides that for purposes of paragraph (c)(3)(i) of this section, a dealer's income or gain from an item of property is not derived by the dealer in the ordinary course of a trade or business of dealing in such property if the dealer held the property for investment at any time before such income or gain is recognized. Therefore, it is pertinent to determine if the S Corporation should be i) considered trading or dealing in any property and ii) held the shares of IC DISC for investment or as a part of its trade or business. S Corporation should be considered trading or dealing in widgets. An IC DISC is a creature of statue. 8 Congress created the IC DISC to reduce the tax costs of US taxpayers that engage in qualified export transactions. Specifically, taxpayers with qualified exports establish an IC DISC in furtherance of a transaction or transactions giving rise to qualified export receipts of the domestic corporation (i.e. the S Corporation in this example). 9 Although not entirely free of doubt, S Corporation should be considered receiving the dividend from the IC DISC as income derived in the ordinary course of trading or dealing in widgets. S Corporation should not be considered holding the shares of IC DISC for investment purposes. Code (b)(2) provides that in the case of an individual, estate, or trust that owns an interest in a passthrough entity (for example, a partnership or S corporation), and that entity is engaged in a trade or business, the determination of whether IC DISC dividends is derived in a passive trade or business is made at the owner level. Code 469(c) defines a passive activity for individuals as any activity in which the taxpayer does not materially participate. US individual does materially participate in S Corporation. Although not entirely free of doubt, a reasonable position exists to treat the IC DISC dividend reported on Schedule K-1 as not subject to the NIIT. CIRCULAR 230 DISCLOSURE: To comply with Treasury Department Regulations, we advise you that, unless expressly indicated, any federal tax advice contained in this memo or any enclosures cannot be used for the purpose of (i) avoiding penalties imposed by the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any matters addressed herein. We make this disclosure because providers of tax advice are now required to do so by law when offering advice concerning federal tax matters. 8 9 Code 991 This notion is acknowledged by Congress in Code 993(e)(3)(B) in the context of a related foreign export corporation.