Domestic International Sales Corporations (DISCs) SUMMARY

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1 Domestic International Sales Corporations Prepared by: James R. Browne (214) February 1, 2016 SUMMARY The opportunity Any profitable U.S. company that -- sells or leases products for use outside the U.S. where products have 50% foreign content by value; or performs engineering or architectural services for projects located (or proposed for location) outside the U.S. can divert a portion of its export sales income to a related domestic international sales corporation ( DISC ) and avoid federal income tax on that income. 2 1

2 Benefits C corporation exporter: SUMMARY Eliminates corporate level tax on DISC commissions Translates to minimum pre-tax savings of ~2.06% of gross export sales Flow thru entity exporter (LLC / LP / S corp): Converts current ordinary income into deferred dividend income Translates to minimum pre-tax savings of ~1.39% of gross export sales (not accounting for tax deferral benefits) Additional tax savings possible on high margin products or services, and on investment of DISC commissions (e.g., producer loans and receivables factoring) 3 Costs SUMMARY Costs to implement and maintain a DISC are very modest Companies with as little as $100,000 of annual export sales may benefit from a DISC 4 2

3 How it works SUMMARY U.S. exporter or its shareholders form a corporation and elect DISC status for the corporation U.S. exporter pays a commission (typically 4% of gross export sales) to the DISC and deducts the payment DISC pays no tax on the commission income DISC s shareholders pay an interest charge at a very low rate (0.24% for 2015) on the DISC s undistributed income* When the DISC distributes its income to its shareholders, it is qualified dividend income (maximum 23.8% tax rate for individuals) * This interest charge on undistributed earnings is what gives rise to the name interest charge DISC, or IC-DISC. 5 Basic Transaction Structure C-Corp Structure 6 3

4 Basic Transaction Structure Flow Thru Entity Structure 7 Basic Transaction Structure Owners of U.S. corporation ( MFR ) form a C corp. ( DISC ) to receive commissions on export sales of U.S. manufactured property If MFR is an LLC, LP, or S corp, MFR can form and own DISC DISC has no employees or activities MFR pays a commission to DISC = 4% of export sales MFR commission payments are deductible by MFR, but not taxable to DISC (DISC is a tax-exempt entity) DISC dividends = qualified dividend income Owners pay an interest charge on dividends if DISC earnings are not paid as a dividend in the year earned DISC can make loans to MFR ( producer loans ) 8 4

5 Net result: Basic Transaction Structure If MFR is a C corporation, the DISC structure eliminates the corporate level taxes on MFR income paid as DISC commissions If MFR is classified as a partnership or S corporation, the DISC structure converts MFR ordinary operating income into deferred dividend income to the extent of the DISC commissions DISC can generally defer paying dividends indefinitely (subject to certain limitations), incurring a very low interest charge* on deferred earnings * 0.24% for 2014 (Rev. Rul ). 9 Steps to Implement a DISC Owners/exporter form DISC as a C corporation with one class of stock and at least $2,500 of par or stated value of stock DISC opens a bank account DISC and owners/exporter elect on IRS Form 4876-A to treat DISC as an IC-DISC within 90 days of formation Exporter and DISC execute a commission agreement Exporter computes and pays commissions to DISC within 60 days of year end (must make actual cash transfers) 10 5

6 Calculating the DISC Commission Three methods: 4% of gross receipts method 50% of combined taxable income method Section 482 method (applies only where DISC has substantive activities; rarely used) Use the method that produces the greatest amount of income to the DISC Method used can vary on a transaction by transaction basis 11 Calculating the DISC Commission 4% of gross receipts method Commission = 4% of qualified export receipts of the exporter Add reimbursement for DISC costs plus a profit markup; does not apply if DISC has no activities 50% of combined taxable income method Commission = 50% of combined taxable income of DISC and exporter attributable to the qualified export receipts of the exporter Add reimbursement for DISC costs plus a profit markup; does not apply if DISC has no activities Use this method when net margin is greater than 8% No loss rule: DISC taxable income cannot exceed combined taxable income of DISC and exporter 12 6

7 Calculating the DISC Commission Accounting methods Identification of qualified export receipts (e.g., indirect sales) Calculation of gross receipts (costs of goods sold) Calculation of combined taxable income, including expense allocation methods and marginal costing methods Transaction by transaction reporting versus grouping Application of no loss rule A knowledgeable tax preparer should be engaged to correctly calculate, maximize, document, and report the tax benefits of the DISC arrangement 13 Qualified Export Receipts Qualified export receipts gross receipts from any of the following the sale of export property the lease of export property outside the U.S. services related and subsidiary to any sale or lease of export property, engineering or architectural services for construction projects located (or proposed for location) outside the U.S. the sale by the DISC of any qualified export assets (other than export property) at a taxable gain managerial services in furtherance of the production of qualified export receipts of another unrelated DISC dividends (or subpart F income inclusions) with respect to stock of a related foreign export corporation interest on any obligation which is a qualified export asset 14 7

8 Qualified Export Receipts Excluded receipts Gross receipts from the sale or lease of property for ultimate use in the U.S. Gross receipts from a sale of export property which is subsidized Gross receipts from the sale or lease of export property, or from qualified engineering or architectural services, for use by the U.S. or any agency of the U.S. in any case in which any law or regulation requires use of U.S. property or services (with some exceptions) Gross receipts from services related or subsidiary to transactions that produce excluded receipts Gross receipts from transactions with members of a controlled group 15 Qualified Export Receipts Definition of gross receipts Sales of inventory = sales proceeds, unreduced by returns and allowances, costs of goods sold, expenses, or other deductible amounts Sales of other property = gain Commissions = gross receipts derived by the principal Gross income from services, dividends and interest, and other [Reg ] 16 8

9 Export Property Four requirements: Manufactured, produced, grown, or extracted in the United States by any person or persons other than a DISC ( MPGE Test ), Held primarily for sale or lease in the ordinary course of a trade or business to any person for direct use, consumption, or disposition outside the U.S. ( Foreign Use Test ), Not more than 50% of the fair market value of which is attributable to articles imported into the United States ( Foreign Content Test ), and Not excluded property (notably, certain intellectual property and oil and gas products are not export property) 17 Export Property MPGE Test MPGE within U.S. includes U.S. possessions Manufactured or produced: Substantial transformation of the property (e.g., conversion of wood pulp to paper, steel rod to screws, or canning of fish) Operations that are substantial in nature and are generally considered manufacturing Safe harbor: conversion costs (direct labor and factory burden, including packaging or assembly) account for 20% of the cost of goods sold or inventory costs Cannot be subject to further manufacture or production outside the U.S. prior to sale Does not include only assembly or packaging 18 9

10 Export Property Foreign Use Test Destination requirement Ultimate destination is outside the U.S. Delivery to a carrier within the U.S. is permitted if the ultimate delivery is outside the U.S.; F.O.B. point and place at which title or risk of loss passes is disregarded Can t be any use or processing of the property (other than packaging) while in transit Proof of compliance requirement Seller must document delivery outside the U.S. in compliance with the destination test Use-outside-the-U.S. requirement Regulations specify conditions under which property is considered sold for ultimate use in the U.S. 19 Export Property Foreign Content Test 50% value limit on foreign content is applied item-by-item, unless items are substantially identical in terms of type of property and type and proportion of foreign content Value of imported articles is determined when imported, generally determined based on the customs invoice 20 10

11 DISC Requirements Requirements A corporation incorporated in the U.S. 95% of gross receipts are qualified export receipts 95% of assets are qualified export assets One class of stock having par or stated value of $2,500 DISC election on IRS Form 4876-A Maintains separate books and records Adopt tax year of primary shareholder Not an S corporation or other ineligible corporation Deficiency distributions If DISC fails to meet qualified export receipts or qualified export assets test, it can make distributions of the offending receipts or assets after year end in order to meet the tests for the prior year 21 DISC Requirements Qualified export receipts test A DISC typically has no income other than commissions from the affiliated exporter, interest income on producer loans to the affiliated exporter, and some minimal investment income The income from commissions and producer loans is qualified export receipts, so the typical DISC easily meets this test Qualified export assets test A DISC typically starts with no assets other than cash received from its affiliated exporter or temporary investments of such cash The DISC s cash is typically either loaned back to the affiliated exporter as a producer loan or paid out as dividends Because a producer loan and funds awaiting investment are qualified export assets, it is generally very easy to meet this test 22 11

12 DISC Requirements Producer loans Evidenced by a note or other debt instrument with a stated maturity of not more than five years from the loan date Made to a person engaged in export property MPGE in the U.S. Designated as a producer loan Qualifies only to the extent Asset limit: the loan, when added to the unpaid balance of all other producer loans to the borrower outstanding at the time of the loan, does not exceed the borrower s production assets, inventory, and R&D allocable to export sales Increased investment limit: the loan, when added to the unpaid balance of all other producer loans to the borrower during the taxable year, does not exceed the increase during the taxable year in the borrower s production assets, inventory, and R&D allocable to export sales Borrower certification on Form 1120-IC-DISC, Schedule Q 23 DISC Requirements Export receivables factoring DISC purchases affiliated exporter s receivables from export sales at an appropriate discount to compensate the DISC for the time value of money and credit risk Receivables qualify as qualified export assets, and discount earned on factoring qualifies as qualified export receipts More complicated than producer loans, but more tax efficient (because discount earned by the DISC is eligible for deferral, whereas interest on producer loans is not; see below) 24 12

13 Tax on DISC Income and Distributions The DISC is exempt from corporate tax on its income Actual dividends Taxed as qualified dividends (23.8% maximum tax rate) Deemed dividends Certain DISC income (e.g., interest on producer loans) is treated as a deemed dividend to shareholders when earned by the DISC A subsequent distribution of the income is nontaxable Interest charge on deferred tax liability DISC income not treated as a deemed dividend and not paid out as an actual dividend is subject to an interest charge imposed on the shareholders based on their respective deferred tax liabilities (computed on IRS Form 8404) 25 Tax on DISC Income and Distributions Deemed dividends Each shareholder is treated as having received a dividend equal to the shareholder s allocable share of Interest on producer loans DISC income attributable to qualified export receipts of the DISC* for the taxable year that exceed $10,000,000 DISC gain on sale of certain assets 50% of DISC income attributable to military property In the case of a shareholder that is a corporation 1/17 of the remaining DISC income Amounts treated as deemed dividends are classified as previously taxed income ( PTI ), and subsequent dividends are deemed paid first out of PTI * The gross export receipts, not the commission amount 26 13

14 Tax on DISC Income and Distributions Planning DISC can use commissions to purchase the exporter s export receivables Discount is nontaxable to DISC and eligible for deferral (subject to the interest charge, which is currently nominal) DISC can use commissions to make producer loans to exporter Not as tax efficient as purchasing export receivables, but much less complex Must comply with requirements and limitations on producer loans Both types of transactions generate deductible expenses for the exporter, and non-taxable income for the DISC 27 Miscellaneous Coordination with Section 199 deduction Exporter can take both DISC and Section 199 benefits DISC commission deduction reduces domestic production activities income, and reduces the exporter s Section 199 deduction, but the effect is negligible 28 14

15 Miscellaneous State Income Tax Consequences Varies by state In Texas, DISC is a taxable entity If exporter and DISC are affiliated (i.e., >50% owned by one [or more] common owners), they file a combined report and DISC commissions are eliminated, so no Texas franchise tax effects If exporter and DISC are not affiliated and file separate franchise tax reports, exporter should be able to deduct DISC commissions, and DISC might not have sufficient revenue to be taxable on the commission income It might also be possible to have the exporter report the DISC commissions on a Form 1099-MISC and treat the commissions as non-taxable to the DISC 29 Miscellaneous DISC owned by a Roth IRA? Effectively facilitates excess contributions to the Roth IRA Does not avoid tax and interest charge on commissions [995(g)] IRS identified such transactions as listed transactions in Notice , but lost two early Tax Court cases (Hellwig and Ohsman) for failing to harmonize income tax and excise tax treatment Summa Holdings, Inc. v. Comm r, T.C. Memo DISC commissions paid to a DISC owned by a Roth IRA were characterized by the IRS, for both income tax and excise tax purposes, as disguised dividends followed by excess IRA contributions Holding: primary purpose of shifting value to Roth IRA invalidates arrangement notwithstanding normal relaxation of substance requirements for DISCs; IRS properly contended no DISC commission payments were made 30 15

16 Miscellaneous DISC owned by a multigenerational (dynasty) trust? Rev. Rul Shareholders of corporation M form DISC and transfer DISC stock to trusts for children. M enters into a commission agreement with DISC. Transfer to trusts is a taxable gift (but value should be zero) Commission payments are taxable gifts by shareholders to trusts (because payments to a DISC held by a trust are not ordinary course transactions for adequate and full consideration) Summa Holdings suggests that if the primary purpose of the arrangement is to transfer assets to the trusts free from gift tax, the arrangement may be characterized for both income and gift tax purposes as a disguised dividend and gift 31 Miscellaneous DISC owned by foreign shareholders? Section 996(g): gains and dividends are treated as U.S. source income effectively connected with a U.S. permanent establishment; intent is to treat the income as taxable in the same manner as for U.S. residents However, some treaties may override Section 996(g) so that the gains are not U.S. source income, and dividends are subject to withholding tax at reduced or zero tax rates Does Summa Holdings suggest that there must be a primary nontax business purpose for issuing or transferring the DISC stock to a foreign shareholder? 32 16

17 Conclusion Any U.S. company with significant sales of property or engineering and architectural services to non-u.s. customers for use outside the U.S. should review its circumstances to see if it qualifies for DISC benefits Approximate pre-tax equivalent cost savings: LLC/LP/S corp: 1.39% of export sales 4% x (43.4%* %) (1 43.4%) C Corp: 2.06% of export sales 4% x 34% (1 34%) Greater benefits for high margin sales (>8% net margin) Additional benefits on investment of commissions by DISC * 39.6% in some cases. 33 Appendix Legislative History 1972 DISC (Domestic International Sales Corporation) enacted Allows exporters to defer tax without paying interest on a portion of export sales Attempt to place U.S. exporters on an equal tax footing with exporters in other countries 1984 DISC Invalidated; IC-DISC and FSC (Foreign Sales Corporation) created DISC invalidated under GATT (the General Agreement on Tariffs and Trade) and was repealed in 1984 Congress created IC-DISC and also created FSC to exempt a percentage of an FSC s income from U.S. tax 1998 FSC Invalidated The World Trade Organization (WTO) rules the FSC to be an illegal subsidy 2000 FSC Eliminated and EIE (Extraterritorial Income Exclusion) created EIE legislation excludes a portion of extraterritorial income from taxation 2003 Dividend Rate Decreased to 15% Reduced tax rate on dividends provides an additional benefit to IC-DISC shareholders 2004 EIE repealed WTO rules the EIE is an illegal export subsidy American Jobs Creation Act of 2004 repealed the EIE for transactions after 2004, subject to transition rule EIE was completely phased out by the end of calendar 2006 Today IC-DISC is the only remaining export incentive available 34 17

18 DISCLAIMER This document is a general summary only. It not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter