ic-disc compliance: exporter challenges in the federal tax...

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IC-DISC Compliance:

Exporter Challenges in the Federal Tax Break

THURSDAY, DECEMBER 21, 2017, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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Dec. 21, 2017

IC-DISC Compliance

James Loizeaux, Managing Director, Global Tax Services

CliftonLarsonAllen, Minneapolis

[email protected]

Robert J. Misey, Jr., Shareholder

Reinhart Boerner Van Deuren, Chicago & Milwaukee

[email protected]



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.

© 2017 All Rights Reserved

Robert Misey 5

IC-DISCs: Tax Savings for Exporters

Presented by

Robert Misey, Esq.

Chair, International Department

Reinhart Boerner Van Deuren, s.c.

(312) 207-5466; (414) 298-8135

[email protected]


Robert Misey 6

History of Export Benefits

• Congress enacted the Domestic International Sales Corporation

(DISC) regime to try to stimulate exports

• Due to complaints, Congress enacted the Foreign Sales Corporation

(FSC) regime to replace the DISC regime, but allowed the IC-DISC

to remain

• The ETI regime excluded a portion of an exporter's income

• The 2012/2013 Tax Act guaranteed IC-DISC savings

• The IC-DISC has survived the current tax bills


Robert Misey 7

Tax Rates

• Ordinary Income

• Qualified Dividends

• 3.8% Net Investment Income


Robert Misey 8

Introduction to IC-DISC

• Formation of the IC-DISC

A single class of stock

A minimum par value of $2,500

Elect to be an IC-DISC with a Form 4876-A


Robert Misey 9

Introduction to IC-DISC (cont.)

• Taxation of an IC-DISC and its shareholders

An IC-DISC is not subject to corporate tax

When the IC-DISC pays a dividend, its owners will pay tax at a

20% rate

If the manufacturing entity is a flow-through entity, the tax

savings are 20 percentage points

If the manufacturing entity is a C corporation, the tax savings

are 28 percentage points


Robert Misey 10

IC-DISC as a Brother-Sister of a Flow-Through

IC-DISC

US

deductible against

ordinary income


Robert Misey 11

IC-DISC as a Brother-Sister of a C Corporation

IC-DISC

US

C Corp deductible against

corporate income


Robert Misey 12

The Interest Charge in IC-DISC

U.S. tax – with acc IC-DISC Inc.: $8.5 million

U.S. tax – without acc IC-DISC Inc.: $5 million

Deferred U.S. tax: $3.5 million

AFR: 1%

Interest: $35,000

U.S.

F

US

IC-DISC

export customers

acc IC-DISC Inc.:

$10 million

Manufacturer


Robert Misey 13

The Tests to Qualify as an IC-DISC

• Qualified Export Receipts Test

• Qualified Export Assets Test


Robert Misey 14

The Tests to Qualify as an IC-DISC (cont.)

• 95% of its gross receipts must constitute qualified export receipts

Sales of export property

Rents for use of export property outside the

United States

Services related to exports

Engineering or architectural services for construction projects

abroad, and

Commissions


Robert Misey 15

Example 1

Sales Produce Gross Receipts

IC-DISC


Robert Misey 16

Example 2

Ancillary and Subsidiary Services Produce Gross

Receipts

IC-DISC


Robert Misey 17

Example 3

Architectural Services Produce

Gross Receipts

IC-DISC


Robert Misey 18

Example 4 -- Architectural and Engineering Services

Provided by an IC-DISC

US

F

IC-DISC

designs for

foreign projects

US

dividend

engineers

architects


Robert Misey 19

The Tests to Qualify as an IC‐DISC

• 95% of the assets of the IC-DISC must be qualified export assets

Temporary investments

Export property

Accounts receivable

Loans to producers

Shares of a related foreign export corporation


Robert Misey 20

Example 5 Working Capital as Qualified Export Assets

IC-DISC


Robert Misey 21

Example 6

Export Property as Qualified Export Assets

IC-DISC


Robert Misey 22

Example 7 Producer Loans as Qualified Export Assets

IC-DISC


Robert Misey 23

Example 8 --Avoid Subpart F Income With a

Related Foreign Export Corporation

S

widgets

$400

US

IC-DISC commission

RFEC

other country export

customers

HKCo

same country

foreign customers

widgets

$500

US

F


Robert Misey 24

Qualification as Export Property

• The property must be manufactured in the U.S. by a person other

than the IC-DISC

• The export property must be held primarily for use outside the

U.S.

• The property must have a maximum of 50% foreign content


Robert Misey 25

Qualification as Export Property (cont.)

• Property is manufactured within the U.S. if either

U.S. conversion costs incurred constitute 20% of the cost of

goods sold

There is a substantial transformation in the United States, or

The operations in the U.S. are generally considered to

constitute manufacturing


Robert Misey 27

Example 9

Conversion Costs as Manufacturing

IC-DISC


Robert Misey 28

Example 10

Substantial Transformation as Manufacturing

IC-DISC


Robert Misey 29

Example 11

Generally Considered to Constitute

Manufacturing

IC-DISC USAco

commission

US

blank CDs

Foreign

U.S.

CDs with music

Exports

US

IC-DISC USAco


Robert Misey 30

Qualification as Export Property

• The Destination Requirement

The destination test

requires being held

for use outside the

United States


Robert Misey 31

Example 12

Satisfying the Destination Test

IC-DISC


Robert Misey 32

Example 13

Satisfying the Destination Test?

IC-DISC Exporter


Robert Misey 33

Example 14

No Further U.S. Manufacturing

IC-DISC

Big3co

Familyco


Robert Misey 34

Example 15

P

US

IC-DISC


Robert Misey 35

Qualification as Export Property (cont.)

• The Maximum of 50% Foreign Content Requirement

No more than 50% of the fair market value of export property

may be attributable to the fair market value of imported

articles

The fair market value of the foreign content is determined by

its dutiable value


Robert Misey 36

Example 16

Foreign Content > 50% FMV

IC-DISC PAPco

W US


Robert Misey 37

Determining the IC-DISC Benefit

• The commission is the greater of

4% of the qualified export receipts

50% of the combined taxable income, or

The arm's-length amount determined under the transfer pricing

principles of Section 482


Robert Misey 38

Implementation Considerations

for the IC-DISC

• Incorporate the IC-DISC before the export

sales begin

• Analyze the export sales – don't forget indirect sales and Canada

• Draft the commission agreement

• Prepare and timely file the Form 4876-A that elects IC-DISC status

• Prepare a manual that contains guidelines and a checklist/calendar


Robert Misey 39

About Robert Misey

Robert Misey is Chair of the International

Department for Reinhart Boerner Van Deuren

and Chair of the International Tax Committee

for the American Bar Association.

A graduate of the law schools at Vanderbilt

University and Georgetown University, Robert is a former trial attorney for

the Internal Revenue Service Chief Counsel (International) in

Washington, DC. He is also the author of the books A Practical Guide to

U.S. Taxation of International Transactions and Federal Taxation:

Practice and Procedure. Rob can be reached at either 312-207-5456 or 414-298-8135 or [email protected]

38306413

WEALTH ADVISORY | OUTSOURCING | AUDIT, TAX, AND CONSULTING

Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor. | ©2017 CliftonLarsonAllen LLP

Compliance and Reporting for IC-DISCs – Part III Presented by: Jim Loizeaux

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James D. (Jim) Loizeaux Managing Director

Global Tax Services, CliftonLarsonAllen LLP

612-397-3204

[email protected]

Jim is a national practice leader in the Global Tax Services group for CliftonLarsonAllen. He has over 25 years of international tax experience focusing on cross-border transactions, reorganizations, repatriation of earnings and exports.

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Pricing Rules

• An IC-DISC can act as a buy-sell entity or a commission-based entity.

• The commission or transfer price between the IC-DISC and related supplier is calculated under one of the three following methods:

– 4 % gross receipts

– 50% combined taxable income (CTI)

– Section 482

• The commission or transfer price is the greater of the allowable method

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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)

• 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 DISC before the transaction took place.)

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Pricing Rules

• The pricing method chosen may be based export on transactions using one of the following approaches:

– Aggregate

– Transaction by transaction

– Product groupings

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Pricing Rules

• When utilizing the CTI method, overhead costs generally are allocated and apportioned between export and domestic sales, based on detailed rules [Reg. 1.861-8].

• 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 to compute marginal costing CTI (MC CTI).

• Overall, the CTI method generally produces a larger benefit than the gross receipts method, when exports have a greater-than-8% profit ratio.

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Sample Commission Calculation

Total Domestic Exports

Domestic Sales 400 300 100

COGS 200 150 50

Gross Profit 200 150 50

SG&A 100 75 25

Taxable Income 100 75 25

Profit Margin 25%

Related Supplier Income Statement Before IC DISC Commission

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Sample Commission Calculation continued

Method 4% of Export Sales 50% of CTI

Export Sales 100 100

COGS (50)

Gross Profit 50

SG&A (25)

Combined Taxable Income (CTI)

25

Total Commission 4 12.50

DISC Commission Calculation

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Grouping Transactions

• Calculations are generally to be done on a transaction-by-transaction basis.

• Regulations permit grouping of transactions along product or product lines.

• Grouping can be beneficial when the groups have different characteristics.

• Example: ABC Company produces multiple products, including Products A and B.

– Product A is a high-profit product line with limited export sales.

– Product B is a low-profit line but has high exports.

– If the two can be combined, then the high profit may raise the permissible commission paid for the AB group.

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Grouping Transactions (Cont.)

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Marginal Costing

• Reg. Sec. 1.994-2

• Permits taxpayers to use marginal costing to determine permissible DISC profit under the 50% method

• Requires that the DISC is treated as seeking to establish or maintain a foreign market

– A DISC is seeking to establish or maintain a foreign market if the CTI for the specific transaction or group of transactions is lower than the CTI calculated by applying the overall profit percentage from the product or product line to the qualifying export receipts.

– In effect, the DISC meets this requirement if the profit determined using marginal costing is higher than the full costing profit.

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No Loss Rule (Reg. 1.994-1(e)(1))

• No loss rule is a limitation on the DISC’s income if the computation of CTI results in a loss. – If CTI is a loss, CTI is limited to $0

– See schedule P, Part I, Section A, Line 3

• 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% – See Schedule P, Part I, Section C, Line 22

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No Loss Rule continued

Method 4% of Export Sales CTI

Export 100 100

COGS (75)

Gross Profit 25

Overhead (40)

Net Income 0

Total Commission 0 0

DISC Commission Calculation – 1.994-1(e)(1)(i)

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No Loss Rule – Application of Special Rule (Reg. 1.994-1(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)

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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 15th 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)

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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.

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Interest Charge – Domestic International Sales Companies: Common & Alternative Structures Part IV

Presented by: Jim Loizeaux

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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

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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

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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

IC-DISC

Officer

- Commissions paid cannot be direct replacement for incentive compensation the officers would otherwise be eligible to receive under other corporate bonus or incentive plans

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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

IC-DISC

Foreign

Corp

- Benefit based on treaty override of Section 996(g) - Foreign shareholder must file a Form 1120F with a Form 8833 - DISC also reports dividends on a Form 1042-S - Foreign country taxation of the dividend must be addressed

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Generation Transfer

• This structure transfers income to an owner’s children or grandchildren

• Rev. Rul. 81-54

Childre

n

C Corp,

S Corp or

Partnership

IC-DISC

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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.

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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

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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

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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. 1.994-1(e)(3)(i)].

– Reasonable estimate requires at least 50% accuracy

– Payment should generally be in cash to avoid non- compliance risk

– True-up commission requires payment in 90 days.

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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

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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

– Work papers should support the SG&A computations

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Other Issues

• Coordination with DPAD Computations

– Both DPAD and DISC commissions should rely on the methodology found in Reg. § 1.861-8 (see Reg. § 1.199-4(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

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Other Issues

• Non-standard structures

– Treaty-based IC-DISCs

– IC-DISCs in Roth IRAs

– Generation transfers

• Critical to document the legal support and for any non-standard structures

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What the IC-DISC Shareholder Should Understand

• Legislative history

• How the benefit is computed

• Different methods to compute the commission

• Form over substance

• The DISC is fragile

• Cost to requalify the DISC

• Lack of IRS guidance

• IRS audit

• Questionable practitioners

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