Qualified exporters of goods and services can receive a permanent tax savings of up to 20 percent by utilizing an export tax incentive known as the IC DISC. This savings is subject to continued preferential taxation of qualified dividends at 15 percent. Additionally, IC DISCs can achieve a long-term deferral on Federal tax from export profits.
The IC DISC is the sole surviving US export tax incentive amongst decades of failed foreign tax policies that met their demise when challenged by foreign trade organizations. The IC DISC has enabled many companies with foreign sales to defer substantial tax liabilities and achieve permanent tax savings.
IC DISC OVERVIEW
An IC DISC is a domestic corporation that is tax-exempt and the Federal income tax is imposed on the shareholders. Corporations, S Corporations and partnerships can receive an ordinary income tax deduction when a “commission” on qualified exportrelated income is paid to the IC DISC. The commission is generally limited to the greater of 4 percent of the qualified export receipts or 50 percent of the taxable income from the sale of export property. However, the commission cannot create a taxable loss for the taxpayer.
The tax liability associated with this commission is deferred until the earnings are repatriated to the shareholders of the IC DISC, often as a qualified dividend. In addition to the tax deferral, qualified dividends are taxed at 15 percent under current law, which results in a permanent tax savings because the benefit of the ordinary deduction can be as high as 35 percent. The statute does not require the IC DISC to perform economic functions such as maintaining office space, employees or tangible assets.
A TYPICAL IC DISC:
There are several variations to the IC DISC structures to accommodate different objectives, but each structure offers the ability to defer recognizing the commission income until it is distributed to the shareholders. However, the statute requires the shareholders to pay interest on the deferred income tax liability for deferrals greater than one year.
QUALIFICATIONS OF AN IC DISC
1. 95% or more of its gross receipts must be qualified export receipts
2. 95% of the assets of the corporation must be qualified export assets
3. The corporation must have capital of at least $2,500 and only one class of stock on each of the taxable year
4. The corporation must make a valid election to be treated as an IC DISC
Qualified Export Receipts: At least 95 percent of the IC DISCs gross receipts must be from qualified export receipts, which includes sales and leases of export property, export-related services (including engineering, design, architectural and managerial services), and interest from producer’s loans and export accounts receivable.
Qualified Export Assets: At least 95 percent of the IC DISCs assets must be comprised of qualified export assets, some of which include export property, receivables, producer loans, and reasonable working capital. Qualified export property must be manufactured, produced or grown in the US and cannot contain more than 50 percent of imported materials.
United States international taxation traces its beginnings to the enactment of Subpart F of the Internal Revenue Code, when in 1962, President Kennedy sought to end abusive foreign tax havens. Subpart F, which remains largely intact today, is far-reaching and complex, but essentially taxes the oversees businesses of US companies. President Nixon’s administration attempted to counteract the effects of Subpart F and encourage US exports to curtail growing trade deficits by proposing a special tax exemption for exports. This proposal was created into law in 1971 and was known as the domestic international sales corporation (DISC).
However, the United States’ trading partners attacked the DISC as an illegal export subsidy arguing that it resulted in bi-level pricing, whereby injuring the economies of other countries. After 13-years of controversy, the Regan administration in 1984 succumbed to the pressure and replaced the DISC regime with the Foreign Sales Corporation (FSC) which was believed to be functionally equivalent to the DISC but complied with multilateral trade negotiations. Also at this time, the DISC rules evolved into the interest-charge DISC (IC DISC).
Much like the failed DISC, the European Union objected by claiming the FSC gave US companies an unfair advantage and distorted international trade. On appeal in 2000, the WTO upheld that the FSC was an illegal export subsidy because it ruled that the US gave up tax revenue that was otherwise due. As a result, in 2000, the FSC was repealed and replaced by Extraterritorial Income Exclusion (EIE) Act of 2000.
Almost as soon as it was enacted, the WTO ruled the EIE was also an illegal export incentive. In 2002, on appeal, the WTO upheld this ruling and imposed trade sanctions on the United States for failure to comply with the ruling. In 2004, President Bush pledged to comply with the 2002 WTO rulings and the EIE was repealed and phased-out over two years as part of the American Jobs Creation Act (AJCA).
The DISC legislation, originally enacted in 1971, was largely transformed in 1984 by introducing the interest charge DISC. This export tax incentive remains available today to qualifying taxpayers.
Domestic companies with foreign activity should examine whether they can utilize the benefits of an IC DISC. The tax savings attributable to an IC DISC can be substantial, particularly while qualified dividends have a preferential tax rate. However, the benefits of an ICDISC can only be realized on sales that occur after the IC DISC is established.