Export Incentive Tax Break

Taking advantage of IC-DISC opportunities

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© Grant Thornton LLP. All rights reserved. 4

Leading today’s discussion

Randy Free Partner, International Tax Practice Leader

Irvine

Jim Loizeaux

Director,International Tax

Minneapolis

Michael Reeves

Sr. Manager,International Tax

Boston

© Grant Thornton LLP. All rights reserved.© Grant Thornton LLP. All rights reserved.5

IC-DISC strategy

• Most companies can increase their after-tax cash flow by incorporating an IC-DISC.

• After repeal of ETI exclusion, the IC-DISC is the only option available to obtain export tax benefits—IC-DISC has existed since the '70s and not been challenged by courts or WTO.

• IC-DISC structure takes advantage of the 15% tax rate on dividends.


IC-DISC strategy

Services

IC-DISC Shareholder Owned (C or S corporation)

Shareholder

U.S. Export

Corporation

Customer

IC-DISC

Commission Payment

Services

Export Sales

Services

IC-DISC S-Corporation Owned

Shareholder

U.S. Export Corporation

Customer

IC-DISC

Commission Payment

Services

Dividend

Export Sales

Dividend


IC-DISC benefits

Foreign trading gross receipts 10,000,000

Cost of goods sold (8,000,000)

Gross Margin 2,000,000

Selling, general and administrative costs (1,500,000)

Export sales net income 500,000

IC-DISC commission (greater of):

50% of export net income 250,000

4% of export gross receipts 400,000

IC-DISC commission 400,000

Federal tax savings (35%) 140,000

IC-DISC Dividend 400,000

Federal tax cost (15%) (60,000)

IC-DISC net tax savings 80,000


• Background and overview• Benefit computation• Advanced topics• Questions and answers

Today's agenda

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We will address questions in Q & A at the end of the program. Please type in your questions at any time.


DISC is exempt from income tax

• A DISC is exempt not only from the regular corporate income tax but also is exempt from the minimum tax on tax preferences and the accumulated earnings tax.


Question 1

• Who was President of the United States when the IC-DISC entity was created by the Deficit Reduction Act?

a) Ronald Reagan

b) Bill Clinton

c) Gerald Ford

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• To qualify as a DISC for a tax year the corporation must meet all of the following requirements for that tax year:

1. Be an eligible corporation

2. Be an actual corporation

3. Meet the qualified gross receipts test

4. Meet the qualified export assets test

5. Have one class of stock

6. Make a timely election

7. A DISC cannot be a member of any controlled group of which a FSC is a member.

Qualifying as a DISC


These corporations cannot be DISCs

• The following corporations are not eligible to be treated as a DISC:

1. Tax exempt corporation

2. Personal holding companies

3. Banks and trust companies

4. Insurance companies

5. Regulated investment companies (mutual funds)

6. S corporations


• The law contains no restrictions on who can be a DISC stockholder. DISC stockholders can include:

Corporation Tenants in CommonPartnership Joint TenantsEstate Tenants by the EntiretyTrust MinorHusband and Wife Foreign Person

No restriction on who can be a DISC stockholder


• The corporation must be incorporated under the laws of a state (any state) or the District of Columbia.

• The separate incorporation of a DISC is required by statute, but this does not necessitate in all other respects the separate relationships which otherwise would exist between a parent corporation and its subsidiary.

Actual corporation


Qualified gross receipts test

• At least 95% of the corporation’s gross receipts for the tax year must consist of qualified export receipts.


Qualified export asset test

• The adjusted basis of the qualified export assets of the corporation at the close of the tax year must be at least 95% of the sum of the adjusted basis of all assets of the corporation at the close of the tax year.


One class of stock

• The corporation must have only one class of stock, and the par or stated value of its outstanding stock must be at least $2,500 on each day of the tax year.


Making timely election to be treated as DISC

• The corporation must make a timely election to be treated as a DISC and that election must be in effect for the tax year.


When to elect

• For a corporation’s first tax year, elect within 90 days after the beginning of the year.

• For any other year, elect during the 90 day period just before the first day of the year the election is to apply.


How to elect

• The corporation files Form 4876-A with the service center with which it would file an income tax return if it were subject to income tax. Consents of each person who is a shareholder as of the beginning of the first tax year for which the election is effective are to be or attached to the form.


DISC accounting methods

• A DISC generally may choose any permissible method of accounting.

• But if a DISC is a member of a controlled group it may not choose a method of accounting which would result in a material distortion of the income of the DISC or any other member of the controlled group.

• These are examples of what IRS considers a material distortion of income:– a DISC uses the cash basis and acts as a commission agent in a substantial

volume of sales of property by a related corporation which is on the accrual basis and which customarily pays commissions to the DISC more than two months after the sales.

– a DISC uses the accrual basis and leases a substantial amount of property from a related corporation on the cash basis, and the DISC customarily accrues any part of the rent more than two months before the rent is paid.


DISC accounting periods

• The tax year of a DISC must be the tax year of that shareholder (or group of shareholders with the same 12-month tax year) who has the highest percentage of voting power.

• If two or more shareholders (or group of shareholders) have the highest percentage of voting power under the above rule, the tax year of the DISC is the same 12-month period as that of any such shareholder (or group).


IC-DISC strategyCalculation of IC-DISC commission income

• IC-DISC able to calculate commission income under the following methods (whichever is greater):

‒ 4% of gross receipts method

Commission cannot exceed sum of 4% of qualified export receipts of IC-DISC plus 10% of export promotion expenses

− 50% of combined taxable income method

Commission cannot exceed 50% of the combined taxable income of supplier and IC-DISC plus 10% of export promotion expenses

‒ IC-DISC's taxable income based on the actual sales price, subject to adjustments under IRC §482


IC-DISC strategyQualifications

• "Qualified Export Receipts" are receipts from sales of export property that are manufactured in the US by the supplier and sold for direct consumption or disposition outside the US, or to an unrelated person for delivery outside the US with no more than 50% of the FMV of the property being attributable to articles imported into the US.

• A sale of property to an American manufacturer for incorporation in a product to be exported isn’t an export sale.

• "Qualified Export Assets" include A/R arising out of sales in which the IC-DISC is the principal agent, money, bank deposits, and producer's loans. A producer's loan is a loan of an IC-DISC's accumulated tax deferred profits back to its U.S. parent manufacturing company. The loan amount cannot exceed the amount of the borrower's assets related to its export sales.


Export property as qualified export assets

• Export property is any property which meets all three of the following tests:

1. The property must be manufactured, produced, grown or extracted in the US by a person other than a DISC.

2. The property must be held for sale, lease or rental, in the ordinary course of trade or business by, or to, a DISC for direct use, consumption or disposition outside the US.

3. Not more than 50% of the fair market value of the property can be attributable to articles imported in the US.


Whether property is held for export

• The destination test (for use, etc., outside the US) is generally considered satisfied if:

1. The DISC delivers the property to a carrier or freight forwarder for delivery outside the US, regardless of the FOB point or place of passage of title, whether to a US or foreign purchaser and whether for use of the purchaser or for resale; or

2. The sale is to an unrelated DISC for such a purpose, whether delivery is to be made in the US or at a foreign destination, or


Rental, etc. of export property

• Qualified export receipts include gross receipts from the leasing or rental of export property which is used by the lessee of the property outside the US.

• This includes receipts from subleasing.

• Whether leased property satisfied the usage test is to be determined on a year-to-year basis.

• Thus, the receipts on a lease of export property might qualify in some years and not in others depending on the lessee’s use of property in the year involved.

• But a de minimus use of the property in the US is permissible.


Services related to the sales and lease of export property

• Qualified export receipts include gross receipts for services which are both (1) related and (2) subsidiary to any sale, exchange, lease, rental or other disposition of export property by the corporation.

• Such services may be performed within or without the US.

• The DISC need not itself perform the services.


Services related to the sales and lease of export property

• Examples of related services include:

– Warranty

– Maintenance

– Repair

– Installation

– Transportation, including insurance, provided its cost is included in the sale price or rental, or, if separately stated, is paid by the DISC or its principal.


Engineering or architectural services

• Qualified export receipts include gross receipts for engineering or architectural services for construction projects located (or proposed for location) outside the US.

• These services include feasibility studies and design, engineering and construction supervision.

• They do not include the provision of technical assistance or know-how or services connected with the exploration for oil.


Qualified export assets defined

• Qualified export assets include the following:1. Export property

2. Export property assets

3. Accounts receivable, etc.

4. Temporary investments of working capital

5. Producer’s loans

6. Stock or securities in a related foreign export corporation

7. Export-Import Bank and Foreign Credit Insurance Association obligations

8. Export sales finance obligations

9. Temporary bank deposits in US


IC-DISC strategyOperation of IC-DISC

• The ownership of the IC-DISC does not have to mirror the ownership of the supplier. For example, only one shareholder in a C-Corp. that has 20 shareholders could choose to own the IC-DISC

• Employee/shareholders could choose to reduce their salary from C-Corp and increase dividend from IC-DISC

• Commission agreement between supplier and IC-DISC must be executed with assistance from Counsel

• Separate bank account and books and records must be maintained

• Annual financial statements (I/S & B/S) must be prepared

• Cash payments must be made from supplier to IC-DISC pursuant to the commission agreement



Today's agenda

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Question 2

• According to the Statistics of Income Bulletin, the most common type of majority shareholder of the 1,209 IC-DISC returns filed in 2006 was

a) Corporations (except S-Corporations)

b) Individuals, partnerships, trusts, estates or S-Corporations

c) No majority shareholder

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© Grant Thornton LLP. All rights reserved.© Grant Thornton LLP. All rights reserved.

The IC-DISC Benefit

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

• In either case, the income of an IC-DISC is calculated under one of the following:– 4% of qualified export receipts,– 50% of combined taxable income, or– Arm's length amount determined under the

principles of Code section 482.

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Gross Receipts Method

Example

Gross receipts $10,000,000

Cost of goods 6,000,000

Gross margin 4,000,000

Indirect expenses 3,250,000

Net income 750,000

Gross Receipts Method 400,000

CTI Method 375,000

IC-DISC Income 400,000

• The qualified gross receipts

method allocates 4 percent of

the qualified export receipts

from export sales to the IC-

DISC.

• This method is used when net

margins are less than 8

percent.


CTI Method

Example

Gross receipts $10,000,000

Cost of goods 6,000,000

Gross margin 4,000,000

Indirect expenses 3,000,000

Net income 1,000,000

Gross Receipts Method 400,000

CTI Method 500,000


• The combined taxable income

method allocates 50 percent of

the taxable income from export

sales to the IC-DISC

• This method is used when net

margins are greater than 8

percent.


Code Sec. 482 Method

• As a result of limited activities and functions, determining the IC-DISCs income using the transfer pricing principles under Code Sec. 482 generally results in lower income than under the other two methods.

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Maximizing the IC-DISC Commission

• An exporter can use any of the methods to achieve the greatest IC-DISC income.

• IC-DISC rules permit the use of different methods to different groups based on product lines, industry or trade usage, or by transaction.

• Where the net pre-tax margins of export sales are lower than worldwide net pre-tax margins, the exporter may use marginal costing of combined taxable income to compute IC-DISC income.

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Grouping

• Groupings must conform to recognized industry usage or SIC/NAICS codes.

• May use grouping for one product line and transaction-by-transaction for another product line.

ABCompany

AProduct Line

BProduct Line

ATransaction

ATransaction

BTransaction

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Grouping Example

Example

Base Case Product A Product B

Gross receipts $10,000,000 5,000,000 5,000,000

Cost of goods 6,000,000 4,000,000 2,000,000

Gross margin 4,000,000 1,000,000 3,000,000

Indirect expenses 3,000,000 750,000 2,250,000

Net income 1,000,000 250,000 750,000

Gross Receipts Method 400,000 200,000 200,000

CTI Method 500,000 125,000 375,000

IC-DISC Income 500,000 200,000 375,000


Marginal Costing

• If the profit margin on export sales is less than the profit margin on worldwide sales of the same product, the marginal costing rules may be applied to allocate only marginal or variable costs against export receipts.

• Overall profit percentage limitation (OPP) limits export CTI to full costing CTI from all sales (foreign and domestic).

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Marginal Costing Example

Example

Total Sales Export Domestic

Gross receipts $10,000,000 5,000,000 5,000,000

Cost of goods 6,000,000 3,500,000 2,500,000

Marginal Costing CTI 4,000,000 1,500,000 2,500,000

Indirect expenses 2,000,000 750,000 1,250,000

Full Costing CTI 2,000,000 750,000 1,250,000

MC Profit Margin 30%

OPP 20%

MC CTI (Limited to OPP) 1,000,000



Expense Allocation and Apportionment

• When using the CTI method, overhead costs are generally allocated between export and domestic sales, based on the rules under Treasury Reg. Sec. 1.861-8.

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Transaction-by-Transaction

• The pricing method chosen is required on a transaction-by-transaction basis; however, an annual election can be made to group transactions in accordance with products or product lines.

• Neither the gross receipts nor CTI method may be applied in a way that causes, in any taxable year, a loss the U.S. exporter (related supplier).

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Documentation

• Source Data (Sales and Cost of Sales) Support• Product Hierarchy and Support• Expense Allocation & Apportionment Methodology• Transactional Analysis

– Qualified Export Sales (U.S. Manufactured, Non-U.S. Destination and 50% Content)

– Pricing Method Reports• Form 1120-IC-DISC

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Question 3

• IC‐DISC shareholders pays an “Interest Charge” to the IRS when DISC earnings are accumulated and not distributed. The interest charge rate is the Base Period T-Bill rate published annually by the IRS. What is the current rate?

a) 20%

b) zero

c) .34 percent

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Today's agenda

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Advanced Topics

– Roth IRA– Executive Compensation– Sourcing (Passive)– Transaction-by-Transaction– Producer's Loans– IC-DISC and 863(b)– Shared DISCs

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Executive Compensation

IC-DISC ownership is set up through key employees.

CommissionC-Corp

Owner

IC-DISC

Employee

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Sourcing Benefits

• IC-DISC dividends are considered foreign sourced income to U.S. owners

• IC-DISC dividends are categorized into the passive basket

• Can use IC-DISC to increase the ability to utilize tax credits in the passive basket

– Title passage

– FISC income51


Transaction-by-Transaction

• May significantly increase IC-DISC benefit

– Compared to aggregate

• Requires advanced software applications

– Iteration of alternative groupings and marginal costing analyses

• Redetermination of open years

• Documentation

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Producer's Loans

• Producer's loans are a category of qualified export assets which permits a DISC to loan its tax deferred profits back to its parent manufacturing company (or any other U.S. export manufacturing corporation).

• The borrower must increase its inventory, plant, etc. by an amount equal to the loan by the end of the year of the loan.

• These producer's loans are qualified export assets and the interest of these loans constitutes qualified export receipts.

• The loan is designated as a "producer's loan" within the meaning of IRC s. 993(d) at the time of the loan. 53


IC-DISC and 863(b) Sales

• Use of IC-DISC does not preclude use of Section 863(b) to increase foreign source income

• Can claim IC-DISC benefit on 863(b) sales

• May be required to allocate/apportion IC-DISC commission to foreign source income under Section 861

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Shared IC-DISC

• Available for smaller exporters to share costs

• Availability and structure is fact specific

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Today's agenda

56


Our presenters will answer your questions

Please type any questions into Q&A

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Who to contact

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Randy Free,Partner

Irvine T 949.608.5311 E [email protected]

Jim Loizeaux, Director

Minneapolis T 612.677.5107 E [email protected]

Michael Reeves,Senior Manager

Boston T 617.848.4889 E [email protected]

mailto:[email protected]




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Export Incentive Tax Break