International Taxation - Adnan Islam

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export income $3,600,000 $3,600,000 50% CTI method $1,800,000 $1,800,000 Individual standard & QD rate 37.00% 20.00% After tax cash for owners $1,134,000 $1,440,000 Cash tax savings $306,000.00

      An IC-DISC is a separate (legal) C corporation that acts as a sales commission agent for a U.S. agricultural, food manufacturing, or distributing exporter (the exporting entity). The IC-DISC is by design and by operation of tax law within the IRC more form over substance. In the IRS audit guide, it is apparent that the form, including documentation and a completely thorough and accurate IC-DISC [formal] election, are crucial for the qualification and maintenance for the IC-DISC tax beneficial status.

      An IC-DISC does not need employees or office space and does not have to perform any services or participate in any sales to earn a commission. The entity is required to maintain a separate set of books and records, including a separate bank account. It may have only one class of stock and must, at all times, have stock outstanding with a par or stated value of at least $2,500. Any type of entity or individual can own an IC-DISC. In most situations, ownership should be held by an individual or flow-through entity (an LLC, partnership, or S corporation) for the greatest tax benefit. If the exporting entity is one of these pass-through entities, the IC-DISC can even be formed as a subsidiary. However, if the exporting entity is a C corporation, the IC-DISC should be set up as a sibling to the exporting entity rather than a subsidiary, and it should generally be owned by the exporting entity’s individual shareholders.

      Note that the shareholders of the IC-DISC do not need to be the same as the shareholders of the exporting company. An IC-DISC can be used to provide a benefit to key employees or as a tool in estate and or succession planning.

      An IC-DISC is also allowed to have foreign shareholders as long as the foreign shareholder agrees that any distribution (actual or deemed) is income effectively connected with a U.S. permanent establishment. The dividends paid from an IC-DISC to its shareholders are generally considered to be foreign-source income. This makes the use of an IC-DISC particularly valuable to U.S. shareholders with passive foreign tax credit carryovers.

      Taxation of an IC-DISC

      An IC-DISC is categorized as a domestic C corporation that is tax exempt for federal income tax purposes. However, to obtain this tax exempt status, the corporation must file Form 4876-A, Election to Be Treated as a DISC, within 90 days of its first taxable year. If the corporation elects to be treated as an IC-DISC moving forward, then the election must be made within 90 days before the beginning of the first taxable year of the DISC. The election must be signed by all shareholders as of the effective date of the election. Once made, the election is effective for all subsequent years until it is revoked by the corporation. Based on foreign sales of products manufactured, produced, grown, or extracted in the United States, the exporter pays a commission to the IC-DISC and then deducts the commission from its ordinary business income. This results in a deduction at ordinary tax rates. The IC-DISC receives the commission without having to pay federal tax on the income. In most cases, the IC-DISC then distributes this cash as a dividend to its shareholders. As long as the shareholders are individuals or pass-through entities such as S corporations or partnerships, the dividend is taxed at the favorable qualified dividend tax rates.

      In this example, the first method gives us a commission of $1m (50% of $2m, the grower’s net taxable international income), and the second gives us a commission of $600,000 (4% of $15m). Generally, the taxpayer will want to choose the larger of the two amounts for the greatest tax benefit. In this case, the first choice results in a $1m commission paid by the grower to the IC-DISC. As a result of this commission, the grower’s taxable income is reduced by $1m. Because the grower is an S corporation, its shareholders report this income (now reduced by $1m) on their individual income tax returns. Assuming the shareholders are in the top tax bracket (and taxed at 37%), the commission payout results in a federal tax reduction of $370,000 in total for the shareholders. The $1m paid to the IC-DISC is taxed to the IC-DISC’s owners (when paid or deemed paid) as a qualified dividend at the 23.8% rate (factoring in the 3.8% NIIT tax), resulting in tax of $238,000. The difference between the ordinary income tax saved by the individual shareholders and the qualified dividend tax liability incurred by the IC-DISC results in a tax savings of $132,000. The IC-DISC may also choose not to pay a dividend to its shareholders. In this case, an interest charge would apply to the deferred tax (hence the entity’s name). The interest charges are based on Treasury bill rates, so at this time the potential interest charges are small. There are also deemed distribution rules related to qualified export receipts that exceed $10m; these rules can result in shareholders being taxed on the DISC’s earnings without there being an actual distribution.

      Commissions

      As summarized earlier, there are a few different methods that may be used to calculate (and optimize) the amount of commission the IC-DISC may receive.

       Four percent of its qualified export receipts, subject to export profit limitations

       Fifty percent of its CTI (its export profits)

       The actual amount earned by a buy-sell IC-DISC that has employees and operations of its own

      Annual maintenance of IC-DISC

      Once an IC-DISC is formed, annual requirements must also be met. These requirements include:

       At least 95% of the gross receipts must be qualified export receipts.

       A reasonable estimate of the commission must be paid within 60 days of the exporter’s tax year-end.

       An IC-DISC tax return, Form 1120-IC-DISC, must be filed annually by the 15th day of the ninth month following the close of the IC-DISC’s taxable year. (The IC-DISC’s taxable year must be the same as that of its principal shareholder.)

       The IC-DISC must maintain its own separate set of books and records.

       International boycott (Israel) operations must be disclosed (in conjunction with Form 5713).

      At least 95% of the IC-DISC’s assets must be qualified export assets that fall into several categories: export property, working capital (only the amount necessary for required working capital), commission receivable, stocks or securities of a related foreign export corporation, and producers’ loans.

       manufactured, produced, grown, or extracted in the United States, and

       for use or consumption outside the United States.

      Up to 50% of the

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