Tax Incentives for Exporters

Given the inevitable repeal of the extraterritorial income (ETI) exclusion and the current 15% tax rate on corporate dividends, companies that export property should consider the advantages of using an interest charge domestic international sales corporation (IC-DISC). As discussed below, in many cases, the IC-DISC will provide greater tax benefits.

The ETI Exclusion

The ETI provisions exclude a portion of income earned from certain export sales. The most basic application of the Sec. 941(a)(1) ETI rules generates an exclusion of the greater of (1) 1.2% of gross receipts from export sales or (2) 15% of the net income from export sales. The result is a reduction in the tax rate applicable to income from export sales, in the range of 5%10%.

The ETI exclusion applies to export sales of qualifying foreign trade property, defined by Sec. 943(a)(1) as property manufactured, produced, grown or extracted that does not consist of foreign content exceeding 50% of its fair market value. Also, under Sec. 942(b) and (c), for entities with annual export sales in excess of $5 million, certain economic processes must occur outside the U.S. for gross receipts from export sales to qualify for the ETI exclusion.

IC-DISC

An IC-DISC is a domestic corporation whose income is derived predominantly from export sales and rentals. The IC-DISC itself is not subject to income tax; however, the shareholders can be taxed on the IC-DISCs income on an actual or constructive distribution. The exporter (generally a closely held C corporation, an S corporation, limited liability company (LLC) or partnership) pays commissions to the IC-DISC, which is owned by the exporters shareholders or partners.

Because dividend distributions to a C shareholder are taxed at normal corporate tax rates, the double tax attributable to IC-DISC earnings results in a combined corporate
and individual tax rate on IC-DISC taxable distributions of approximately 43.9% (0.34 + ((1 0.34) x 0.15)). Alternatively, when an IC-DISC is owned directly by individuals, the companys income permanently avoids corporate taxation. Besides avoiding corporate level tax, dividend distributions to individual IC-DISC shareholders will generally be subject to tax at the current 15% rate, provided the Sec. 1(h) requirements are satisfied.

Qualification

To qualify as an IC-DISC, a corporation must meet the following requirements under Sec. 992(a):

1. At least 95% of its gross receipts are qualified export receipts (as defined in Sec. 993(f));

2. At least 95% of its assets (measured by adjusted basis) at the close of its tax year must be qualified export assets;

3. It does not have more than one class of stock;

4. It has minimum capital of $2,500 on each day of the tax year (at par or stated valuenot market value);

5. It elects to be treated as an IC-DISC and such election is in effect for the tax year.

Tax Benefits

As an IC-DISC, a company can obtain a partial deferral of tax on income from export sales and certain services, if 95% of its receipts and assets are export-related. Generally, in the case of individual IC-DISC shareholders, all income attributable to $10 million or less of qualified export receipts is deferrable. Under Sec. 995(b)(1)(F), corporate shareholders, however, may defer only ¹⁶/17 of IC-DISC income attributable to $10 million or less of qualified export receipts. An interest charge will be imposed under Sec. 995(f) on both corporate and individual IC-DISC shareholders, based on the amount of tax that would have been due had the deferred income been distributed. Under Sec. 995(b)(1)(E), IC-DISC income attributable to qualified export receipts in excess of $10 million will be deemed distributed and taxed directly to IC-DISC shareholders. IC-DISC income taxed directly to shareholders, certain other constructive distributions and actual distributions to shareholders are treated as dividends, but, in the case of actual distributions, only to the extent that they exceed income previously taxed directly to shareholders.

According to Sec. 995(b)(1), an IC-DISC shareholder is treated as having received a distribution taxable as a dividend in an amount equal to his or her pro rata share of:

1. The gross interest derived from producers loans (loans from the tax-deferred funds of a IC-DISC to a U.S. producer of products sold or leased outside of the U.S. by the IC-DISC);

2. The gain recognized on the sale or exchange of property, other than qualified export property;

3. The gain recognized on the sale or exchange of certain assets with recapture potential (whether or not qualified export assets);

4. One-half of the IC-DISCs taxable income from sales of military property;

5. The taxable income attributable to qualified export receipts in excess of $10 million;

6. The sum of (i) in the case of a C shareholder, ¹/17 of the excess of the IC-DISCs taxable income for the tax year (before reduction for any distribution during the year) over the amounts deemed distributed in 15 above; (ii) ¹⁶/17 of the excess taxable income referred to in (i), multiplied by the Sec. 999 international boycott factor; and (iii) any illegal bribe, kickback or other illegal payment made by the IC-DISC;

7. The amount of foreign investment attributable to producers loans; and

8. The distributions deemed made when a IC-DISC either revokes its election or fails to qualify as a IC-DISC.

Administrative Pricing Rules

To compute the income from export sales attributable to an IC-DISC (i.e., the DISC commission), certain administrative pricing rules have to be followed. These are similar to the rules provided for the ETI exclusion; however, the allowable percentages are significantly different. Generally, under Regs. Sec. 1.994-1(c)(2) and (3), an IC-DISC can earn income equal to the greater of the following:

1. 4% method: 4% of the qualified export receipts derived from the resale of the property by the IC-DISC, plus 10% of the export promotion expenses incurred by the IC-DISC allocable to such receipts. (Compare to 1.2% of the qualified export receipts for the ETI exclusion.);

2. 50-50 combined taxable income method: 50% of the combined taxable income derived by both the seller and the IC-DISC from the sale and resale of the property, attributable to the qualified export receipts, plus 10% of the export promotion expenses incurred by the IC-DISC allocable to the receipts. (Compare to 15% of the combined taxable income from qualified export receipts for the ETI exclusion.).

The profit attributable to the IC-DISC using the 4% method cannot be greater than 100% of the combined taxable income from export sales.

Exhibits 1 and 2 below illustrate how, for both a closely held C corporation and an LLC, the administrative pricing rules applicable to the IC-DISC clearly result in a much larger deduction to the exporter than the ETI exclusion.

The IC-DISC triggers significant tax savings. For the C corporation (Exhibit 1), it results in a 7.2% reduction in the total effective tax rate, compared to a 2.2% reduction using the ETI exclusion. For the LLC (Exhibit 2), the IC-DISC results in a 5% reduction in the total effective tax rate, compared to a 2.4% reduction using the ETI exclusion.

Conclusion

An IC-DISC can be a useful tool to reduce the effective tax rate on income from export sales. Given the uncertain future of the ETI exclusion, now may be the time to consider the IC-DISC alternative.

From Michael W. Granberg, CPA, Oak Brook, IL