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USA: Interest-Charge Domestic International Sales Corporations

An interest-charge domestic international sales corporation (IC-DISC) can be a powerful tax savings opportunity for many companies exporting products. An IC-DISC is a domestic corporation that primarily engages in foreign sales and exporting activity. Many years ago, the U.S. government created this law as a means to promote U.S. business activities it deemed economically beneficial. In today’s competitive global landscape, any cost-saving measures are coveted. The beauty of the IC-DISC structure is that in order to capture the tax benefits, very little, if any, change is required from how your business is already being conducted. In general, the structure is invisible to your customers, but the benefits can save you money.

Why an IC-DISC is a smart choice now?

In its current form, the IC-DISC provides a permanent federal income tax saving of nearly 16 percentage points for qualifying U.S. exporters1. Some of these savings can be further parlayed through the deferral mechanisms that have been mainstays of the IC-DISC rules for many years.

The IC-DISC is not a listed or reportable transaction. In fact, former regulations specifically acknowledged that IC-DISCs were not tax shelters. Regarded by tax practitioners as a somewhat lackluster tax-deferral vehicle, the IC-DISC largely went ignored for more than 20 years. But, the introduction of the reduced tax rate for qualified dividends under the Jobs and Growth Tax Relief Reconciliation Act of 2003, as currently extended through the American Taxpayer Relief Act of 2012, has resuscitated the IC-DISC.

The IC-DISC also has number of sophisticated features that can be tailored to help businesses meet objectives and goals. Some IC-DISC advantages and benefits include:

  • Permanent tax savings on export sales
  • Increased liquidity for shareholders or the business
  • Ability to leverage cost of capital
  • Opportunities to create management incentives
  • Means to facilitate succession or estate planning

In addition to other attributes, the IC-DISC has better staying power than the other export-oriented tax regimes. U.S. trading partners decried the legitimacy of the original DISC, the foreign sales corporation and the extraterritorial income (ETI) exclusion. However, the IC-DISC, which was added to the tax code in 1984, has not been challenged.

IC-DISC structure

The typical IC-DISC structure involves internal computations and support but does not affect how the exporter deals with its customers and suppliers. An IC-DISC requires the formation of an on-shore corporation with minimal capital, contractual agreements to formalise the IC-DISC’s relationship with the exporter, and submission of an initial tax election and subsequent annual tax returns. The IC-DISC does not have to generate customer invoices, lease office space, employ personnel or invest in fixed assets.

An important feature of the IC-DISC is that there is no limitation on who can own it. Shareholders can be C corporations, S corporations, limited liability companies, partnerships, trusts, individuals or any combination of these. In addition, foreign entities or individuals can be IC-DISC shareholders, but special rules apply to the taxation of IC-DISC dividends paid to a foreign owner.

How an IC-DISC  works

  • The exporting company or its shareholders create a domestic corporation to become the IC-DISC.
  • The shareholders of the corporation elect IC-DISC status.
  • The exporting company pays the IC-DISC a commission based on the profitability of the export sales. The size of the commission is determined under specific statutory rules.
  • The exporting company deducts the commission owed to the IC-DISC from its ordinary income, which is taxed at a maximum federal rate of 39.6 percent.
  • The IC-DISC pays no federal income tax on the commission received from the exporting company. IC-DISCs are a special class of tax–exempt entity.
  • Shareholders that are individuals or trusts pay federal income tax on dividends at a maximum rate of 23.8 percent.
  • The result can be up to a 15.8 percentage point federal tax savings on IC-DISC commissions.2

This diagram illustrates the structure and operation of a typical shareholder-owned IC-DISC. Where the exporter is a pass-through entity, it will often be the sole shareholder of the IC-DISC.This diagram illustrates the structure and operation of a typical shareholder-owned IC-DISC. Where the exporter is a pass-through entity, it will often be the sole shareholder of the IC-DISC.

What an IC-DISC can do for your business

IC-DISC shareholdings can be used in a number of ways to help achieve business goals and objectives. The following are some of the advantages and benefits provided by an IC-DISC.

Generate permanent tax savings on export sales

Permanent tax savings begin with the exporting company deducting the commission it pays to the IC-DISC from its ordinary income, which is taxed at 39.6 percent. Tax law generally sets the commission  rate as the greater of either 50 percent of taxable income from the export sale or four percent of gross receipts, limited to 100 percent of net income from the export sale, although there are even methods that allow a commission to be paid on transactions that are not profitable.

Because the IC-DISC is tax-exempt, tax is paid only on distributions to shareholders. Individual shareholders pay federal income tax on dividends at a maximum of 23.8 percent. C corporations are fully taxed on dividends they receive from IC-DISCSs. Therefore, special considerations apply in determining who should own the IC-DISC when the exporter is a C corporation.

The example overleaf illustrates how a 15.8 percent point tax rate arbitrage creates a permanent tax benefit of over USD 125,000 on an IC-DISC commission of USD 800,000.

Make dividends paid by a C corporation tax-deductible

C corporations, especially closely held C corporations, can obtain a permanent tax saving for payments that would otherwise be made as dividends. Provided the C corporation has sufficient profits from its exporting activities, a sister IC-DISC can earn a commission equal to the payments otherwise earmarked as dividends. Thus, an otherwise non-deductible dividend payment can be converted to a tax-deductible commission expense, while receipt of the dividend payment by the shareholders is taxed the same whether received from a C corporation or an IC-DISC.

Enhance shareholders’ utilization of certain foreign tax credits

Even though an IC-DISC is a domestic corporation, when the IC-DISC’s only receipts consist of commissions and interest, dividends from an IC-DISC  constitute passive basket foreign source income in the hands of shareholders that are U.S. persons.

Increase liquidity for shareholders or the business

Shareholders who need to rebalance their investment risk profiles can, in most cases, use the IC-DISC to gain additional liquidity. By extracting cash in this tax-advantaged manner, they can deploy resources pursuant to their investment risk profiles.

Reduce after-tax cost of capital

An IC-DISC can also be used as a deferral tool to leverage a company’s cost of capital. IC-DISC earnings need not be entirely distributed to shareholders – they can be used to parlay savings created by the lower tax rate applicable to qualified dividends.

One method of parlaying tax savings is to lend accumulated IC-DISC earnings back to the exporting company in return for a note and interest in the form of a producer’s loan. The exporting company can deduct the interest expense, and interest income is considered a dividend to the IC-DISC shareholders. Reinvesting IC-DISC earnings back into exporting business results in additional tax-rate savings and diminishes the group’s cost of capital. There are limitations, however, on the size and use of a producer’s loan.

IC-DISC net federal tax savingsIC-DISC net federal tax savings

Create management incentives

Businesses can use ownership in the IC-DISC to provide incentives. Exporting company management and other personnel can be named shareholders, allowing them to benefit from additional cash flow created by increasing global sales.

Facilitate succession planning

An IC-DISC offers a number of capabilities for executing a succession plan. Among these, ownership in the IC-DISC can be used as a means of generating cash, which can be distributed to shareholders in a tax-advantaged manner. IC-DISC shareholders participating in a buyout of current or previous shareholders can leverage these tax-advantaged IC-DISC earnings to pursue the buyout plan. Alternatively, IC-DISC shares could be used as a method of freezing value.

Interaction with domestic production activities deduction (DPAD)

There is no prohibition against utilizing an IC-DISC and also claiming the DPAD on qualifying domestic production activities. With respect to a product or service that otherwise meets all the respective applicable requirements, export sales qualify for export-related tax benefits based on where the product is used, consumed or disposed of, whereas any sale-export or domestic – qualifies for domestic production-related benefits based on where production occurs.

With the American Taxpayer Relief Act of 2012 permanently extending federal tax rates on qualified dividends at 20 percent (plus the 3.8 percent net investment income tax, when applicable), the question of the future utility of the IC-DISC has been settled. As a result, those companies that do not currently have an IC-DISC should review the potential benefits of using one.

Create management incentives

Businesses can use ownership in the IC-DISC to provide incentives. Exporting company management and other personnel can be named shareholders, allowing them to benefit from additional cash flow created by increasing global sales.

Facilitate succession planning

An IC-DISC offers a number of capabilities for executing a succession plan. Among these, ownership in the IC-DISC can be used as a means of generating cash, which can be distributed to shareholders in a tax-advantaged manner. IC-DISC shareholders participating in a buyout of current or previous shareholders can leverage these tax-advantaged IC-DISC earnings to pursue the buyout plan. Alternatively, IC-DISC shares could be used as a method of freezing value.

Interaction with domestic production activities deduction (DPAD)

There is no prohibition against utilizing an IC-DISC and also claiming the DPAD on qualifying domestic production activities. With respect to a product or service that otherwise meets all the respective applicable requirements, export sales qualify for export-related tax benefits based on where the product is used, consumed or disposed of, whereas any sale-export or domestic – qualifies for domestic production-related benefits based on where production occurs.

With the American Taxpayer Relief Act of 2012 permanently extending federal tax rates on qualified dividends at 20 percent (plus the 3.8 percent net investment income tax, when applicable), the question of the future utility of the IC-DISC has been settled. As a result, those companies that do not currently have an IC-DISC should review the potential benefits of using one.

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