Since the reduction in the individual tax rate on qualified dividends in 2004, the Interest Charge Domestic Sales Corporation (“IC-DISC”) has become an attractive vehicle to obtain a tax incentive for exporting U.S.-produced goods. For individual U.S. and foreign taxpayers, the use of an IC-DISC reduces tax liability by converting a portion of the export income, normally taxable at ordinary income rates of up to 39.6%, into qualified dividend income, generally taxable at rates up to 20%. For foreign taxpayers residing in treaty jurisdictions, however, the benefits may be even greater. If the dividends are subject to a relatively low rate in the foreign jurisdiction, a foreign individual could reap a considerable tax benefit by reducing the taxable income of the U.S. exporter company, while receiving dividends subject to tax at a reduced rate under the treaty.
An IC-DISC is a tax-exempt domestic corporation generally set up by the exporter company to receive commissions on the exporter company’s sales. The IC-DISC is required to maintain a separate bank account, keep separate accounting records, and file an annual U.S. income tax return. It is not, however, required to maintain an office, employees, own tangible assets, or perform any services. The types of businesses that typically benefit from an IC-DISC structure are manufacturers that directly export their products, manufacturers that sell component parts that are included in exported products, and architectural and engineering firms that work on projects that will be constructed abroad (even though the services may be performed in the United States).
Qualifying as an IC-DISC
To qualify as an IC-DISC a domestic corporation must file an election with the IRS to be treated as an IC-DISC for U.S. federal income tax purposes. In addition, the corporation must have only a single class of stock, maintain a minimum capitalization of $2,500 of authorized and issued shares, and meet an annual qualified export receipts test and a qualified export assets test. In order to meet the qualified export receipts and qualified export assets tests, at least 95% of the IC-DISC’s gross receipts and assets must be related to the export of U.S. manufactured property whose value is at least 50% attributable to U.S.-produced content. Engineering and architectural services related to construction projects outside the United States may also generate qualified export receipts.
IC-DISC Tax Benefits
Under an IC-DISC structure, an exporter company sets up an IC-DISC owned either by the exporter company itself (if it is a flow-through entity) or by the shareholders of the exporter company (if it is a corporation). The exporter company pays commissions to the IC-DISC equal to the higher of: (i) 4% of the gross receipts from qualified exports, or (ii) 50% of the net income from qualified exports. The commissions are tax-deductible to the exporter company and can be used to reduce the exporter’s taxable income at rates up to 39.6%. The IC-DISC, as a tax-exempt entity, pays no tax on the commission income.
The IC-DISC can then either defer taxation on the commission income (up to $10,000,000) or distribute the income to its shareholders. If the income is deferred, the IC-DISC shareholders are required to pay only a nominal interest charge to the IRS with respect to taxes that are deferred on the IC-DISC’s income. Alternatively, the IC-DISC can distribute the commission income to its shareholders as a dividend. If those shareholders are U.S. individual taxpayers, they will be subject to tax at the qualified dividend rate of up to 20% (plus an additional 3.8% tax which applies to net investment income if the taxpayer’s adjusted gross income exceeds certain thresholds).
IC-DISC Taxation of Foreign Persons
Foreign persons are generally subject to U.S. federal income tax in one of two ways. First, if a foreign person carries on a trade or business in the United States, U.S. federal income tax is imposed on all taxable income that is effectively connected with that U.S. trade or business (“ECI”). In addition, income of a foreign person which is not effectively connected with a U.S. trade or business is subject to U.S. federal income tax if it is considered to be from sources within the United States and is of certain classes of income known as “fixed or determinable, annual or periodical” (“FDAP”) income. FDAP income includes, for example, interest, dividends, rents, and royalties.
By definition, foreign persons are subject to tax on FDAP income only if it is U.S.-source income. Likewise, even when a foreign person carries on a trade or business in the United States, foreign-source income is generally not treated as ECI as long as property is sold for use outside of the United States. Thus, under many circumstances, foreign-source income escapes taxation completely. While Section 861(a)(2)(D) treats dividends received from DISCs that are attributable to export sales as foreign source income for U.S. shareholders for foreign tax credit purposes, Section 996(g) provides that in the case of a foreign shareholder, all DISC distributions are treated as ECI earned through a permanent establishment and derived from sources within the United States. Consequently, dividends received by foreign shareholders from an IC-DISC will be subject to tax at the usual marginal tax rates applicable to U.S. taxpayers, which means that foreign individuals are eligible for the same qualified dividend rates of up to 20%.
Tax treaty provisions may, however, apply to reduce dividend taxation, in many cases to as low as 5%. There is nothing in the IC-DISC provisions or the legislative history which specifically states that the IC-DISC rules are intended to override subsequent federal income tax treaties. A number of treaties have since come into effect containing provisions that are inconsistent with the IC-DISC concept of deemed permanent establishment. Under those treaties, there can be no permanent establishment in the absence of an actual physical presence in the United States. As a result, the language in the IC-DISC rules which deems a foreign person to have a permanent establishment in the United States may be inconsistent with the treaty and thus overruled by the treaty. Whether a specific treaty overrides the IC-DISC deemed permanent establishment rule must be determined on a case-by-case basis. If the treaty’s language does prevent a permanent establishment, the treaty’s regular dividend provisions should apply, which would reduce the U.S. income tax on dividends to as low as 5%.