Tax incentives for exporters.
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.
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-DISC's 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 exporter's 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 (1.15)). Alternatively, when an IC-DISC; is owned directly by individuals, the company's 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.
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 value--not market value);
5. It elects to be treated as an IC-DISC and such election is in effect for the tax year.
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 producer's 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-DISC's 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 DISC's taxable income for the tax year (before reduction for any distribution during the year) over the amounts deemed distributed in 1-5 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 producer's 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 on p. 543 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 saving. 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.
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.
Exhibit 1: Total tax for closely held C corporation Qualified export receipts = $200,000 Combined taxable income from qualified export receipts = $50,000 All after-tax income is distributed to shareholders. The highest tax rates apply. Total ETI IC-DISC Taxable income before ETI exclusion/DISC $100,000 $100,000 $100,000 DISC/ETI exclusion deduction 0 (7,500) (25,000) Taxable income $100,000 $92,500 $75,000 Corporate tax (34%) 34,000 31,450 25,500 Individual tax (15%) 9,900 10,283 11,175 Total tax $43,900 $41,733 $36,675 Effective tax rate 43.9% 41.733% 36.675% Exhibit 2: Total tax for LLC Qualified export receipts = $200,000 Combined taxable income from qualified export receipts = $50,000 All after-tax income is distributed to shareholders. The highest tax rates apply. Total ETI IC-DISC Taxable income before ETI exclusion/DISC $100,000 $100,000 $100,000 DISC/ETI exclusion deduction 0 (7,500) (25,000) Taxable income $100,000 $92,500 $75,000 Individual tax: LLC income (35%) $35,000 $32,375 $26,250 DISC distribution (15%) 0 0 3750 Total tax $35,000 $32,375 $30,000 Effective tax rate 35% 32.375% 30% Exhibit: Countries having totalization agreements with the U.S. 1. Australia 2. Austria 3. Belgium 4. Canada 5. Chile 6. Finland 7. France 8. Germany 9. Greece 10. Ireland 11. Italy 12. Luxembourg 13. Netherlands 14. Norway 15. Portugal 16. South Korea 17. Spain 18. Sweden 19. Switzerland 20. U.K. Source: www.saa.gov/international/agreements_overview.html.
FROM MICHAEL W. GRANBERG, CPA, OAK BROOK, IL
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|Author:||Granberg, Michael W.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2004|
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