Foreign Income & Taxpayers
On March 12, the IRS released its advanced audit guide (LB&I-04-0212-003) for agents involved in examinations of interest charge domestic international sales corporations (IC-DISCs). IC-DISCs’ goal remains the same as when they were originally enacted in the early 1970s: to stimulate U.S. exports and motivate U.S. manufacturers to produce products domestically.
Prior to the reduction in the individual tax rates on qualified dividends in 2003 and the repeal of the extraterritorial income exclusion regimes in 2004, the IRS received a relatively small number of Forms 1120-IC-DISC, Interest Charge Domestic International Sales Corporation Return. Since then, the number of IC-DISC returns has increased significantly; in 2008 approximately 2,000 IC-DISC returns were filed. The IRS expects this number to continue to grow in future years, especially if the qualified dividend rates remain significantly lower than ordinary income rates.
Given its increasing use, the IC-DISC is now on the IRS radar screen, and the newly released audit guide gives IRS examiners a step-by-step procedure on how to audit these companies. The guide educates the examiners on the relevant Code sections, related regulations, and cases regarding IC-DISCs. Although an IRS audit guide cannot be cited as the basis for an adjustment, it does provide agents with the materials that can be cited and gives them a starting point for their audits as well as issues to red flag. Understanding what IRS examiners are looking for can help practitioners and their clients avoid surprises.
An IC-DISC is a domestic corporation that, under Sec. 991, is not subject to income tax. These corporations are now the only export tax incentive within the Code. One benefit that makes an IC-DISC attractive is its ability to defer income tax on export profits. Perhaps the most attractive benefit of the IC-DISC is that the owner of the IC-DISC is eligible for the lower qualified dividend tax rate on distributions (currently a top rate of 15%, which is set to expire after Dec. 31, 2012, and increase to as high as 43.4%).
To qualify as an IC-DISC, the taxpayer must meet the strict requirements of Sec. 992. The primary qualifications are:
- 95% or more of the corporation’s gross receipts must be qualified export receipts. This test is performed annually, as described in Regs. Sec. 1.993-1.
- The adjusted basis of the qualified export assets must be at least 95% of the sum of the adjusted bases of all assets of the corporation. This test must be satisfied on the last day of the tax year, as provided in Regs. Sec. 1.993-2.
- The corporation must have only one class of stock, with a par or stated value of $2,500 or more.
- The corporation must elect to be treated as an IC-DISC. This election requires unanimous consent from the shareholders and is filed on Form 4876-A, Election to Be Treated as an Interest Charge DISC.
If a domestic corporation qualifies and elects to be treated as an IC-DISC, it is permitted to defer up to $10 million of income derived from qualified export receipts. In addition, the related supplier receives a current tax deduction for the commission paid to the IC-DISC. Per Sec. 991, the IC-DISC pays no corporate income tax. The shareholders of the IC-DISC pay tax on deemed and actual distributions from the IC-DISC. When an IC-DISC shareholder is an individual or a flowthrough entity with individual owners, these owners currently derive tax savings because of the spread between the ordinary income rates and the qualified dividend rate. Currently, that tax savings is 20% (35% top ordinary rate – 15% top rate on qualified dividends).
If Congress raises the tax rate on qualified dividends or allows the Bush tax rates to expire after Dec. 31, 2012, this benefit may be eliminated or significantly reduced. On the downside, Sec. 995(f) provides that all IC-DISC shareholders must pay an interest charge on their portion of the IC-DISC–related deferred tax liability. The shareholder reports the interest charge on Form 8404, Interest Charge on DISC-Related Deferred Tax Liability, and does not change the shareholder’s basis in the corporation’s stock. Generally, these interest rates are very favorable to the taxpayer.
Under the audit guidelines, IRS examiners should first ensure that the IC-DISC properly elected IC-DISC treatment by filing Form 4876-A. A corporation that is making the election for its first tax year must file the form within the 90-day period after the beginning of the tax year. An existing corporation must file the form within 90 days preceding the first day of the first tax year to which the election applies. Further, the IC-DISC must choose the same tax year as the IC-DISC shareholder with the largest percentage of voting power (Sec. 441(h)). Proof of timely filing and mailing or an acknowledgment from the IRS should be sufficient to show that the corporation made a timely election. If the election was not timely or the electing corporation has operated on a nonconforming year end, the corporation does not qualify as an IC-DISC.
Next, the agent is instructed to review the history of the IC-DISC to determine whether the IC-DISC was previously audited. If so, the guidelines suggest that the previous audit results should be the starting point for the current examination.
Step three of the audit guide instructs agents to learn about the business of the IC-DISC and its related supplier. The guide says that agents should understand what the product is, where it is manufactured, and how and to whom it is sold. This background information enables agents to focus on the applicable regulations and whether the IC-DISC properly allocated expenses in determining its qualified export receipts.
The examiner is next instructed to request the tax return workpapers of the related supplier and the IC-DISC. The guide instructs agents to look at any divisional or separate product line income statements and balance sheets and the internal workpapers used to determine the expenses that were allocated to export vs. nonexport sales. Determining the related supplier’s net income attributable to export sales is critical in determining the commission the IC-DISC should have been charging to the related supplier.
The guidelines then instruct the examining agent to review the information from a broadly conceptual approach, keeping in mind whether (1) the workpapers and related Form 1120-IC-DISC, Schedules P, Intercompany Transfer Price or Commission, were prepared on a tax basis (as opposed to book basis); (2) the expense allocations are reasonable (i.e., large expenses not allocated to export income should be scrutinized); (3) the intercompany pricing rules of Sec. 994 have been followed; and (4) the allocations are made in accordance with Regs. Sec. 1.861-8. The result may require further analysis (e.g., if the IC-DISC’s profit on export sales far exceeded profits on sales of similar products sold in the United States by the supplier).
The guide also informs agents about other issues relevant to the examination. By the time examiners begin to look into the following five issues, they should already understand the rules regarding IC-DISCs as well as have a basic understanding of the taxpayer’s industry.
- Export property and qualified export receipts (QER): To determine whether the export property and the QER qualify under the Code and regulations, agents should request a description of the property sold, a description of the manufacturing process, a description of the movement of property from the related supplier to the customer, and a review of the customers and whether or not the property has returned or would be expected to return to the United States. The taxpayer must prove that the property was manufactured in the United States using less than 50% foreign components. The taxpayer must also meet the destination test and be able to prove through bills of lading or other documentation that the property was delivered for use or consumption outside the United States within one year of its manufacture. Especially for products sold through distributors, the destination test creates significant documentation requirements that can lead to complications upon examination.
- Computation of combined taxable income (CTI): Examiners are instructed to step back and look at the big picture when examining CTI. Among the most common areas of scrutiny is where a taxpayer has distorted its income through an unreasonable allocation of expenses.
- Grouping: Taxpayers can elect under Regs. Sec. 1.994-1 to compute IC-DISC taxable income on a group level instead of on a transaction-by-transaction basis. Examples of normal groups are groups of different products or product lines. The audit guide instructs the examiners to make sure the groups do not violate the Code or regulations dealing with the grouping of assets or are not one of the specific groups that are disallowed under Regs. Sec. 1.994-1(d)(3)(ii).
- IC-DISC claims: IC-DISC claims are reviewed to make sure they were timely filed and are consistent with the Code and regulations. Claims that the guide specifically mentions deal with IC-DISCs that change their groups, ungroup, or add sales to the IC-DISC.
- No netting of interest for overlapping periods of tax overpayments and underpayments: The guide clarifies that when a change is made to the IC-DISC commission income and the related supplier’s commission expenses, the change generates both a refund and a deficiency, but since these entities are separate taxpayers, they are not allowed to net the refund with the deficiency.
For U.S. companies that earn significant revenue through export sales operations, an IC-DISC can be a beneficial tax planning device. Because of the increased number of IC-DISC returns being filed, the IRS is now planning to audit these returns in greater detail, making sure that taxpayers are following all of the strict statutory and regulatory requirements. Whether taxpayers are planning to form an IC-DISC, currently operating one, or are already subject to an IC-DISC audit, the newly released audit guidelines can help them prepare for an examination.
Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.
For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.