Exporters, Other Businesses May Combine Tax Incentives to Yield Substantial Savings by James W. Spencer. CPA
Posted on December 10, 2018
Tax reform’s aim to protect the US tax base and prevent domestic companies from shifting jobs, manufacturing and profits to lower tax jurisdictions overseas resulted in a significant benefit to export businesses. Not only does the new law preserve the preferential tax treatment of Interest Charge-Domestic International Sales Corporation (IC-DISC), it also introduces a new tax incentive for C corporations that sell American-made goods or services to foreign customers for consumption outside of the U.S.
Interest Charge-Domestic International Sales Corporation (IC-DISC)
U.S. businesses that sell, lease or distribute goods made in the US to customers in foreign countries may realize significant tax benefits when they create an IC-DISC to act as their foreign sales agent to which they pay commission as high as 4 percent of gross receipts or 50 percent of taxable income from the sale of export property.
Essentially, a qualifying business forms the IC-DISC as a separate US-based “paper” company, typically with no offices, employees or tangible assets, to receive tax-free commissions that the business can claim as deductions that ultimately reduce its taxable income. The amount of the tax savings the business may reap for the commission it pays to the IC-DISC can be as high as 37 percent, depending on its structure (21 percent for C corporations beginning in 2018) and its source of income. Only when the IC-DISC distributes earnings to shareholders will there be a taxable event. At that time, the shareholders will be liable for paying taxes on the IC-DISC earnings at lower qualified dividend rates not to exceed 23.8 percent.
While businesses that make IC-DISC elections are most commonly exporters and distributors of U.S.-manufactured products or their components, software companies, architects, engineers and other contractors who provide certain limited types of services overseas may also qualify to take advantage of this permanent tax benefit.
Foreign Derived Intangible Income (FDII)
To encourage U.S. corporations to keep their exporting operations and profits in the country, the TCJA introduces a new tax-savings opportunity in the form of a deduction of as much as 37.5 percent on profits earned from Foreign Derived Intangible Income (FDII).
This new concept of FDII is defined as income C corporations earn from (1) sales or other dispositions of property to a foreign person for a foreign use; (2) an IP license granted to foreign person for a foreign use; and (3) services provided to a person located outside of the U.S. The types of services that qualify for FDII are not severely restricted, like they are for IC-DISC applications.
Under the law, FDII earned after Dec. 31, 2017, is subject to an effective tax rate of 13.125 percent until 2025, when the rate is scheduled to increase to 16.046 percent for a total FDII deduction of 21.87 percent. That’s quite an incentive for domestic businesses to use the U.S. as its export hub and distribute products made in the country to foreign parties located outside the country!
It is important to note that like most provisions of the tax code, the FDII deduction is subject to a number of restrictions and calculation challenges. For example, it applies only to domestic C corporations, which under the TCJA are subject to a permanent 21 percent income tax rate beginning in 2018, down from 35 percent before tax reform. In addition, the amount of the deduction is reduced annually by 10 percent of the corporation’s adjusted basis of depreciable tangible assets used to produce FDII.
Corporate taxpayers that combine the benefits of an IC-DISC and the new FDII deduction may receive enhanced tax savings. However, every business entity is unique and not all businesses will qualify to apply the benefits of both export tax incentives. However, with proper planning under the guidance of experienced tax professionals, businesses can maximize the benefits that are available to them.
For example, an S corporation or LLC with an IC-DISC may not realize the added tax savings of the FDII deduction, which is only available to C corporations. While an S corporation may consider changing its entity structure to a C corporation to take advantage of the lower tax rate, it must first consider its unique business goals and weigh them in context against all of the new provisions of the new tax code, which will affect the tax liabilities of both the business and its shareholders.
Companies doing business across borders can successful plan around the new provisions of tax law with the strategic counsel and guidance of knowledgeable advisors and accountants with deep experience in these matters.
About the Author: James W. Spencer, CPA, is a director of International Tax Services with Berkowitz Pollack Brant, where he focuses on a wide range of pre-immigration, IC-DISC, transfer pricing and international tax consulting issues for individuals and businesses. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service