Posted: 1:14 pm Wed, December 19, 2012
By Finance and Commerce 1:14 pm Wed, December 19, 2012
Containers are stacked and ready for export at the Port of Long Beach, Calif., in this 2009 photo. (AP FILE PHOTO)
Editor?s note: John Middleton is an international tax manager at Baker Tilly Virchow Krause LLP in Minneapolis.
Over the past decade, most of the export incentives for companies in the United States have been repealed.
Currently, there is one export incentive for businesses intact through Dec. 31, 2012: the Interest Charge ? Domestic International Sales Corporation (or IC-DISC). But the IC-DISC benefits enjoyed by the U.S. taxpayer may be reduced, or altogether eliminated, as a result of the Obama administration?s plan to increase qualified dividend rates for taxpayers with income exceeding $200,000.
Essentially, an IC-DISC is a tax-exempt entity, which is paid a commission from the U.S. exporter for exporting its products into foreign countries. The tax benefit to the U.S. exporter is the ability to deduct the commission payment to the IC-DISC at a 35 percent rate. The commission paid to the IC-DISC is then distributed by the IC-DISC to its individual shareholders at a 15 percent rate. In other words, there is a permanent tax savings of 20 percent on the commission payment.
In the alternative, the commission income may also be accumulated and remain deferred from taxation in the IC-DISC. The IC-DISC shareholders are required to pay interest (to the IRS) on any accumulated IC-DISC income. IC-DISC income deferral is allowable on annual export sales up to $10 million.
President Barack Obama has stated he plans to maintain the qualified dividend rate at 15 percent for taxpayers with income levels below $200,000, and raise the tax rate to ordinary income rates for taxpayers earning greater than $200,000 (ranging anywhere from 20 percent to 39.6 percent).? Keep in mind, the Medicare tax of 3.8 percent on net investment income in 2013 will be a tax added on top of the ordinary income tax rate (i.e., the highest rate could be 43.4 percent).
Given the fact that a majority of small and medium size manufacturing businesses operate through an IC-DISC, and the individual shareholders have earnings above the $200,000 threshold level, the tax incentive to invest in an IC-DISC would greatly diminish. As a result, shareholders of IC-DISCs are being advised to make dividend distributions by Dec. 31, 2012, to maximize the permanent tax savings.
If the preferential tax rate on dividends does change to reflect ordinary tax rates, there are certain benefits the IC-DISC can still offer to taxpayers earning income higher than $200,000.
C Corporation as the IC-DISC shareholder
Assuming the preferential treatment on dividends is significantly reduced or eliminated, a C Corporation can still make deductible dividend payments, but the income taxed to the shareholders will be at ordinary income tax rates plus the Medicare tax of 3.8 percent.
Deferral of IC-DISC earnings
The benefit of deferral of IC-DISC earnings is that it can act as loan to the shareholder.? Specifically, when a corporation takes a deduction for the commission payment to the IC-DISC and the IC-DISC defers a dividend payment, there are certain tax savings generated by the commission deduction. These tax savings can be used by the taxpayer in a variety of different ways. When dividends are deferred, there is an interest charge to the shareholders, but the current interest charge is less than 1 percent.
Corporations with non-U.S. (or foreign) shareholders
A dividend paid to foreign shareholders may provide preferential treatment in limited circumstances. It is possible to have an IC-DISC owned by foreign shareholders, but whether there is an overall benefit requires significant analysis. In general, when a dividend is paid to a foreign shareholder, not only is it a nondeductible expense in the U.S., it is most likely subject to withholding tax.
When the IC-DISC is held by foreign shareholders, the commission payment to the IC-DISC is deductible and is paid to the foreign shareholders as a dividend. Certain U.S. tax treaties can either significantly reduce, or completely eliminate, the withholding tax on dividend payments to foreign countries. Therefore, the overall benefit is a deductible dividend less the withholding tax paid, unless there is foreign tax credit available in the foreign shareholders country of residence.
The next steps to be taken by U.S. manufacturers who have international sales is largely predicated upon what the tax rate on dividends will be following the sunset of the Bush-era tax cuts.
The advice for many small and medium size U.S. manufacturing companies is to distribute the IC-DISC earnings as dividends to the shareholders by Dec. 31, 2012. Then, it is a ?wait and see approach? as to whether the administration will extend the preferential rate on qualified dividends, increase the dividend rates to 20 percent to 25 percent, or simply have dividends taxed at ordinary income tax rates for taxpayers with income levels above $200,000. ?Stay tuned!
Disclaimer from the author: This article is not meant to be a technical analysis of current and proposed law. It is a general discussion and cautionary summary of the potential changes to the qualified dividend rates, which are set to expire on Dec. 31, and the impact on certain taxpayers should this preferential rate disappear.
John Middleton?s practice focuses on international tax services, including compliance, research and consulting. He can be reached at 612-876-4500 or john.middleton@bakertilly.com.
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