The interest charge domestic international sales corporation, or IC-DISC, regime was enacted nearly 50 years ago to promote the exporting activities of certain U.S. businesses. Its benefits have included tax deferral and reduced income taxation, and were mainly targeted to smaller exporters. The Tax Cuts and Jobs Act made a number of changes to the Internal Revenue Code that affect the taxation of U.S. exporting businesses, leading some tax practitioners to question the continued relevance of the IC-DISC. However, the IC-DISC continues to provide income tax benefits for smaller exporters, and the talk of its demise is premature.
Background of IC-DISC
The IC-DISC can be traced back to 1971 when Congress enacted the DISC regime to promote the export of domestically produced goods by U.S. businesses. The DISC provisions, which required the organization of a separate corporation, allowed U.S. exporters to defer the tax on income earned by an exporting corporation until said income was distributed to its shareholders.
The DISC provisions were revised in 1984 as a result of pressure from foreign governments that complained the regime was an export subsidy in violation of international law. This resulted in the current IC-DISC regime, which introduced an interest charge on the profits that were generated by the DISC but not distributed to its shareholders. While the TCJA included changes that affect the taxation of U.S. exporting businesses, it did not specifically make any changes to the IC-DISC provisions — although an earlier draft version of the bill considered repealing it altogether.
Mechanics of IC-DISC
To benefit from an IC-DISC, U.S. exporters must utilize two distinct entities: an operating entity that already serves as an exporter of goods and a separate IC-DISC. An IC-DISC is essentially a shell corporation organized under U.S. law that has made an election to be taxed under a special tax regime. Its earnings are nothing more than a commission paid by the related operating entity to the IC-DISC. The related operating entity claims a tax deduction on the commission paid to the IC-DISC. The IC-DISC is not subject to income tax on the commission it generates but rather, such earnings generated by the IC-DISC are taxed when they are distributed to its shareholders.
Prior to the TCJA, individual shareholders paid income tax on distributions from an IC-DISC at qualified dividend rates (between 20 percent and 23.8 percent)  instead of the ordinary rates (39.6 percent). Accordingly, a qualifying exporter implementing an IC-DISC structure could reduce its effective income tax rate from a 39.6 percent rate to 23.8 percent rate, a savings of 15.8 percent.
However, the benefits of an IC-DISC are limited in some respects. For example, the ICDISC provisions require that the export income be generated from the sale of products produced in the United States. The “foreign content” provision requires that the cost of foreign content used to manufacture a product not exceed 50 percent of the cost of the exported property. Finally, the IC-DISC provisions restrict the benefits as relates to the export of services.
Impact of TCJA on U.S. exporters
The TCJA is the most sweeping change to U.S. tax law since the Tax Reform Act of 1986. Effective Jan. 1, 2018, the TCJA revised three areas that affect U.S. exporters and the way the United States taxes their income. First, the TCJA reduced the tax rates applicable to certain taxpayers. For example, the individual income tax rate was reduced from a top rate of 39.6 percent to 37 percent. Further, the federal corporate income tax rate was reduced from a top rate of 35 percent to a flat 21 percent rate. Although a subchapter C corporation is subject to double taxation, the lower rate may make a corporation a more palatable structure choice from a business tax planning perspective.
Second, Congress introduced a deduction for Foreign Derived Intangible Incom, or FDII. The FDII deduction is equal to 37.5 percent of a subchapter C corporation’s income generated within the United States, and results in an effective tax rate of 13.125 percent on qualifying income. Unlike the IC-DISC provisions, FDII does not contain the restrictions that require that products be manufactured and substantially improved in the United States. For example, a pure U.S. distributor that purchases goods from a foreign manufacturer and sells the product for consumption outside the United States could qualify for FDII benefits. Finally, and to provide a tax benefit to noncorporate taxpayers, the TCJA introduced a deduction for Qualified Business Income, or QBI, for owners of certain pass-through entities, including subchapter S corporations, partnerships and some limited liability companies. The QBI deduction is equal to 20 percent of an individual’s taxable income from certain business activities conducted within the United States, resulting in an effective tax rate of 29.6 percent on qualifying income. There are restrictions on the availability of the deduction to the extent the taxpayer’s adjusted income exceeds a threshold and/or the taxpayer is engaged in certain service-related industries.
Future of IC-DISC
Prior to the TCJA, an individual shareholder utilizing an IC-DISC was subject to income tax on export sales at a 23.8 percent effective tax rate. This reduced the shareholder’s effective
tax rate on qualified export income by 15.8 percent. Starting Jan. 1, 2018, the tax savings have decreased to 13.2 percent — i.e., regular 37 percent rate minus the 23.8 percent effective tax rate. The tax savings further have decreased to 5.8 percent, presuming the individual could benefit from the QBI deduction — i.e., 29.6 percent QBI effective rate less the 23.8 percent effective tax rate. However, the QBI deduction has a myriad of requirements, which makes achieving the 29.6 percent rate easier said than done.
Companies could use a subchapter C corporation and the FDII deduction to achieve a corporate tax rate of 13.125 percent and some deferral until the earnings are ultimately distributed to the corporation’s shareholders. Once a distribution is made, the overall effective tax rate increases to 33.8 percent — i.e., 13.125 percent corporate rate plus subsequent 23.8 percent tax upon a distribution by the corporation. Please note that state taxation may result in even a higher effective tax rate.
The TCJA represents broad tax reform that has affected the manner in which U.S. exporters are taxed. The reduction of the subchapter C corporation income tax rate, introduction of FDII deduction and introduction of the QBI deduction are new provisions that U.S. exporters should consider, especially if they cannot meet the current requirements of the IC-DISC. Notwithstanding, the IC-DISC continues to be a tax efficient manner for structuring U.S. exports and U.S. exporters should speak with an international tax adviser to determine which tax provisions and structures may be most beneficial for their business.