If U.S. tax rates increase, how would this affect the U.S. export tax incentives known as the foreign-derived intangible income (FDII) deduction and the interest charge domestic international sales corporation (IC-DISC) regime? What steps should U.S. exporters consider taking to maximize the benefit of these tax breaks in a higher-tax environment? These questions are the focus of this article.
At the time of this writing, it is unknown what tax changes might be enacted. On various occasions, President Joe Biden's administration has proposed raising the federal corporate income tax rate to 28% from 21%, as well as doubling the effective federal corporate income tax rate on global intangible low-taxed income (GILTI) from 10.5% to 21%. Proposed changes affecting business owners notably include an increase in the federal tax rate on capital gains to 37% for taxpayers with adjusted gross income of over $1 million, a phaseout of the 20% qualified business income (QBI) deduction for taxpayers earning more than $400,000 a year, and the elimination of the cap on the wage base for Social Security taxes, which are currently paid on only the first $142,800 in wages for 2021.
If the federal corporate income tax rate increases, the formula used in computing the FDII deduction means that a taxpayer's FDII would have a higher effective tax rate.
While the Biden administration has proposed eliminating the FDII deduction, which was introduced as part of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, it is unknown as of the time of this writing how this proposal will fare. The administration has stated that it believes the FDII deduction is ineffective at incentivizing corporations to invest in research and development (R&D) and encourages them to shift assets abroad.
There is currently no Biden administration proposal to modify the IC-DISC regime. But this export tax incentive would become less valuable if taxes were increased on qualified dividend income, as the administration has proposed.
In short, these two export tax incentives could be affected by changes ahead. Taxpayers that are considering taking advantage of the preferential rates under the FDII or IC-DISC regimes, or that already do, are likely questioning what the impact of the proposed tax increases would be on their operating and supply chain structures and how — taking into account the myriad proposed tax changes — to best prepare for such an environment.
The FDII deduction's purpose is to provide U.S. corporations an incentive to export goods and services to other countries while locating their intangible assets (such as patents, trademarks, and copyrights) in the United States. The deduction is available only to C corporations.
This export tax incentive, effective for tax years beginning after Dec. 31, 2017, allows a reduced effective federal corporate income tax rate to be applied to excess returns on certain foreign-derived income. Specifically, under Sec. 250(a)(1)(A), a domestic C corporation can claim a deduction equal to 37.5% of its FDII (this will decrease to 21.875% for tax years beginning after Dec. 31, 2025).
The calculation of a taxpayer's FDII involves a complex and definition-heavy formula. To arrive at FDII, a taxpayer first computes its deemed intangible income (DII) and then multiplies the DII by the ratio of foreign-derived deduction-eligible income (FDDEI) to deduction-eligible income (DEI). The concepts are explained below:
- DEI is generally equal to the taxpayer's gross income (with certain exceptions), less allocable deductions.
- DII is equal to the excess of DEI over a deemed tangible income return of 10% of the taxpayer's qualified business asset investment.
- FDDEI is the portion of DEI that is foreign-derived. For a taxpayer's gross income to be considered FDDEI, it must be DEI derived in connection with property sold by the taxpayer to any person who is not a U.S. person, and which the taxpayer can establish is sold for foreign use, or be derived in connection with services provided by the taxpayer, which the taxpayer establishes are provided to any person not located within the United States (or provided with respect to property not located within the United States). A number of additional criteria must be met to qualify as FDDEI, including documentation requirements substantiating the "foreign person" and "foreign use" qualifications.
As noted, a C corporation presently can deduct 37.5% of its FDII. At the current 21% federal corporate income tax rate, the result of the FDII deduction can be an effective federal corporate income tax rate on FDII of 13.125% (rising to approximately 16.4% once the deduction decreases to 21.875%). However, an increase in the corporate income tax rate to 28%, with all other things remaining equal, would increase the effective federal corporate income tax rate on FDII to 17.5% (rising to 21.875% for tax years beginning after Dec. 31, 2025).
Prior to the TCJA, the United States' predominant export tax incentive was the IC-DISC regime. In its simplest form, an IC-DISC is an entity set up by an exporter that acts as a sales commission agent. An IC-DISC is commonly owned either by an exporter itself (if it is a flowthrough entity, such as an S corporation or a partnership) or by the shareholders of the exporter via a brother-sister structure (if the exporter is a C corporation). The primary reason exporters use IC-DISCs is to convert a portion of ordinary income into qualified dividend income, thus reducing the effective tax rate on some export income.
The exporter can pay the IC-DISC a commission based on the level of its export activity. The IC-DISC commission reduces taxable income for the exporter and is not subject to U.S. federal income tax at the level of the IC-DISC. Instead, the commission may be distributed to the IC-DISC's shareholders, making it subject to qualified dividend income tax rates (currently up to 20%), plus a 3.8% net investment income tax, as opposed to being taxed at ordinary income tax rates. This potential tax rate differential provides the main incentive for operating through an IC-DISC structure.
Another beneficial feature of an IC-DISC is that it may defer the distribution of net income from up to $10 million of its qualified export receipts. (Any undistributed amounts in excess of this $10 million receipts threshold are subject to an interest charge, and in practice most taxpayers generally seek to defer distribution by no more than one year.)
One disadvantage of using IC-DISCs is that eligibility requirements are arguably more stringent than for the FDII regime. At least 95% of the IC-DISC's gross receipts must be "qualified export receipts," and at least 95% of the IC-DISC's assets must be "qualified export assets."
Qualified export receipts include gross receipts from the sale, exchange, or disposition of export property, gross receipts from the lease or rental of export property outside the United States, and gross receipts for services that are related to or are subsidiary to any exchange of property, while qualified export assets include accounts receivable, temporary investments, and export property. Both of these definitions refer to "export property," which is defined to mean:
- The property must be manufactured, produced, grown, or extracted in the United States by a person other than the IC-DISC;
- At least 50% of the fair market value of the property must be U.S. content; and
- The property must be held primarily for sale, lease, or rental in the ordinary course of business for direct use, consumption, or disposition outside the United States.
In contrast to these made-in-the-USA requirements, the FDII regime does not contain specific rules governing where the goods are manufactured or where their content is derived, but instead predominantly looks to the location of the purchaser and (other than in the case of services) the location in which the product is used.
The income of an IC-DISC is limited to the greater of: (1) 4% of qualified export receipts, plus 10% of the export promotion expenses attributable to such receipts; (2) 50% of the combined taxable income from qualified export receipts, plus 10% of the export promotion expenses attributable to such receipts; or (3) an arm's-length amount determined under transfer-pricing principles. Given this calculation, a careful analysis of each taxpayer's fact pattern is imperative, particularly focusing on the potential grouping of income streams and ensuring an appropriate expense allocation methodology.
In recent years, the benefit of operating through an IC-DISC has diminished somewhat because it has become less advantageous to convert ordinary income to qualified dividend income, due to the fact that the TCJA reduced the corporate income tax rate to 21% and introduced the QBI deduction.
EFFECTS OF POSSIBLY RISING TAX RATES
However, could the prospect of an increased corporate income tax rate, combined with a phaseout of the QBI deduction, bring an IC-DISC structure back into consideration? And for C corporations currently taking advantage of the FDII regime, will the prospect of a diminished FDII benefit, combined with the potential removal of qualified dividend income rates upon repatriation, necessitate entity type changes?
To help answer these questions, the table "Basic Rate Comparison" compares the IC-DISC and FDII incentives both under current tax rates and certain potential future higher rates.
In the status quo scenario, the comparison is relatively clear. For a U.S. exporter operating in a flowthrough structure, the IC-DISC may be a more efficient option in that it results in the lowest overall effective federal income tax rate (in addition to allowing an opportunity to defer U.S. income tax on the commission). FDII, too, allows for a number of efficiencies in a status quo scenario. Particularly notable is the fact that the overall federal income tax in a reinvestment scenario may be the lowest, and — compared with an IC-DISC — there is more flexibility to defer U.S. taxation on profits that are reinvested into the business.
But what about the impact of the proposed changes in tax rates? Given the many variables, the comparison in the rising tax scenario is less clear. It is obvious, however, that a repeal of qualified dividend income rates would limit the benefit of an IC-DISC to a mere tax deferral in a structure where the exporter is a flowthrough entity. If federal corporate income tax rates increase, the FDII structure may result in the highest overall tax, in particular due to the double layers of taxation involved when repatriating earnings to the shareholders of a domestic C corporation (the only entity type eligible to claim an FDII deduction).
Does this mean that operating in a flowthrough structure is the best option going forward, all other things being equal? The answer is "not quite." For those exporters that would still be eligible for qualified dividend income rates (i.e., taxpayers with adjusted gross income below the proposed $1 million threshold), using an IC-DISC may continue to be a viable and efficient strategy. For smaller exporters eligible for qualified dividend income rates, FDII, too, may continue to remain a viable option.
Other U.S. taxpayers, however, that have structured themselves into a C corporation to claim the FDII deduction may be looking to restructure into a flowthrough entity (especially if the intent is to distribute the corporate earnings on a frequent basis). Alternatively, such C corporation exporters could consider establishing an IC-DISC. In a C corporation structure, if the intent is to distribute more frequently, establishing an IC-DISC may provide an advantage of a deductible dividend being achieved by way of a commission paid to a sister IC-DISC. Interestingly, it is worth noting that current guidance does not appear to preclude the taxpayer's ability to pay the IC-DISC commission and take an FDII deduction on the same transaction. The final FDII regulations (T.D. 9901) are silent regarding the interaction of the FDII regime with the IC-DISC regime.
The analysis here assumes that the IC-DISC and FDII regimes will continue to exist in their current form. If the FDII deduction is eliminated, as the Biden administration has proposed, a different set of issues will arise.
Assuming that both the IC-DISC and FDII incentives remain in place, another important aspect to highlight in connection with ownership structure decisions is how these tax incentive regimes affect non-U.S. investors. For taxpayers residing outside the United States in tax treaty jurisdictions, the export tax incentives may be greater. If dividends are subject to a relatively low tax rate in the non-U.S. investor's home jurisdiction, a non-U.S. investor could obtain a significant tax benefit by reducing the taxable income of the U.S. exporter entity, while receiving dividends subject to U.S. tax at a reduced rate (15%, 5%, or even 0%) under the applicable treaty.
It should be noted that Sec. 996(g) (applicable in the IC-DISC scenario but not the FDII structure) provides that in the case of a non-U.S. shareholder, all IC-DISC distributions are treated as U.S.-source income earned through a permanent establishment (and, thus, taxable to the non-U.S. investor in a manner similar to the U.S. investor). Nonetheless, certain specific tax treaty provisions (determined on a case-by-case basis) may override this IC-DISC permanent establishment rule, thereby significantly reducing the U.S. income tax on dividends in the hands of an eligible non-U.S. investor. Alternatively, FDII benefits could be explored for a non-U.S. investor not eligible for reduced treaty rates as a result of the application of Sec. 996(g).
MULTIPLE FACTORS TO CONSIDER
Tax planning should be undertaken holistically. Other important factors to consider include the implications of restructuring and any entity type changes, the investor profile, whether deferral of taxation is preferred, the implications of exit, and state and local tax considerations, to name a few. Nonetheless, given the potential increase in effective tax rate differential, as well as uncertainty about the future of the FDII and IC-DISC incentives, taxpayers that have set up structures — or seek to — that take advantage of these export tax incentives should consider whether their facts and circumstances could result in a different ownership structure yielding savings.
About the authors
Natallia Shapel, CPA, MST, MBA, is a partner, international tax services, and Sebastian Biddlecombe, E.A., ACA, CTA, is a manager on the International Tax Services team, both at BDO USA LLP in New York.
To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, a JofA senior editor, at David.Strausfeld@aicpa-cima.com.
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