CHAPTER XXXVII IC-DISC, FSC, ETI ACT, AJCA

1. CHAPTER XXXVII IC-DISC, FSC, ETI ACT, AJCA • Interest Charge Domestic International Sales Corporation (IC-DISC) • Foreign Sales Corporation (FSC) • Extraterritorial Income Exclusion Act of 2000 (ETI Act) • American Job Creation Act of 2004 (AJCA) Copyright(c) 2012 Dr. Chase C. Rhee

2. Interest Charge Domestic International Sales Corporation (IC-DISC) (1) Definition of an IC-DISC • IC-DISC is formed as domestic subsidiary by a parent company or exporter for deferral of income tax on its export earnings. • IC-DISC not taxed on its income but pays an interest charge on deferred tax liability at the U. S. Treasury Bill rate with annual maturities. • Shareholders pay income tax on dividends at a lower tax rate than ordinary income tax rate, when the income is actually (or deemed) distributed. Copyright(c) 2012 Dr. Chase C. Rhee

3. Interest Charge Domestic International Sales Corporation (IC-DISC) (1) Definition of an IC-DISC (cont.) • Deferral can be indefinite. • Net export income from qualified export receipts exceeding $10 million a year is deemed distributed. • IC-DISC can buy from parent company and export. • Intercompany Transfer Pricing Rules under Section 482 of the Internal Revenue Code are applied. Copyright(c) 2012 Dr. Chase C. Rhee

4. Interest Charge Domestic International Sales Corporation (IC-DISC) • IC-DISC act as commission export agent for a parent exporter. • IC-DISC’s taxable income from its export sales may not exceed the greatest of: • 4 % of qualified export receipts on IC-DISC’s sale plus 10 percent of export promotion expenses. • 50% of IC-DISC's and parent company's combined taxable export income plus 10 percent of export promotion expenses. • Taxable income based on the sale price actually charged. Copyright(c) 2012 Dr. Chase C. Rhee

5. Interest Charge Domestic International Sales Corporation (IC-DISC) • When an IC-DISC is set up as a direct subsidiary of a U.S. S-Corporation or U.S. LLC, • IC-DISC can distribute its deferred income as a dividend taxable at 15 percent, thus converting 35 percent ordinary income to 15 percent dividend income for shareholders. • If an IC-DISC is owned by individual shareholders of a closely-held C Corporation, • Dividend can avoid double taxation and shareholders can take advantage of 15 percent dividend tax. Copyright(c) 2012 Dr. Chase C. Rhee

6. Interest Charge Domestic International Sales Corporation (IC-DISC) (1) Definition of an IC-DISC (continued) • In 1971, U.S. enacted DISC tax provisions, which allowed exporters to establish domestic subsidiaries which would receive the tax deferral on export earnings. • The objection to the DISC as a U.S. export subsidy by the European Community (EC) from 1972 • DISC was changed to Interest Charge DISC by the 1984 Tax Reform Act. • Must be incorporated under the laws of a State or DC • Corporation must elect to be an IC-DISC by filing a Form 4876-A with the Internal Revenue Service Copyright(c) 2012 Dr. Chase C. Rhee

7. Interest Charge Domestic International Sales Corporation (IC-DISC) (2) Qualification Conditions • At least 95 percent of its gross receipts during the tax year are qualified as export receipts • At the end of the tax year, the adjusted basis of its qualified export assets is at least 95 percent of all its adjusted assets. • It has one class of stock, and its outstanding stock has a par value of at least $2,500 on each day of the tax year. • It keeps separate books and records. Copyright(c) 2012 Dr. Chase C. Rhee

8. Interest Charge Domestic International Sales Corporation (IC-DISC) (2) Qualification Conditions (continued) • Its tax year must conform to the tax year of the shareholder (or shareholder group) who has the highest voting power. • Its election to be treated as an IC-DIDC is in effect • Not required to perform substantial business functions. Most IC-DISCs are paper corporations without own employees or offices. Copyright(c) 2012 Dr. Chase C. Rhee

9. Interest Charge Domestic International Sales Corporation (IC-DISC) (3) Advantages of an IC-DISC • Deferral of U. S. income taxes on export earnings. Can be indefinite; Not taxable until the income is actually distributed • Interest charge on deferred income taxes at the U.S. Treasury Bill rate with annual maturities, which is much lower than commercial rates. • IC-DISC is not taxed at the corporate level. It file an information tax return. No double taxation. Copyright(c) 2012 Dr. Chase C. Rhee

10. Interest Charge Domestic International Sales Corporation (IC-DISC) (3) Advantages of an IC-DISC (continued) • In the case of a commission agent IC-DISC, the parent company deducts commission from its ordinary income but the IC-DISC pays no tax on the commission income • When dividends are distributed to parent company, it pays income tax on dividends at the capital gains rate of 15 percent instead of higher income tax on ordinary income Copyright(c) 2012 Dr. Chase C. Rhee

11. Foreign Sales Corporation (FSC) • A foreign corporation set up by a U.S. corporation in a foreign country or a U.S. possession approved by the U.S. Treasury Department • A corporate tax exemption on a portion of export earnings. • Became effective January 1, 1985. Replaced DISC. This change was made to accommodate claims by the GATT members, specially the European Community (EC) that the DISC was a prohibited export subsidy for exports Copyright(c) 2012 Dr. Chase C. Rhee

12. Foreign Sales Corporation (FSC) • An FSC had to be incorporated in one of the U.S. possessions and countries approved by the U.S. Treasury such as four U.S. territories and 25 nations (mostly Caribbean nations). • The FSC received a corporate tax exemption equivalent to 15 percent of the corporate tax that would otherwise be paid on the export earnings. Based on maximum corporate tax bracket at 35%, a net tax saving of an FSC was a 5.25% (35% x 15%) of the export earnings. Copyright(c) 2012 Dr. Chase C. Rhee

13. Foreign Sales Corporation (FSC) • European Union’s petition with the World Trade Organization(WTO) to rule the FSC is an illegal export subsidy by the U.S. • In March 2000, the WTO adopted rulings of its Dispute Settlement Panel and Appellate Body which found the FSC provision of U.S. tax law on tax exemption on export income to be a prohibited government subsidy in violation of SCM Agreement (Agreement on Subsidies and Countervailing Measures) of the WTO. Copyright(c) 2012 Dr. Chase C. Rhee

14. Extraterritorial Income Exclusion Act of 2000 (ETI Act) • To comply with the WTO’s final rulings against the FSC, on November 15, 2000, the United States enacted the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (ETI Act). • ETI Act repealed the FSC provisions and excludes extraterritorial income from gross income for U.S. tax purposes. Income originating outside the United States is placed outside the taxing jurisdiction of the United States. Copyright(c) 2012 Dr. Chase C. Rhee

15. Extraterritorial Income Exclusion Act of 2000 (ETI Act) • The Act’s exclusion of income applies to all foreign income not only from export sales but also any other sales and treats all tax payers alike without regard to whether the income is earned by a U.S. person or a foreigner. • By excluding extraterritorial income from gross income for tax purposes, the ETI Act parallels the foreign-source income excluded under most territorial tax systems, particularly those employed by European Union’s member states. Copyright(c) 2012 Dr. Chase C. Rhee

16. Extraterritorial Income Exclusion Act of 2000 (ETI Act) • On November 17, 2000, the EU commenced a WTO dispute, alleging that the ETI Act failed to eliminate the problems that the WTO had found with the FSC provisions. • EU also requested authority from the WTO to impose trade sanctions on $4.043 billion worth of U.S. exports, the amount of the export subsidy. Copyright(c) 2012 Dr. Chase C. Rhee

17. Extraterritorial Income Exclusion Act of 2000 (ETI Act) • On January 29, 2002, the WTO adopted rulings by its Dispute Settlement Panel and Appellate Body which also found the ETI Act to be WTO-inconsistent. As a result of this action, the arbitration automatically resumed. • The WTO rules on August 30, 2003 that the European Union is entitled to impose $4.043 billion in trade sanctions as a result of the Foreign Sales Corporation provisions of U.S. tax law Copyright(c) 2012 Dr. Chase C. Rhee

18. Extraterritorial Income Exclusion Act of 2000 (ETI Act) • The United States contended that sanctions should have been limited to $1 billion based on the actual impact of the FSC provisions on EU commercial interests. • On March 2, 2004, EU announced it imposes retaliatory tariffs at 5% on U.S. exports with a 1 percent increase every month until they reach a maximum level of 17% in March 2005 Copyright(c) 2012 Dr. Chase C. Rhee

19. American Job Creation Act of 2004 (AJCA) • In October, 2004, U.S. enacted the American Job Creation Act of 2004 (AJCA) which • lowered the corporate income tax rate for manufacturers from 35 percent to 32 percent • repealed the FSC and the ETI Act tax provisions of the U.S. tax code. • took effect on January 1, 2005. The European Union’s extra tariff rate on U.S. exports to Europe became 12 percent in October, 2004 Copyright(c) 2012 Dr. Chase C. Rhee

20. American Job Creation Act of 2004 (AJCA) • European Union announced on October 25, 2004 that it decided to lift heavy punitive tariffs on U.S. exports on January 1, 2005, when the U.S. American Job Creation Act of 2004 would take effect, unless the WTO rules otherwise. • Punitive extra tariffs started in March were estimated to be $300 million in 2004 alone. Copyright(c) 2012 Dr. Chase C. Rhee

21. American Job Creation Act of 2004 (AJCA) • Punitive tariffs were indeed lifted on January 1, 2005 • In October, 2005, a WTO dispute settlement body ruled against the U.S. AJCA’s grandfather rule and transitional phase out of the FSC and ETI benefits for 3 years. • EU Trade Commissioner, Peter Mandelson, said, “ The U.S. now has 3 months to act to avoid the re-imposition of retaliatory measures in this case.” • U.S. Congress backed down and repealed the grandfathered benefits in the Tax Increase Prevention and Reconciliation Act signed by President George Bush in May, 2006. • The European Union (EU) has not reintroduced the punitive tariffs against the U. S. products. Copyright(c) 2012 Dr. Chase C. Rhee