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Last Tax Break Standing

With other breaks coming under pressure, companies are showing renewed interest in a lucrative but little-used tax structure that involves setting up a shell company to which it can funnel export revenues.
Alix Stuart, CFO.com | US
May 20, 2009

President Obama's proposed limit on the tax benefits associated with income generated overseas is likely bad news for most multinational businesses. But there may be some consolation for  companies selling U.S-made goods overseas.  

Experts say they're seeing renewed interest in a lucrative but little-used export tax break known as the IC-DISC (interest charge - domestic international sales corporation). Although the provision fluctuates in popularity depending on the presence of other tax incentives, it's been part of the tax code for 37 years.  

The structure, which experts say can pay for itself in months, is a way for closely-held companies to cut taxes and for many others to defer taxes on a cash stash. "It's the only export tax incentive we still have," says Jonathan Lysenko, international tax director for Amper, Politziner & Mattia, an accounting firm. "What's really disappointing is that so few exporters take advantage of it."

To be sure, there are reasons for caution. Staying within the legal requirements of an IC-DISC requires good controls, and the ephemeral nature of tax legislation may affect the benefits. Finance executives considering establishing IC-DISCs "should carefully monitor the potential for future legislative changes," says Marc J. Gerson, a tax policy specialist with Miller & Chevalier, a Washington, D.C. law firm, noting that in the past Congress has considered legislation that would change the vehicles' tax treatment.

Assuming they don't get the ax this session, though, they may provide some welcome tax relief. For companies that are eligible, an IC-DISC "is a no-brainer in terms of the benefits outweighing costs," says Larry Harding, CEO of High Street Partners, a consulting firm that helps companies expand internationally.

Here's how an IC-DISC works: an export manufacturer or distributor sets up a shell company, to which it can funnel a percentage of export revenues annually, creating either a tax deduction or tax deferral for the underlying corporation. Those funds are considered "commissions" and are also largely tax-free to the IC-DISC.

The benefits that follow depend upon how a company chooses to use the provision. In closely held companies, for example, owners may use it to transform ordinary income into dividends-and thus be taxed at a lower rate. In that case, the corporation can receive a 35% tax deduction on the commissions it pays to the shell company. The owners of the company would then decide to have the shell company issue dividends to the shareholders (in many cases, themselves), who would then be taxed at the current rate of 15%. Thus the owners would net a 20 percent tax break, says Lysenko.

Since the amount of revenues that can be deferred is limited, IC-DISCs generally offer savings equal to 10% of a company's qualified export profits, estimates Ralf Eschenburg, director of international tax services at accounting firm CBIZ MHM.

This benefit may diminish somewhat after 2010, when the 15% rate is slated to increase. But the payback period is short enough that companies may still gain from establishing an IC-DISC now.  Setting up the structure takes about a month, and the costs are relatively cheap, meaning "you could see 10 to 40 times the fees in savings within the first year," Lysenko says.

For companies in need of cash, the IC-DISC can also function as a rainy-day fund for 50% of profits attached to $10 million in export revenues a year. Companies that securitize their export receivables may be able to defer quite a bit more, says Englert.

With interest rates as low as 2%, "it's a very attractive tool from a treasury management standpoint," says Joseph Englert, chief executive officer of Export Assist, an export-finance management firm that specializes in setting up IC-DISCs. "We're seeing much more activity now because of the tightness in the credit market."

Englert says his business grew between 50 percent and 60 percent last year, mainly because of the adoption of the structure by large and often public companies seeking an extra liquidity cushion. The funds are somewhat restricted, but can be used either as working capital for exports or towards general research and development, which would generate further tax benefits, Englert notes. While few companies announce such a strategy publicly, Thomas Betts and Danaher both list IC-DISCs among their subsidiaries in filings with the Securities and Exchange Commission.

There are, of course, some requirements to qualify. A company must either manufacture products within the United States or distribute U.S.-made products, and at least 50% of the materials used in the process must be made in the United States as well, since the focus is on creating American jobs. (U.S. architects and engineers can also treat service income on foreign construction projects as "export receipts" that qualify for an IC-DISC benefit, Lysenko notes.) The amount of money that can be deferred tax-free is limited to either 4% of export sales, 50% of taxable income from exports, or to a set of formulas emerging from a transfer-pricing method known as marginal costing. Companies can vary their methods from transaction to transaction to get the best deduction, says Lysenko.


Practically speaking, annual export sales need only be about $100,000 to make a dividend-issuing IC-DISC worthwhile, and around $2 million to make using an IC-DISC as a piggy bank worthwhile, says Englert. The benefits associated with deferral diminish rapidly after about $250 million in such sales, he adds.

Sound too good to be true? Lysenko says that most companies miss the incentive because they're not aware of it, and that it has so far generated little controversy among tax authorities. "This has survived all of the changes in tax regime for the past several decades, and as far as we can tell, it doesn't look like there are going to be any challenges from foreign trading bodies or the U.S. government," he says. Adds Englert: "Congress has always endeavored to help exporters; it's not like we just discovered a tax loophole or something."  




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