Exporters and U.S. Taxes - A Savings Tool Still Exists for Small and Midsize Exporters
Joseph J. Dehner
Almost every country, except perhaps the Kingdom of Bhutan, encourages exports. Exporters bring in currency, create jobs that tend to pay more than domestic jobs, and earn profits for residents. It is no surprise that governments support and try to subsidize export activities.
“Free trade” is fine with most people, labor union leaders included, as long as it is “fair.” And that is where disagreements start. An export subsidy by one government is an unfair trade practice to other governments. The World Trade Organization (WTO), along with numerous trade agreements and domestic laws, aim to create a level playing field, so that competition can thrive. This means eliminating – over time – artificial barriers and subsidies that distort world trade flows.
The U.S. uses its tax code as a public policy tool, not simply as a collection device. Tax subsidies that single out exports for favorable treatment embody important national interests, while simultaneously infringing ideals of free trade. Tax regimes differ around the world. The U.S. is one of a few countries that tax their residents and companies on worldwide income, regardless of where income is earned. Many countries tax their citizens only on profits made inside their borders. Nonetheless, because the U.S. applies income tax to all profits, regardless of where earned, it has encountered opposition when using the Internal Revenue Code to distinguish export earnings (and apply no tax) from other profits.
History of U.S. Export Savings Mechanisms
My first assignment in 1972 as a summer intern in a west coast law firm was to write a paper on DISC’s – Domestic International Sales Corporations, created by Congress in 1971. DISC’s exempted qualified export earnings from U.S. income tax. Corporations from large to small created DISC’s in the 1970’s and early 1980’s, and ran export activities through these affiliated entities. The reward was lower or no taxes on export earnings. Although commentators debated whether DISC’s actually encouraged export activities, or were simply a tax break that had no stimulating impact, DISC’s lowered taxes on U.S. exporters. The challenge followed – this was an illegal trade distortion, said the Europeans and others. And they won in the WTO.
In the mid-1980’s, Congress eliminated most of the DISC provisions – save one to be featured below. But Congress is relentless and not easily cowed by world opinion. The DISC was replaced by the FSC – the foreign sales corporation. FSC’s became a new tool with tax advantages for exporters. By creating a FSC and running exports through it, taxes on export earnings were again dramatically lowered as compared with tax on earnings from domestic sales. Again, a challenge arose, and the WTO ruled that FSC’s were illegal too. Under threat of sanctions authorized by the WTO, Congress repealed the FSC in 2000.
Next came the Extraterritorial Income Exclusion Act of 2000, declaring basically that specified export income earned outside the U.S. was exempt from U.S. tax. The WTO again found no basic difference in what the U.S. was trying to do, and ruled in favor of challenges one more time. In late 2004, Congress voted to repeal ETI, with exclusions to be phased out by 2006. This eliminated a series of escalating retaliatory tariffs that the European Union imposed on specific U.S. imports, and a broader trade war was averted.
One might think this ends Congress’ efforts to aid U.S. exporters in a way that our trading partners find unfair and anti-WTO. But life is not that simple. In fact, despite repeal of DISC, FSC and ETI, an important export subsidy remains – the Interest Charge DISC (IC-DISC).
Current Export Savings Opportunity
An IC-DISC is a Domestic International Sales Corporation, with a special feature – an Interest Charge. It is best suited for Subchapter S corporations, and does not work well with C corporations or very large companies. For a great number of U.S. exporters, with export revenues of US $10 million or less, it can be the basis for significant tax savings. Here is how it works.
A U.S. Company is owned by one or a number of individual shareholders, who report on their personal tax returns their allocated percentage of corporate gains or losses. The gains include export profits. Assuming there are overall company profits, the taxable income will be taxed at each individual’s personal rate, which can range beyond 35%.
If the same shareholders create an IC-DISC, it can enter into a simple agreement with the Company that entitles the IC-DISC to earn commissions on export sales (within limits and on terms specified by IRS regulations). The commission earnings of the IC-DISC are not taxed at all at the IC-DISC level, and the commissions are deductible by the Company as an expense. When the IC-DISC pays a dividend to the shareholders, the shareholders are taxed at the individual dividend rate – i.e., 15%. The savings to the shareholders arise from the difference between the rates imposed on individuals for Sub S corporate profits and for dividends received.
In simple terms (before refinements and ignoring accounting and incidental costs), let’s say the IC-DISC receives $1 million in export commissions. No tax is imposed on the IC-DISC itself. By using an IC-DISC, instead of reporting export gains simply as part of the Company’s profits (assuming a 35% personal tax rate), if the $1 million is distributed to the shareholders, they pay $150,000 in federal income tax instead of $350,000 on the $1 million profit.
Setting up an IC-DISC and creating the agreement between the IC-DISC and its sister corporation are rather simple steps, although there are details, ongoing minor accounting costs and IRS rules to observe.
What if the shareholders of the IC-DISC want to defer receipt of the $1 million in commissions earned by the IC-DISC (but not taxed at that level)? That’s where the “Interest Charge” part of the name comes into play. Deferral is possible. When earnings of an IC-DISC are deferred, however, the IRS imposes and collects an interest charge calculated according to IRS regulations on the deferred sums. This prevents an IC-DISC from being used to pile up untaxed earnings for an indefinite period. In particular instances, nonetheless, it may be beneficial not to distribute all or part of IC-DISC earnings to shareholders, but instead to bankroll them and pay the interest charge to the IRS.
Anyone considering setting up an IC-DISC might ask how long it would be viable, in light of the prior DISC, FSC and ETI repeals. The answer is uncertain. Our European trading partners have already said that the 2004 congressional action repealing the Extraterritorial Income Exclusion was not adequate, and a continuing WTO challenge to export subsidies in all forms can be expected. Nonetheless, it took many years of pressure and disputes before the basic DISC, FSC and ETI were repealed by Congress. The likelihood, therefore, is that the IC-DISC will be in effect for many years. Even if repealed in the future, it is virtually certain that repeal would not cause recoupment of past tax savings or other adverse effects on those who utilize the tool while it is in place.
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Joseph J. Dehner chairs Frost Brown Todd’s International Services Group. Group members advise U.S. and foreign individuals and businesses on a range of global tax issues, including the formation and operation of IC-DISC’s.
The next couple of years will likely witness global retail giants aside from Wal-Mart opening their outlet stores across China. Opening of China’s retail and distribution sector is exciting news for foreign companies. The amended China Foreign Trade Law that took effect last summer demonstrates that China has taken firm steps to fulfill its WTO commitments in that sector. To enforce the new law, Ministry of Commerce of China has issued implementing rules and measures, such as the Commercial Sector Investment Measures, and will continue to do so in near future. The new rules lift restrictions on foreign companies to carry on trade and distribution in China and will certainly bring them new opportunities.
The amended China Foreign Trade Law exterminated the monopoly status of state import and export companies for good. It expanded trading rights from state trading companies and organizations licensed by Chinese government to natural persons. It also eliminated the administrative examination and approval procedures and only requires Chinese entities or individuals wishing to carry out foreign trade to register as foreign trade operators. Foreign companies will be able to do international trade directly with Chinese counterparts. Without government protection, how state import and export companies provide services and charge commission is to be bound by market rules rather than government enforced privileges.
The Commercial Sector Investment Measures allow foreign companies to carry out retail and wholesale business in China market without geographical restrictions. The Measures specifically state that foreign investment commercial enterprises can engage in commission agency services, wholesale services, retail services, franchise services, and other auxiliary services. For those who have already had the right to import goods and technology for their own use and export goods and technology they manufactured and developed themselves, the Measures allow them to import goods for resale in China market and export goods they do not manufacture themselves.
The threshold for foreign companies to set up such a commercial enterprise is low. First, the minimum capital requirements are set to be the same as those in PRC Corporate Law. The minimum registered capital is RMB 500,000 for wholesale enterprises and RMB 300,000 for retail enterprises according to PRC Corporate Law (approximately US $ 60,000 and 36,000, respectively). Second, foreign companies may apply with provincial level of commerce authorities for setting up commercial enterprises. Third, an existing foreign investment enterprise may simply apply with local industry and commerce authorities to add distribution to its business scope. Some investors may wish to add distribution structures to their representative offices. Some may want to relocate their trading companies from bonded zones and redesign their distribution networks across major cities in China.
A series of new rules issued by Ministry of Commerce of China last year have granted foreign investment enterprises market access to some specific, distribution-related sectors that they did not have in the past. Now foreign companies can set up conference and exhibition enterprises in the form of joint ventures or wholly owned enterprises. Freight forwarding service is also open to foreign investment. Foreign companies can conduct repair and maintenance services, which were highly restricted to foreign companies in the past.
The amended Foreign Trade Law serves as a framework of Chinese legislation on foreign trade. To enforce the new law, The State Council and other administrative agencies must issue new measures or amend old ones. Understanding these new rules is a must for those foreign companies interested in entering the distribution sector in China.
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Dillon Shi is an Assistant Trade Professional at Frost Brown Todd. He can assist our clients with structuring their operations and achieving their goals in the China market.
The Office of Foreign Assets Control (“OFAC”), of the United States Department of the Treasury, administers a series of laws and regulations that impose economic sanctions against nations perceived to be hostile to United States’ foreign policy and national security objectives. The U.S. Government has long utilized a variety of economic sanctions (including trade embargoes, blocked assets controls, and other commercial and financial restrictions) to further its foreign policy objectives. Today, economic sanctions remain a powerful tool in the diplomatic arsenal as the U.S. strives to: (1) successfully conduct the war and reconstruction of Iraq; (2) deny financial and logistical support to terrorist groups; and (3) stem the flow of sensitive products and technologies to proliferators of weapons of mass destruction.
In order to advance the aforementioned goals, the U.S. government has imposed sanctions against various countries around the world, as well as against groups who threaten the security, economy, and safety of the U.S. (i.e., narcotics traffickers and terrorists). In recent years, it has become evident that the U.S. Government considers economic sanctions to be powerful foreign policy tools, and consequently, the Government requires active participation and support from U.S. corporations, entities, and citizens.
Oversight and management of U.S. sanctions is entrusted to the Department of the Treasury. As a branch of the Treasury, OFAC is responsible for promulgating, developing, and administering U.S. economic sanctions. However, other regulatory agencies such as the Department of Commerce’s Bureau of Industry and Security, and the Department of Homeland Security, Customs and Border Protection, cooperate in ensuring compliance with U.S. economic sanctions.
OFAC Sanctions Consequences
OFAC acts under executive wartime and national emergency powers, as well as authority granted by specific legislation, to impose controls on transactions and freeze foreign assets under U.S. jurisdiction. Many of the sanctions are based on United Nations Resolutions and other international mandates, are multilateral in scope, and involve close cooperation with allied governments. Persons and entities that are subject to U.S. sanctions and regulations include the following: (1) American citizens and permanent resident aliens, wherever they are located; (2) individuals and entities located within the territorial boundaries of the U.S. (including all branches of foreign corporate entities); and (3) corporations organized under U.S. law. Willful violations of U.S. sanctions can lead to penalties providing for up to ten (10) years imprisonment and/or $100,000 fine for individuals and a fine of up to $1,000,000 for corporations.
It should be noted that foreign subsidiaries of U.S. firms are generally not subject to U.S. sanctions and regulations. However, all U.S. parent corporations, citizens, and residents, wherever located, are strictly prohibited from approving or providing financial assistance, advice, consulting services, goods, or any other support to subsidiaries in connection with any export destined for a sanctioned country. Accordingly, a U.S. corporation or citizen may not facilitate or assist foreign companies (e.g., as financiers, brokers or other intermediaries) with transactions in which they themselves could not directly participate. Furthermore, U.S. employees of foreign corporations or subsidiaries (including board members) must ensure that they do not engage in transactions on behalf of their employer which would be prohibited if the company was American.
Beware of Specially Designated Nationals
U.S. sanctions programs go far beyond the borders of target countries. The U.S. Government has identified and listed thousands of “front” individuals and organizations, known as “Specially Designated Nationals” (SDN), to further the effectiveness of sanctions regimes. SDNs are individuals and entities located anywhere in the world that are owned, controlled by, or acting on behalf of the government of a sanctioned country, designated international narcotics traffickers or terrorists. SDNs include companies, banks, vessels, and individuals that, at first glance, may not appear to be related to the sanctions targets they actually represent. Most SDNs have innocuous names and are located in countries with which the U.S. enjoys harmonious trade relations. Nonetheless, all property and interests of a SDN that come into the possession of a U.S. corporation must be blocked. Blocking or “freezing” property immediately imposes an across-the-board prohibition against transfers or transactions of any kind with regard to the property. Examples of property could include, but are not limited to money, checks, drafts, debts, obligations, notes, letters of credit, warehouse receipts, bills of sale, evidences of title, negotiable instruments, trade acceptance, contracts, goods, wares, merchandise, chattels, and ships.
Individuals or organizations who act on behalf of the government of sanctioned nations anywhere in the world are considered to be SDNs. A list of SDNs can be obtained from OFAC, and includes banks domiciled in Europe and Africa, as well as the names of individuals who are officers and directors of substantial international corporations. However, this is only a partial list and a U.S. individual or organization engaging in an international transaction must take reasonable care to make certain that a foreign national is not acting on behalf of a sanctioned government. U.S. individuals and organizations who transact business with a SDN may be subject to criminal and civil prosecution.
As of January 2005, the following countries and/or regions are subject to various sanctions regimes enforced and administered by the Office of Foreign Assets Control: Balkans, Burma (Myanmar), Cuba, Iran, Iraq, Liberia, Libya, North Korea, Sierra Leone, Sudan, Syria, and Zimbabwe. Due to the current international political climate and the U.S. government’s commitment to national security, any corporation conducting business with any overseas entity should take the necessary measures to ensure full and complete compliance with all United States sanction regimes. Failing to do so could expose corporations and/or their employees to severe civil and criminal penalties.
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Jan de Beer is an Associate with Frost Brown Todd’s International Services Group. Jan, together with other attorneys at FBT, have experience and assist clients in avoiding collusion with U.S. sanctions programs.
In December 2004, President Bush signed the Omnibus Appropriation Act for FY 2005, which contains provisions affecting the H-1B and L nonimmigrant visa categories. Both these categories are used heavily by U.S. employers to sponsor temporary foreign workers. The H-1B reforms hold the greatest interest to most U.S. employers because they provide work visas and temporary stay in the U.S. for business professionals.
H-1B visas have been capped at 65,000 for FY 2005. Unfortunately for many employers and potential foreign workers, this cap was reached on the first day of the new fiscal year—October 1, 2004. New numbers will not be available until October 2005 for FY 2006. To ease the stress that the cap has caused many U.S. employers, the new law exempts from the cap the first 20,000 H-1B beneficiaries who have earned master’s degrees or higher from a U.S. institutions of higher education. This provision is not effective until March 8, 2005, and the process for filing these petitions has not been announced by the U.S. Customs and Immigration Services (USCIS).
However, the new law also imposes additional fees on H-1B employers. Beginning March 8, all petitioning employers will be required to pay a $500 Fraud Prevention and Detection Fee, unless the petition is to amend or extend a beneficiary’s stay and is filed by the existing H-1B employer. Further, since the day the President signed the law, most employers are required to pay a $1,500 fee, which is a resurrection of the prior fee that was imposed by the American Competitiveness and Workforce Improvement Act of 1998 (ACWIA). The ACWIA fee was instituted, in part, to finance job training and low-income scholarships and grants for U.S. citizens, lawful permanent residents and other U.S. workers. This fee had sunset on October 1, 2003. Petitioners who employ no more than 25 full-time employees, including any affiliate or subsidiary, may submit a reduced fee of $750, and certain types of petitions, that were previously exempt from the ACWIA fee, are also exempt from this fee. Thus, for most employers, it will now cost a minimum of $1,685 in fees (including an H-1B $185 filing fee) to the USCIS to file a simple H-1B Petition. As of March 8, 2005 this cost will jump to $2,185.
Although the advanced-degree exemption is welcome relief for many employers, the new fees may prove deterrents for many would-be H-1B employers.
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Barbara Menefee is an Associate with Frost Brown Todd’s Immigration Practice Group, which assists our clients with their business, family and personal immigration needs.
For those clients concerned about absolute privacy for their trust documents, consideration should be given to a Luxembourg Fiduciary Agreement with a bank in that country. This document can be tailored to have all the features of a domestic trust agreement, but with the assurance of being protected by the Luxembourg bank secrecy law, the toughest in the world.
Our client, a European businessman, wanted to set up a trust for the protection of his wife, and children, but desired strict confidentiality. We introduced him to Dexia Banque Internationale à Luxembourg (Dexia BIL) one of the two largest commercial banks in Luxembourg and a member of the large Dexia group of Europe. A professional introduction and a personal interview are required for any new customer of this bank. The interview followed, and the client was accepted. The bank charges reasonable fees and places emphasis on capital growth through conservative investments.
Frost Brown Todd’s good reputation with Dexia can facilitate the introduction of clients and our experience with Luxembourg Fiduciary Agreements and bank counsel can result in an excellent product. For U.S. clients, tax considerations are important and members of FBT’s Personal Planning and Family Business Department would work together with members of the International Practice Group to provide the best possible service for the client.
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Richard Rogovin is a Member with Frost Brown Todd, experienced in a variety of international business matters of interest to our clients.
For details and more information, click on the event links below.
March 22, 2005
How to Start and Manage Your Business in China - Free Luncheon Event
Cincinnati, OH Louisville, KY Lexington, KY
April 12, 2005
National City Export Trade Seminar - Inside Trade Finance - FBT Sponsored Seminar
April 22, 2005
Importance of Origin Marking Rules in International Trade - Free Luncheon Event
Cincinnati, OH Louisville, KY Lexington, KY
(L-R) Patricia Harris, formerly with FBT, now General Counsel of FBT's international client, Sud-Chemie, Inc., Omar Ayyash, Director of Louisville Metro Office for International Affairs, Adel Al-Jubeir, Foreign Affairs Advisor to the Crown Prince of Saudi Arabia, Charles Cassis of FBT, Djenita Pasic of FBT and Benjamin Jones, Director of Louisville International Cultural Center (LICC) at an official presentation about U.S.-Saudi Arabia relations organized by the LICC.
(L-R) Raymond Neusch of FBT, President of Japan America Society of Greater Cincinnati (JASGC), Yoshiyuki Sadaoka, Consul General of Japan, Edwin Rigaud, Co-Chair of the Board of the National Underground Freedom Center, and Rocky Nishitata of Fujitec America help break the barrel at the 11th annual ceremonial barrel breaking and sake tasting, heralded by the JASGC.
(L-R) Jerry Abramson, Louisville Metro Mayor, Djenita Pasic of FBT and Jonathan Blue of Cobalt Ventures at the unveiling of the new Louisville Metro Hispanic Yellow Pages, El Enlace Latino.
Joe Dehner (far right) at Honda International HQ - Tokyo - with Cosimo the robot. Joe Dehner was part of Governor Taft's Trade Mission to Japan and Taiwan in late 2004.