ReDISCOVERING A TAX CLASSIC: THE NATIONAL INTERNATIONAL SALES COMPANY – Taxation
Created by Congress in 1971 as a tax incentive for domestic exporters of U.S.-made goods, the National International Sales Corporation (DISC) remains a viable tool for small and medium-sized exporters to reduce their federal income taxes.1
A DISC is generally simply “a shell company with no employees, whose sole purpose is to act as an accounting vehicle for the earnings of its affiliate or parent company”.2 Special transfer pricing rules allow DISCs to “skim the parent company’s export profits by taking “commissions” on the parent company’s export sales.”3
This is convenient because DISCs are not subject to federal income tax.4 Instead, DISC shareholders are treated as receiving a distribution equal to their shares on a pro rata basis of certain income earned by DISC during the tax year.5 The exact types and amounts of income on which these deemed distributions are based vary depending on the identity of the shareholders (individuals versus corporations) and the operations of the DISC.6 But, the bottom line is that federal income tax on the first $10 million of DISC-qualified export earnings (more on those below) is generally deferred until DISC actually makes a distribution to its shareholders, or that the shareholders sell their shares in the DISC. .seven
However, this postponement has a cost. DISC shareholders must pay interest each tax year at the base period treasury bill rate on the amount that their tax liability for the year would have increased had they included their shares pro rata in the deferred income of the DISC as this year’s gross income. .8
What is a DISC?
A DISC is a corporation incorporated under the laws of any U.S. state or the District of Columbia that, in any taxable year, meets the following requirements:
- 95% or more of the company’s gross receipts are qualifying export receipts;
- the adjusted base of eligible export assets of the company is at least 95% of the adjusted base of all assets of the company at the end of the taxation year;
- the corporation has no more than one class of shares and the par or stated value of its outstanding shares is at least $2,500 on each day of the taxation year; and
- the company has elected to be treated as a DISC for the tax year and maintains its own books and records.9
Some national societies, however, are not eligible to be treated as a DISC. These include tax-exempt organizations, personal holding companies, financial institutions, insurance companies, regulated investment companies, and S corporations.ten
What are qualified export earnings and qualified export assets?
“Qualifying export receipts” generally include gross receipts from the disposal of export goods, services rendered in connection with the disposal of such goods, engineering and architectural services for construction projects located outside the United States, and certain dividends and interest.11
“Qualifying export assets” include (among others) export goods and assets primarily used in connection with the sale, lease, rental, storage, handling, transportation , packaging, assembly or maintenance of export goods, or the provision of certain services which generate qualifying export revenue.12
What is a qualifying export property?
A common feature of the definitions of eligible export earnings and eligible export assets is their reference to “export property”, which is defined as property (excluding certain intangible property, a depletion allowance, unprocessed softwood lumber and goods the export of which is prohibited or restricted) i.e.:
- manufactured, produced, grown, or mined in the United States by someone other than a DISC;
- held primarily for sale, lease, or rental, in the ordinary course of trade or business, by or to a DISC, for direct use, consumption, or disposal outside the United States ; and
- no more than 50% of its fair market value is attributable to items imported into the United States.13
A person is considered to manufacture or produce a good if he substantially transforms the good. Examples of substantial transformation include “the conversion of wood pulp into paper, steel rods into screws and bolts, and the canning of fish”. A good is also considered to be manufactured or produced by a person if the person’s conversion costs for that good are at least 20% of the cost of the goods sold by the person for the good (if the good is to be sold) or the adjusted basis of the person in the property (if the property is to be leased or leased).
Are there special transfer pricing rules for records?
As mentioned above, a DISC often works in concert with a related entity to sell export goods, with the related entity paying the DISC a commission for its services. Special transfer pricing rules govern the amount of such commission that will be accepted for purposes of determining the taxable income of DISC and the related entity.
The Internal Revenue Service generally has the authority to allocate gross income and deductions between two or more organizations owned or controlled by the same interests if such allocation is necessary to prevent tax evasion or to clearly reflect the income of those organizations.14 And, “[i]In determining the true taxable income of a controlled taxpayer, the standard to be applied in all cases is that of an arm’s length taxpayer to an uncontrolled taxpayer.”15 As a result, “[a] a controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been obtained if non-controlled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result).”16 Despite the detailed and lengthy guidelines of Treasury regulations for determining whether a particular transaction meets the arm’s length standard, determining the appropriate transfer price can be a matter of intense and protracted contention.
Things are a bit simpler for DISCs. The taxable income of a DISC and a related entity is the transfer price that would allow the DISC to derive taxable income not exceeding the greater of:
- 4% of DISC qualifying export earnings on the sale of such goods plus 10% of DISC export promotion expenses attributable to such earnings;
- 50% of the combined taxable income of that DISC and that person that is attributable to qualifying export earnings on that property from a sale by the DISC plus 10% of that DISC’s export promotion expenses attributable to that earnings, Where
- taxable income based on the sale price actually invoiced (but subject to normal transfer pricing rules).17
Thus, DISCs have more concrete methods for determining transfer prices between themselves and related entities.
How does a company choose to be a DISC?
A company must elect to be treated as a DISC by filing a Form 4876-A.18 The election must be filed with the IRS within the 90-day period immediately preceding the start of the tax year, unless the IRS agrees to another time.19
All of this is just the tip of the iceberg when it comes to DISC. If you want to dig deeper or have questions about DISCs, our company is here to help. Call us to schedule a free consultation.
1 See S.Rep. No. 437, 92d Cong.
2 Caterpillar Tractor Co. v. Comm’r, 589 F2d 1040, 1044 (Ct. Cl. 1978).
3 Dresser Indus., Inc. v. Comm’r, 911 F.2d 1128, 1131 (5th Cir. 1990) (citing note, The Creation of a Subsidy, 1984: The International Tax and Commercial Implications of the Foreign Sales Company Law, 38 Stan. L.Rev. 1327, 1334-55 (1986)).
4 IRC § 991.
5 IRC § 995(b).
6 View ID.
seven See IRC §§ 995(b)(1)(E), (c), 996
8 IRC § 995(f).
9 See IRC § 992(a)(1); Treasures. Reg. § 1.992-1(a)(1), (7).
10 IRC § 992(d); Treasures. Reg. § 1.992-1(f).
11 IRC § 993(a)(1)(A).
12 IRC § 993(b).
13 IRC § 993(c)(1).
14 IRC § 482.
15 treasures. Reg. § 1.482-1(b)(1).
16 treasures. Reg. § 1.482-1(b)(1).
17 IRC § 994(a). “Export promotion expenses” are “expenses incurred to advance the distribution or sale of export goods for use, consumption, or distribution outside the United States.” ID. § 994(c).
18 IRC § 992(a)(1)(D).
19 IRC § 992(b)(1)(A).
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