Created by Congress in 1971 as a tax incentive for domestic exporters of U.S.-made goods, the domestic international sales corporation (DISC) remains a viable tool for small-to-medium sized exporters to reduce their federal income tax liability.[1]
A DISC typically is just “a shell corporation with no employees, the only purpose of which is to act as an accounting vehicle for the earnings of its affiliated or parent corporation.”[2] Special transfer pricing rules allow DISCs to “skim[] the export profits of the parent corporation by taking ‘commissions’ on the parent’s export sales.”[3]
This comes in handy because DISCs are not subject to federal income tax.[4] Instead, the DISC’s shareholders are treated as receiving a distribution equal to their pro rata shares of certain income earned by the DISC during the taxable 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 gist is that federal income tax on the first $10 million of the DISC’s qualified export receipts (more on those below) generally is deferred until either the DISC actually makes a distribution to its shareholders, or the shareholders sell their stock in the DISC.[7]
This deferral comes at a cost, however. The DISC’s shareholders must pay interest each taxable year at the base period T-bill rate on the amount that their tax liabilities for the year would have been increased if they had included their pro rata shares of the DISC’s deferred income as gross income in that year.[8]
What is a DISC?
A DISC is a corporation formed under the laws of any U.S. state or the District of Columbia that, during any taxable year, meets the following requirements:
- 95% or more of the corporation’s gross receipts are qualified export receipts;
- the adjusted basis of the corporation’s qualified export assets is at least 95% of the adjusted basis of all of the corporation’s assets as of the end of the taxable year;
- the corporation does not have more than one class of stock and the par value or stated value of its outstanding stock is at least $2,500 on each day of the taxable year; and
- the corporation has made an election to be treated as a DISC for the taxable year and keeps its own books and records.[9]
Certain domestic corporations, however, are ineligible to be treated as a DISC. These include tax-exempt organizations, personal holding companies, financial institutions, insurance companies, regulated investment companies, and S corporations.[10]
What are Qualified Export Receipts and Qualified Export Assets?
“Qualified export receipts” generally include gross receipts from the disposition of export property, services performed in connection with the disposition of such property, engineering and architectural services for construction projects located outside the United States, and certain dividends and interest.[11]
“Qualified export assets” include (among other things) export property and assets primarily used in connection with the sale, lease, rental, storage, handling, transportation, packaging, assembly, or servicing of export property, or the performance of certain services that generate qualified export receipts.[12]
What is Qualified Export Property?
A common feature of the definitions of qualified export receipts and qualified export assets is their reference to “export property,” which is defined as property (not including certain intangible property, property qualifying for a depletion deduction, unprocessed softwood lumber, and property whose export is prohibited or curtailed) that is:
- manufactured, produced, grown, or extracted in the United States by a person other than a DISC;
- held primarily for sale, lease, or rental, in the ordinary course of a trade or business, by, or to, a DISC, for direct use, consumption, or disposition outside the United States; and
- not more than 50% of its fair market value is attributable to articles imported into the United States.[13]
A person is considered to manufacture or produce property if the person substantially transforms the property. Instances of substantial transformation include “the conversion of wood pulp to paper, steel rods to screws and bolts, and the canning of fish.” Property also is considered to be manufactured or produced by a person if the person’s conversion costs for such property account for at least 20% of the person’s cost of goods sold for the property (if the property is to be sold) or the person’s adjusted basis in the property (if the property is to be leased or rented).
Are there Special Transfer Pricing Rules for DISCs?
As mentioned above, a DISC often works in concert with a related entity to sell export property, with the related entity paying the DISC a commission for its services. Special transfer pricing rules govern the amount of this commission that will be accepted for purposes of determining the DISC’s and the related entity’s taxable income.
The Internal Revenue Service generally has the authority to allocate gross income and deductions among two or more organizations owned or controlled by the same interests if this allocation is necessary to avoid tax evasion or clearly reflect the income of such organizations.[14] And, “[i]n determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.”[15] As a result, “[a] controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result).”[16] Despite the Treasury Regulations’ detailed and lengthy guidelines for determining whether a particular transaction meet the arm’s length standard, determining the appropriate transfer price can be a matter of intense and protracted contention.
Things are a little 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 to exceed the greatest of:
- 4% of the DISC’s qualified export receipts on the sale of such property plus 10% of the DISC’s export promotion expenses attributable to such receipts;
- 50% of the combined taxable income of such DISC and such person which is attributable to the qualified export receipts on such property derived as the result of a sale by the DISC plus 10 percent of the export promotion expenses of such DISC attributable to such receipts, or
- taxable income based upon the sales price actually charged (but subject to normal transfer pricing rules).[17]
Thus, DISCs have more concrete methods for determining the transfer prices between themselves and related entities.
How does a Corporation Elect to be a DISC?
A corporation must elect to be treated as a DISC by filing a Form 4876-A.[18] The election has to be filed with the IRS during the 90-day period immediately preceding the beginning of the taxable year, unless the IRS agrees to another time.[19]
Closing Thoughts?
All of this is just the tip of the iceberg when it comes to DISCs. If you would like delve further into or have any questions whatsoever regarding DISCs, our firm is here to help.
International and Offshore Tax Compliance Attorneys
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[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) (quoting Note, The Making of a Subsidy, 1984: The Tax and International Trade Implications of the Foreign Sales Corporation Legislation, 38 Stan. L. Rev. 1327, 1334-55 (1986)).
[4] I.R.C. § 991.
[5] I.R.C. § 995(b).
[6] See id.
[7] See I.R.C. §§ 995(b)(1)(E), (c), 996
[8] I.R.C. § 995(f).
[9] See I.R.C. § 992(a)(1); Treas. Reg. § 1.992-1(a)(1), (7).
[10] I.R.C. § 992(d); Treas. Reg. § 1.992-1(f).
[11] I.R.C. § 993(a)(1)(A).
[12] I.R.C. § 993(b).
[13] I.R.C. § 993(c)(1).
[15] Treas. Reg. § 1.482-1(b)(1).
[16] Treas. Reg. § 1.482-1(b)(1).
[17] I.R.C. § 994(a). “Export promotion expenses” are “those expenses incurred to advance the distribution or sale of export property for use, consumption, or distribution outside of the United States.” Id. § 994(c).
[18] I.R.C. § 992(a)(1)(D).
[19] I.R.C. § 992(b)(1)(A).
