Since Congress created interest-charge domestic international sales corporations (IC-DISCs) in the 1970s, they’ve fallen into and out of favor as tax laws evolved. While popular since 2004, in the past few years their popularity has slipped slightly due to the higher tax rate on qualified dividends—the type of income IC-DISCs can generate—and the 3.8 percent net investment income tax. But there’s a way to offset the effect of these rising rates and increase the benefits of using an IC-DISC: by increasing its income through accounts receivable (A/R) factoring.
If your business exports goods it has manufactured, produced, grown, or extracted, setting up an IC-DISC could yield permanent tax savings.
IC-DISCs are IRS-approved corporations set up by exporting companies. They work like this: An IC-DISC charges its exporting company a commission on the exporting company’s qualified export sales. The IC-DISC itself isn’t required to pay tax on the commission income. Generally, the IC-DISC then distributes its income back to its owners in the form of a qualified dividend. The individuals who are shareholders in an IC-DISC (either directly or indirectly, through a pass-through entity such as a partnership or S corporation) then pay tax on that income at the beneficial qualified dividend rate.
While the IC-DISC can also be owned by a C corporation, individuals that directly own the IC-DISC stand to benefit most. Consequently, individual taxpayers in the highest tax bracket are able to reduce their tax rate from 39.6 percent to 20 percent on a portion of their qualifying export profit. (That’s before adding in the Medicare contribution tax.) For many exporters, this amounts to significant annual tax savings.
If your business already has an IC-DISC and has at least $5 million of export sales, you could be leaving money on the table if you aren’t also taking advantage of A/R factoring. Let’s look at how this kind of arrangement can help further reduce the overall taxes you owe.
How does A/R factoring result in additional tax savings through an IC-DISC? It allows a company to increase its qualified export revenue and, as a result, the income it can ultimately pay out as dividends. Under the tax code, qualified export revenue includes interest on any obligation that’s a qualified export asset. Income earned through a factoring arrangement is treated as interest. Qualified export assets include A/R that arises as a result of a qualified export sale. This is where A/R factoring comes into the picture.
In a typical A/R-factoring agreement, a company sells its A/R to another party at a discount in exchange for immediate payment. The buyer’s discount takes specific factors into consideration, such as whether the factoring arrangement is with or without recourse, the creditworthiness of debtors, debtor notification, and the administrative costs of collection. This additional burden, which the buyer takes on, is the bargaining chip that allows the buyer to purchase A/R at a discount when it could potentially reap the benefits of collecting on the full A/R amount.
When an exporter and its IC-DISC enter an A/R-factoring agreement, the exporter sells its A/R at a discount to the IC-DISC. The IC-DISC recognizes the discount as interest income, and the exporter is able to deduct the loss that results from the sale of its A/R. As a result, the A/R-factoring agreement increases the IC-DISC’s qualified export revenue, which isn’t subject to federal tax, and reduces the income of the exporter. Note that while this arrangement may seem a bit underhanded, the IRS agrees with the classification of these transactions, and the above positions are supported through a revenue ruling.
As for the financial impact of such an arrangement, let’s assume an exporter has $10 million in export sales with a 15 percent margin. It enters into an A/R-factoring agreement with its IC-DISC at a discount rate of 3 percent. The additional annual tax savings—beyond what the exporter would already reap from the IC-DISC alone—are almost $24,000.
Here’s how we got there: Thanks to the 3 percent rate stated in the A/R-factoring agreement, the IC-DISC earns an extra $300,000 on the $10 million in export sales, generating an additional $150,000 (using a typical 50/50 commission calculation) in income eligible to be paid as a dividend to the IC-DISC’s shareholders. That additional income now receives the same preferential tax treatment as other IC-DISC dividends. Rather than paying the 39.6 percent ordinary income tax rate at the top tax bracket, shareholders pay 23.8 percent (the qualified dividend tax rate plus the 3.8 percent net investment income tax). That creates a differential of 15.8 percent, reducing the tax paid on $150,000 from more than $59,400 to a little under $35,700, which creates the $24,000 in savings.
So, whether you do or don’t have an IC-DISC, what’s your next step?
If your exporting company already has an IC-DISC, the first step is to determine which receivables can be assigned to it. If none, then you’ll need to have the terms of those receivables changed to allow A/R to be purchased by your IC-DISC.
Next, determine whether the factored A/R is recourse or nonrecourse. At this point, it’s essential to have a transfer pricing study performed to determine the appropriate discount margin. The purchase price of the A/R must abide by the arm’s-length principle, which requires that transactions between related parties be conducted as if they were between unrelated entities. Your transfer pricing study will also establish a pricing scheme for A/R-related services provided by the exporter.
If you don’t currently have an IC-DISC but are interested in setting one up, you’ll first need to analyze your export sales to determine if your export activity is profitable. Since the commission payable to the IC-DISC can’t create a loss for the supplier, you’ll have to overcome this initial hurdle before you can take advantage of the benefits of an IC-DISC, let alone A/R factoring.
We Can Help
Our international tax professionals are well-versed in IC-DISCs and many other international tax planning opportunities that may reduce your tax exposure.
If you don’t already have an IC-DISC, Moss Adams can help you quantify the potential annual tax savings of implementing one. If you do have an IC-DISC and want to explore the tax benefits of A/R factoring, we can help you identify appropriate A/R and provide transfer pricing services to support an arm’s-length purchase price for the A/R as well as coordinate with legal counsel to draft a factoring agreement between you as the exporter and your IC-DISC. Furthermore, we can help you complete your year-end accounting by calculating the commission paid to your IC-DISC and determining the income from factoring. To learn more, contact your Moss Adams professional.