Foreign Sales Corporations and Domestic International Sales Corporations Can Provide Significant Tax BenefitsFall 1995
The federal tax code contains two systems designed to provide tax incentives for foreign sales, the foreign sales corporation ("FSC") provisions and the domestic international sales corporation ("DISC") provisions. In the proper situation, the FSC and DISC provisions provide significant tax savings. Companies with foreign sales should consider whether utilization of either of these provisions would be beneficial.
The FSC provisions generally provide that U.S. taxpayers establishing a FSC may obtain a partial exemption from U.S. tax on export profits. To utilize FSC benefits a taxpayer must organize a foreign corporation (in one of a number of permissible countries) that meets the following requirements: the corporation must (1) not have more than 25 shareholders, (2) not have any preferred stock outstanding, (3) maintain an office outside the United States at which it keeps certain financial records, (4) have at least one board member who is not a resident of the United States, (5) not be a subsidiary of a group of corporations of which a DISC is a member, and (6) elect to be taxed as a FSC. A number of service companies provide "turn-key" services tailored to FSCs that make it quite easy to establish a foreign office, retain a non-resident director and otherwise satisfy the requirements.
The FSC typically enters into a contract with its U.S. affiliate (the "Operating Company") that enables the FSC to earn a profit on foreign sales by the Operating Company. The profit on these foreign sales is split between the FSC and the Operating Company on the basis of statutorily-established intercompany pricing rules. A portion of the profit allocated to the FSC is treated as tax-exempt income in the hands of the FSC and the remaining portion is subject to U.S. income tax. The FSC may then pay a dividend to its shareholder (ordinarily the Operating Company) and the dividend generally qualifies for a full dividends received deduction, provided that the recipient is a "C" corporation and not an individual or "S" corporation.
As an example, under one common administrative pricing method 23% of the combined taxable income of the FSC and the Operating Company from qualified foreign sales is allocated to the FSC. Of this amount, 15/23 is exempt income not subject to U.S. tax, while 8/23 is subject to U.S. tax. The result is a 15% reduction in the U.S. tax on qualifying foreign sales. Assuming a 34% federal income tax bracket, the 15% reduction translates into a five percentage point decrease in the federal income tax rate.
For export transactions to qualify for the FSC benefit, certain "foreign management" and "foreign economic process" requirements have to be met. However, these requirements usually are not very difficult to satisfy. Furthermore, a corporation may elect to be treated as a "small FSC" and only take into account up to $5 million of foreign sales, in which case the FSC is excused from these requirements.
The FSC system was enacted to replace the DISC system and today FSCs are much more prevalent than DISCs, although DISCs may still be beneficial in some situations. DISCs were first created in 1971 to provide tax benefits to U.S. exporters. An exporter could establish a DISC, which was then permitted to earn a portion of the income generated from foreign sales by the exporter. Unlike a FSC, all of the U.S. tax on the income earned by the DISC could be deferred until the DISC repatriated the income to its shareholders in the form of dividends. Most DISCs did not pay dividends to their shareholders, but rather loaned their accumulated earnings to the U.S. Operating Company. The DISC system thus allowed for an indefinite deferral of U.S. tax on a portion of the income from foreign sales.
The DISC provisions were challenged as providing an impermissible export subsidy and violating the terms of the General Agreement on Tariffs and Trade. In 1984, partially in response to international pressure, Congress enacted the FSC provisions and amended the rules applicable to DISCs to provide that a DISC and its shareholders could continue to defer tax on the DISC’s income, but only if the DISC shareholders paid interest on the deferred tax. The revised DISCs, known as "interest charge DISCs," still provide benefits in at least two situations. First, a DISC can provide a source of financing to a start-up or growing business that otherwise finds financing difficult to obtain. No specific "underwriting" for the loan is required, other than the ability to meet the requirements for a DISC. Second, DISCs may have an unlimited number of shareholders and almost any type of shareholder. A "C" corporation paying dividends or desiring to pay dividends may find a DISC beneficial in reducing the double level of tax (both corporate tax and shareholder tax) on dividends distributed by the Operating Company. In effect, the DISC can operate as a mini S corporation by allowing only one level of tax on distributed profits.
The Wisconsin tax treatment of FSCs was unclear until earlier this year when the Legislature passed a bill federalizing Wisconsin treatment of FSCs. After this change, the overall tax savings of a FSC for a company operating in Wisconsin are greater than they were previously.
Due to the relative ease of organization and administration, we strongly recommend that companies with foreign sales explore the possible benefits of a FSC or a DISC.