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California treatment of transactions between IC DISCs and their owners
Multistate tax alert | July 17, 2015
This tax alert summarizes the California Franchise Tax Board's Legal Ruling 2015-02, which addresses California tax treatment of Interest Charge Domestic International Sales Corporations, and provides taxpayer considerations.
- IC DISC background
- California treatment of IC DISC transactions
- Taxpayer considerations
The California Franchise Tax Board (FTB) recently issued Legal Ruling (LR) 2015-02, which addresses California tax treatment of Interest Charge Domestic International Sales Corporations (IC DISCs).1
California does not conform to Internal Revenue Code (IRC) §§ 991-997, which provides for the federal taxation of IC DISCs and their shareholders. The FTB has determined that “because transactions between an IC DISC and its owner consist only of entries on the IC DISC's books and records, those transactions lack true economic substance. Even in instances where there is a cash payment pertaining to a commission, the underlying transaction lacks economic substance.”2 Using the authority granted to the FTB by California Revenue and Tax Code § 25102, the FTB has determined it has the authority to allocate gross income and deductions between the corporation (the IC DISC) and its owners (or other affiliated entities owned or controlled directly or indirectly by the same interests) in order to properly report income that the FTB views as lacking economic substance for California purposes.3
Except when an IC DISC and its owner, another C Corporation, are included within a combined return, it is the FTB’s position in LR 2015-02 that all of the IC DISC’s income is to be attributed to the owner of the IC DISC or other commonly controlled affiliates. The mechanics of the reallocation differ depending on the type of taxpayer that owns the IC DISC and the nature of the income attributable to the IC DISC.4
In LR 2015-02 the FTB held that if the owner of an IC DISC is a C Corporation and is included in a combined report, the income attributed to the IC DISC is offset by the cost of goods sold or expenses attributed to its owner, resulting in no additional California taxable income.5 If the owner is an individual or pass-through entity and the income is attributable to sales, the FTB will allocate the sales to the owner(s) of the IC DISC.6 If the income is a commission, the FTB will allocate the commission income to the owner(s), and then such income will be offset by the commission expense at the level of the IC DISC owner.7 For an IC DISC that does not file as a member of a combined return, the allocation causes the IC DISC to have no income or earnings and profits for purposes of California taxation. For an IC DISC organized under California law or registered with the California Secretary of State, the corporation designated as the IC DISC will be subject to the California minimum tax with the result generally being a liability of $800.
This tax alert summarizes LR 2015-02 and provides taxpayer considerations.
For a full list of references, download the PDF
IC DISC background
IC DISCs were created by the US Congress to encourage the export of American goods.8 An IC DISC usually has no employees or actual operations and is not directly subject to federal taxation.9 Instead, theowners of an IC DISC are taxed on the earnings and profits of the IC DISC, whether or not the IC DISC makes a distribution to its owners.10 Therefore, under federal law, owners are treated as receiving a deemed dividend distribution from the IC DISC.11 If an IC DISC owner is an individual, the dividends are subject to tax at the capital gains rate under IRC § 1(h)(11).12 Consequently, IC DISCs are often structured through ownership by pass-through entities, resulting in the deemed dividend distribution from the IC DISC flowing up to the individual owners where it is taxed at capital gains rates.13
Income is attributable to IC DISCs in two ways. In the first situation, the owner attributes offshore sales to the IC DISC through a series of entries on the IC DISC’s books and records, with the profits from the first $10 million of export revenue included in the IC DISC’s earnings and profits (E&P), but excluded from the deemed dividend provisions.14 The income related to the first $10 million of export revenue represents an additional tax deferral, though the owner is subject to an “interest charge” on the amount of tax savings related to the deferral.15 For purposes of federal income tax, title of the goods sold offshore (export sales) is not transferred to the IC DISC; however, the profits from the attributed sales are reflected in the IC DISC’s earnings. The profits associated with more than $10 million of export revenue are deemed distributed to the owner in the form of a dividend.
In the second situation, the owner pays a commission to the IC DISC for acting as a broker for sales made by the IC DISC.16 Because the IC DISC is generally a “shell” company without actual employees, the IC DISC does not actually act as a broker.17 Nevertheless, the commission income is reflected in the IC DISC’s E&P.18 However, the owner of the IC DISC is allowed a deduction, on the owner’s federal tax return, for the commission that it pays to the IC DISC.19 The commission income in excess of the commission associated with $10 million of export revenue is deemed distributed to the owner in the form of a dividend.20 In both cases, even if cash is actually transferred between the IC DISC and its owner(s), the FTB finds no economic substance to the transactions generating the income.21
California treatment of IC DISC transactions
LR 2015-02 formalizes the FTB’s position with respect to California tax treatment of IC DISCs. Specifically, the FTB stated IC DISCs are not respected for California purposes, even though the corporations designated as IC DISCs and their owner(s) may have a filing obligation in California.22
As previously noted, the FTB stated that if the owner of an IC DISC is a C Corporation and is included in a combined report, the income attributed to the IC DISC is offset by the cost of goods sold to its owner, resulting in no additional California taxable income.23 However, the FTB recognized that most owners of IC DISCs are individuals or pass-through entities and as such are not subject to combined reporting. Without combined reporting, the transactions between an IC DISC and its owner(s) will not have the effect of offsetting one another.
For California purposes, the FTB has deemed the sales or commission income attributed to the IC DISC under federal tax law lacks economic substance.24 Therefore, the sales are allocated to the owners of the IC DISC or commonly controlled entity that actually made the sales attributed to the IC DISC. If the IC DISC income is commission income, the commission income is allocated to the owner(s) or commonly controlled entity. In effect, this offsets the commission expense at either the level of the IC DISC owner or other controlled entity.25
The FTB provided five examples in LR 2015-02:
- Where an S Corporation is the owner of the IC DISC and the S Corporation attributes all of its foreign sales to the IC DISC, the FTB held the foreign sales income attributed to the IC DISC is allocated to the owner, the S Corporation, for purposes of determining its taxable income.
- Where an LLC is the owner of the IC DISC and the LLC paid a commission to the IC DISC, the FTB held all of the commission income is allocated to the owner, the LLC, which offsets the LLC’s commission expense for purposes of determining the LLC’s California taxable income.
- Where a partnership is the owner of the IC DISC and the partnership attributes its foreign sales to its IC DISC, the FTB held all of the foreign sales income is allocated to the owner, the partnership, in calculating its income for California tax purposes.
- Where an individual is the owner of the IC DISC and the individual attributes all of his or her foreign sales to his or her IC DISC, the FTB held all of the foreign sales income is allocated to the individual.
- Where a shareholder is the owner of both an IC DISC and a C Corporation and the C Corporation pays a commission to the IC DISC, the FTB held the IC DISC’s commission income is allocated to the commonly controlled C Corporation, offsetting its commission expense when determining its taxable income.26
In all instances, the FTB also held that if the IC DISC was registered in California, the IC DISC is subject to the California minimum franchise tax.27
LR 2015-02 provides that California does not follow federal tax treatment of IC DISCs. FTB Legal Rulings are considered equivalent authority to an IRS Revenue Ruling, provide the FTB’s interpretation of existing law, and have retroactive effect unless stated otherwise.28 LR 2015-02 does not contain a statement limiting its retroactive effect. Accordingly, owners of IC DISCs or related affiliates, including partners, members, and shareholders of pass-through entities, should discuss their options with their tax advisor, including amending their prior year tax returns to reflect the income allocable to them from their IC DISCs, applying the principles as outlined in LR 2015-02.29 Any changes to the income of an S Corporation will be taxed at the level of the S Corporation at a tax rate of 1.5 percent. A taxpayer that proactively amends its returns to apply this guidance may be better positioned should FTB enforcement efforts related to IC DISCs increase in connection with the ruling.
IC DISCs that paid amounts in excess of the California minimum tax (generally $800) may want to consider filing a refund claim. Entities either organized under California law or registered with the California Secretary of State are subject to the California $800 minimum tax.
If you have questions regarding LR 2015-02 or other California tax matters, please contact any of the following Deloitte Tax LLP professionals:
Steve West, director, Deloitte Tax LLP, Los Angeles, +1 213 688 5339
Mark Chao, director, Deloitte Tax, LLP, Costa Mesa, +1 714 436 7816
Mark C. Thompson, partner, Deloitte Tax LLP, Minneapolis, +1 612 397 4728
David Vistica, director, Deloitte Tax LLP, Washington DC, +1 202 370 2268
Valerie Dickerson, partner, Deloitte Tax LLP, Washington DC, +1 202 220 2693
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