Why Filmmakers, Independent Studios, and Content Creators Should Consider IC-DISCs For Tax Planning

The IC-DISC (Interest Charge Domestic International Sales Corporation) is a powerful tax shelter that can significantly benefit Hollywood filmmakers. Through an IC-DISC, U.S. exporters may defer the U.S. tax on taxable income attributable to certain qualified export receipts. While an IC-DISC sounds like a strategy built exclusively for traditional factories exporting heavy machinery, films, television shows, and software may be legally classified as “qualifying export property” under the Internal Revenue Code. An IC-DISC exists as a separate entity apart from a parent company. Export sales from the parent company flow through the IC-DISC, and the IC-DISC receives a commission based on either 4% of gross receipts or 50% of the net foreign sales income. Tax can be deferred on commissions on up to $10 million per year in export sales conducted by the IC-DISC. The commissions are then possessed as dividends to IC-DISC shareholders.
An IC-DISC must be a domestic corporation with a single class of stock that has a minimum par value of $2,500. However, an IC-DISC is not subject to the regular U.S. corporate income tax. Although the IC-DISC itself is not a taxable entity, the IC-DISC’s U.S. shareholders are subject to tax on deemed dividend distributions from the first $10 million of the IC-DISC’s qualified export receipts each year. Therefore, an IC-DISC allows a U.S. shareholder to defer paying U.S. tax on the income derived from up to $10 million of qualified export receipts each year. Once IC-DISC dividends are distributed, they may be taxed at preferential capital gains rates.

This article provides an overview regarding the qualifications for an IC-DISC. This article also discusses how an IC-DISC is a highly effective tax strategy that permits independent filmmakers, production companies, and content creators to reduce their federal tax burden when exporting films, television shows, and other digital content.

Special Rules for IC-DISCs

Beyond the standard tax savings discussed below, firmmakers, independent studios, and content creators may defer U.S. tax on taxable income attributable to $10 million or less on “qualified export property.” However, shareholders of an IC-DISC must pay an interest charge on its IC-DISC-related deferred tax liability, which equals the difference between the accumulated IC-DISC income of the shareholder that has been deferred over the years. See IRC Section 995(f)(2). Therefore, a shareholder of an IC-DISC must continue to pay interest on deferred IC-DISC income until that income is distributed or deemed distributed by the IC-DISC. The interest rate is the current market rate for 52-week Treasury bills. IRC Section 995(f)(5). That rate is adjusted annually and applies for the fiscal year ending September 30.

IC-DISC shareholders compute the interest charge on Form 8404, Computation of Interest Charge on DISC-Related Deferred Tax Liability. No estimated tax payments are required with respect to the interest charge. If the IC-DISC distributes cash representing all its income, the interest charge is inapplicable.

To qualify as an IC-DISC, the entity must be a corporation. The corporation must (1) be incorporated under the laws of any state or the District of Columbia; (2) have only one class of stock; (3) have outstanding capital stock with a par or stated value of at least $2,500; (4) elect to be treated as a IC-DISC; and (5) meet an export gross-receipts test and an export-assets test.

The export-receipts test requires that at least 95 percent of the corporation’s gross receipts consist of qualified export receipt. In general, qualified export receipts are receipts, including commission receipts, derived from the sale or lease for use outside the United States of export property or from the furnishing of services related to the sale or lease of export property. Certain receipts for managerial services performed by an IC-DISC for an unrelated IC-DISC are qualified export receipts. Interest on any obligation which is a qualified export asset is also a qualified export receipt. Export property must be manufactured, produced, grown or extracted in the United States and held primarily for sale, lease, rent, consumption or disposition outside the United States. See IRC Section 993(c).

The export-assets test requires that at least 95 percent of the corporation’s assets constitute qualified export assets. Qualified export assets include principally inventories of export property, necessary operational equipment and supplies, trade receivables from export sales, producer’s loans, working capital, and obligations of domestic corporations organized solely to finance export sales.

The Manufacturing Requirement

The IC-DISC may not manufacture the export property. It must be manufactured in the United States by a person other than the IC-DISC. Generally, the shareholders of a U.S. manufacturing entity will form an IC-DISC to capture export sales. The IC-DISC will typically receive a commission for the export sales (with a corresponding commission deduction by the U.S. manufacturing entity). Although not as common, occasionally an IC-DISC will be a “buy-sell” IC-DISC, whereby the IC-DISC will actually buy and take title to the export property from the U.S. manufacturing entity before the export sales occurs. Property is manufactured within the United States if either 1) 20 percent of its conversion costs are incurred in the United States; (2) there is a substantial transformation in the United States; or 3) the operations in the United States are generally considered to constitute manufacturing. See IRC Section 993(c).

The Destination Test

The export property must satisfy a destination test, which must be held for sale, lease or rental in the ordinary course of business for direct use, disposition or consumption outside the United States. See IRC Section 993(c)(1)(B). Property satisfies the destination test if it is delivered to a freight forwarder for ultimate shipment abroad. Treas. Reg. Section 1.993-3(d)(2)(i)(a). Property also satisfies the destination test if it is sold to a purchaser in the United States, provided the property does not undergo further manufacturing by the purchaser prior to export and the property is shipped to a foreign destination within one year. See Treas. Reg. Section 1.993-3(d)(2)(i)(b). Under this destination test, what may seemingly be domestic sales could qualify as export sales. The purchasers of an exporter’s product will have to provide the exporter with information showing that the product was exported and, if the domestic purchasers cooperate, the IC-DISC can benefit from these sales. The U.S. purchaser will have to provide the IC-DISC with documentation of ultimate shipment outside the United States, which includes a copy of the export bill of lading or the shipper’s export declaration.

The Minimum of 50 Percent U.S. Content Requirement

All properties may have no more than 50 percent of the value of the final costs attributable to foreign components. The fair market value of the foreign content is determined based on the dutiable value of any foreign components, regardless of any customs benefits that would result in a lower dutiable value. See Treas. Reg. Section 1.993-3(e)(4)(i).

Determining The IC-DISC Benefit

The income of an IC-DISC of export property is in an amount constituting:

1) 4 percent of qualified export receipts from a transaction.

2) 50 percent of the combined taxable income of the IC-DISC and its related party from an export transaction; in either case, the IC-DISC is also deemed to earn ten percent of export promotion expenses, or

3) The arm’s-length amount determined under the transfer pricing principles of Section 482. The IC-DISC provisions include special elective intercompany price rules, which may be used in lieu of the general intercompany pricing rules of Section 482 to determine the profits which a IC-DISC may earn on products that it purchase from a related company and then resells for export or that it sells on a commission basis.

Maximizing The IC-DISC Income

An exporter can use any of the methods discussed above to achieve the greatest IC-DISC income possible. The IC-DISC rules permit the use of different methods to different sales based on product lines, recognized industry or trade usage, and even by transaction. See Treas. Reg. Section 1.994-1(c)(7).

Grouping

Grouping refers to the exporter maximizing the IC-DISC’s commission by separating high-margin sales from low-margin sales. Exporters have considerable flexibility in grouping. An exporter’s product or product line grouping will be accepted if the grouping conforms to recognized trade or industry usage or the two-digit major groups (or interior classifications) of Standard Industrial Classification codes. Treas. Reg. Section 1.994-1(c)(7)(ii). In addition, within the same taxable year, an exporter can use grouping for one product line and the transaction-by-transaction method for another product line. Treas. Reg. Section 1.994-1(c)(7)(iii). The availability of specialized software designated to optimize the IC-DISC’s income generated by transactional pricing (as well as marginal costing and expense allocation, as discussed below) has greatly enhanced the ability of companies to take advantage of these planning techniques.

Marginal Costing

As per Internal Revenue Code Section 994(b)(2) and Treasury Regulation 1.994-2(c), a second technique for increasing the IC-DISC’s income is marginal costing. Under the general rule, combined taxable income equals the excess of the qualified export receipts over the total direct and indirect costs related to exports. If the exporter elects marginal costing, however, only marginal costs are taken into account in computing combined taxable income. Therefore, marginal costing allows a taxpayer to increase combined taxable income by the amount of the fixed costs related to export sales. All other costs, such as selling, general, and administrative expenses, and interest expenses, are ignored for purposes of computing combined taxable income. See Treas. Reg. Section 1.994-2(b)(2). An overall profit percentage limitation restricts the combined taxable income of an exporter to an amount equal to full costing combined taxable export receipts to total receipts (domestic and foreign). See Treas. Reg. Section 1.994-2(b)(3).

Expense Allocation

A third technique for increasing IC-DISC’s income is expense allocations. As discussed above, combined taxable income equals the excess of qualified export receipts over the total costs of the exporter, which includes deductions that are definitely related to export sales (e.g., cost of goods sold) and a ratable portion of any deductions that are not definitely related to any specific class of gross income (e.g., interest expense and selling, general and administrative expenses). See Treas. Reg. Section 1.994-1(c)(6)(iii). Therefore, a taxpayer can increase combined taxable income and, in turn, the amount of its IC-DISC income, by developing defensible apportionment bases that allocate fewer deductions against qualified export receipts.

Domestic Production Deduction

The domestic production deduction is equal to 9 percent of the lesser of taxable income or qualified production activities income of the taxpayer. In determining the amount of the deduction, a taxpayer must analyze the following items:

1) Domestic production gross receipts;

2) Costs allocated to domestic production gross receipts; and

3) Amount of W-2 wages. The deduction is limited to 50 percent of the W-2 wages related to the taxpayer’s domestic production gross receipts. See IRC Section 199(b).

Domestic production gross receipts are generally any sale, exchange, or other disposition of qualifying production property that is manufactured, produced, grown, or extracted by the taxpayer in the United States. Once the domestic production gross receipts are determined, allocable costs (the cost of goods sold deduction and other deductions allocable to the receipts) are subtracted from them to determine qualified production activities income. Finally, the domestic production deduction is limited to 50 percent of the taxpayer’s W-2 wages related to domestic production gross receipts.

Determining Domestic Production Gross Receipts

Domestic production gross receipts are generally any sale, exchange, or other disposition of qualifying production product that is manufactured, produced, grown, or extracted by the taxpayer “in whole or in significant part within the United States.” See IRC Section 199(c)(4)(A)(i)(I).

By using the phrase “in significant part within the United States,” Congress has created an ambiguity with respect to how much of the property can be produced outside the United States. Pursuant to regulations issued by the IRS, property is produced “in significant part within the United States” if the production activity in the United States is substantial in nature. A safe harbor states that property is substantial in nature if at least 20 percent of the cost of goods sold of the property is attributed to U.S. activity. See Treas. Reg. Section 1.999-3(g).

If the 20 percent safe harbor does not apply, there is a facts and circumstances test to determine if the U.S. activity is substantial in nature. However, the use of a previously existing design from the United States with a foreign contract manufacturer does not constitute “substantial” activity in the United States. See Treas. Reg. Section 1.999-3(g)(5)(ex. 9). Qualifying production property also includes the sale of electricity, natural gas, potable water, engineering or architectural services performed in the United States for construction projects located in the United States, software, and the sale or license of a qualified film the taxpayer produces (more than 50 percent of the compensation of which is paid for services that are performed in the United States).See  IRC Section 199(c)(4) and (5).

Broad Definition of Production Activity and its Application to Filmmakers and Production Companies

Qualifying production property also includes the sale or license of a qualified film that an exporter produces (more than 50 percent of the compensation of which is paid for services that are performed in the United States). See IRC Section 199(c)(4) and (5). Because of high costs of filming and production costs in California have dramatically risen over the years, many films are now produced abroad, particularly in Canada. IC-DISC’s provisions offer a planning opportunity for filmmakers and production companies to bring some film production back to the United States.

For example, assume that Sundance Film Co, a U.S. corporation is a motion picture film studio. Sundance Film Co has a film called LA Nights to be set in Los Angeles, California. Wanting to take advantage of lower production costs, Sundance Film Co decides to shoot the film in Vancouver, Canada. Before filing starts, Sundance Film Co is informed about IC-DISC’s provisions by a tax attorney. Sundance’s tax attorney informs it that the company’s cost of services performed in the United States by actors, production personnel, directors, and producers are at least 50% of compensation costs. Under the IC-DISC’s broad definition of “production activity,” the film “LA Nights” will produce gross receipts that are eligible for the domestic production deduction. As a result, Sundance Film Co will shoot only exterior scenes in Vancouver to satisfy the IC-DISC’s requirements and keep at least 50% of its “production activity” in the United States.

Allocable Costs and Qualified Product Gross Income

After determining domestic production gross receipts, an exporter arrives at qualified production activities income by subtracting allocable costs- the cost of goods sold deduction and other deductions allocable to the receipts. See IRC Section 199(c)(1)(B). Special rules determine when the manufacturing of the qualifying production property includes some foreign activity. To maintain the integrity of any cost allocation, any item or service shall be treated as purchased for a cost equal to its value when it enters the United States. See IRC Section 199(c)(3)(A). Furthermore, if property is exported for further manufacturing abroad, when the property reenters the United States, the costs of the further manufacturing abroad cannot exceed the difference between the value of the property when exported and the value of the property when it reenters the United States. This rule effectively limits expenses allocable to foreign production activities, which prevents taxpayers from artificially increasing their qualified production activities income.

Producer’s Loan

One of the major innovations of the DISC system of tax deferral lay in the ability of the IC-DISC to make its undistributed export profits available to its U.S. parent company through “producer’s loans” without losing the benefit of the tax deferral. Because a producer’s loan is not taxed as a dividend, it affords the parent company a means of withdrawing the tax-deferred export profits of the IC-DISC at no tax cost, except the interest on the shareholder’s deferred tax. However, all producer’s loans must bear interest at an arm’s length rate.

A “producer’s loan” must meet certain requirements prescribed in Section 993(d) of the Internal Revenue Code at the time it is made, but once qualified, such a loan is not disqualified by subsequent events. The loan must be designated a “producer’s loan;” by being evidenced by a note with a term of no more than five years. The loan can be made only to a person engaged in the United States in the production of export property and, when added to the unpaid balances of all other producer’s loans, it must not exceed the accumulated IC-DISC income. See IRC Section 993(d)(1).

Tax Treatment of DISC Income

The IC-DISC itself is not taxed on any of its income. Rather, it is the shareholder of the DISC that may be subject to taxation on a portion of the IC-DISC’s earnings and profits. In general, the portion of the IC-DISC’s income that does not qualify for deferral is taxed to its shareholders as a dividend currently, whether or not it is actually distributed, while the remainder is taxed to them when it is actually distributed as a dividend, when it is “deemed distributed,” when the shareholder sells or otherwise disposes of the stock in the IC-DISC or when the corporation ceases to qualify as an IC-DISC.

Under Section 995(b)(1) of the Internal Revenue Code, a shareholder is deemed to have received a distribution taxable as a dividend in an amount equal to the shareholder’s pro rata share of the sum of:

1) The gross interest from producer’s loans;

2) The gain recognized by the IC-DISC on the sale or exchange of property (other than qualified export assets) which was transferred to the IC-DISC in a transaction in which no gain was recognized, but only to the extent of the gain not recognized on the earlier transfer;

3) The gain recognized by the IC-DISC on the sale or exchange of property;

4) The taxable income of the IC-DISC for the tax year is attributable to qualified export receipts that exceed $10 million.

Planning Options for Filmmakers and Production Companies

For filmmakers, independent studios, and content creators, the IC-DISC represents one of the most powerful- yet frequently overlooked federal tax planning options. Because movies, TV shows, and digital content distributed globally are legally classified as “exported property,” an IC-DISC permits filmmakers to convert high-tax ordinary income into lower-tax qualified dividends.

A filmmaker or studio may form a C-corporation that elects IC-DISC status. The failmarker or movie studio can set up the IC-DISC to utilize a number of tax planning strategies. First, if a Filmmaker has high revenues, but narrow overall net profit margin, it can allocate 4% of total qualified foreign gross receipts to an IC-DISC. Below please see Illustration 1 for an example of how a filmmaker can allocate 4% of its total qualified foreign gross receipts to an IC-DISC.

Illustration 1.

UC, a U.S. citizen, owns UC Films, a domestic independent film studio. UC Films has qualifying export sales of $6 million through its IC-DISC. Using 4% of the qualified export receipts method, UC Films will exclude a commission of $240,000 from its U.S. taxable gross receipts. UC Films pays a tax-deductible commission to the IC-DISC which reduces its ordinary taxable income (which can be taxed at a rate as high as 37 percent. When the IC-DISC distributes these profits to UC, the income is taxed at preferential qualified dividend rates (limited to 23.8%, including the net investment income tax). The IC-DISC structure may create significant tax savings.

A filmmaker may also allocate 50 percent of its taxable income from export sales to an IC-DISC. Such a strategy could be ideal for blockbuster indie films or high-margin streaming licensing deals. Below, please see Illustration 2 for an example of such a planning opportunity.

Illustration 2.

UC, a U.S. citizen, owns UC Films, a domestic corporation. UC Films earns $1 million of taxable income from the export of films through its IC-DISC, Using the 50% of combined taxable income method, UC Films pays $500,000 as a commission to its IC-DISC and UC Films pays tax on only $500,000 of remaining taxable income. In this scenario, UC Films would choose the 50% method, as it yields a higher commission and, in turn, a larger tax deduction for the operating company.

Instead of evaluating the entire studio’s annual portfolio as a single block, filmmakers can apply a transaction-by-transaction or “product line” calculation. A movie studio or filmmaker can apply the 50% method to highly profitable films while simultaneously applying the 4% method to international film releases that had limited success. Such an approach will maximize the ultimate tax deduction.

If a filmmaker elects to hold cash inside the IC-DISC, it can defer tax consequences associated with foreign film releases well into the future as long as a loan agreement is executed. A production company may even use untaxed export profits to finance additional films. An IC-DISC is a federal tax incentive. Which means it can be combined with other domestic incentives such as the California Film & Television Tax Credit.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.