The silver lining in the fiscal cliff tax changes
I tell my children that one needs to view the glass as half full and not half empty. That is, we need to focus on the good of each situation and the opportunity it presents. I often see that glazed look in their eyes as their father goes on again, giving some pearl of wisdom he must have been learned in the prior century. Of course, that is all so true.
As expected, Congress rang in the New Year in the heat of the tax debate on the fiscal cliff. For many taxpayers, they can look over the edge but have not fallen into the abyss.
The sigh of relief could be heard in many living rooms on New Year’s Day as the final debate and votes took place in passing the American Taxpayer Relief Act of 2012. The provision that impacted many taxpayers, the alternative minimum tax AMT, was again fixed with the “AMT patch.” The AMT patch was made permanent as were many other Bush-era tax cuts. The long-term capital gains rate and the qualified dividend rate were increased for some, albeit from 15 percent to 20 percent.
The fear, going into the negotiations, was that the qualified dividend rate might actually be sunset to the top ordinary marginal federal rate of 39.6 percent. Of course, all of these rates are before the application of the new 2013 Medicare tax on investment income that will help finance the Patient Protection and Affordable Care Act of 2010.
For many businesses, the extension of the research tax credit for 2012 and 2013 was welcome news. Unfortunately, since it was actually enacted in 2013, the financial statement accounting for the tax benefits will not be allowed to be booked until 2013 even though the change was for the 2012 tax year. Unfortunately, the credit was not permanently extended.
A significant outcome of the act was the permanent enactment of the netting of the long-term capital gains tax rate to 20 percent, as well as tying the qualified dividend income tax rate to the long-term capital gains tax rate. This provision provides tax-planning opportunities for U.S. businesses operating as S-corporations and partnerships (including limited liability companies taxed as partnerships) that engage in cross-border activities.
Dividends that are considered qualified are taxed at the same federal tax rate as long-term capital gains for individuals. This tax rate (depending on income) is generally either 15 percent or 20 percent before consideration of the newly introduced Medicare investment income tax of 3.8 percent. The reduced tax rate is attributable to qualified dividends received from qualified foreign corporations as well as certain gains from the disposition of the foreign shares that are subject to recharacterization as dividends under the tax code.
Qualified foreign corporations are defined as corporations that are incorporated in a possession of the United States or foreign corporations that are eligible for benefits of a comprehensive income tax treaty with the U.S. that the Secretary determines is satisfactory and that includes an exchange of information program. Also, certain public foreign corporations that are traded on a U.S. stock exchange are considered eligible for the favorable dividend tax treatment.
The Internal Revenue Service has provided guidance on the specific countries in which the U.S. has a comprehensive income tax treaty that may allow for qualified dividend treatment on the receipt of dividends from corporations in those respective countries. Other guidance regarding the types of income earned by the foreign country corporation and the availability for the qualified dividend rate is provided in other IRS guidance.
As U.S. businesses consider how to organize foreign activities, consideration of a structure that allows the use of the qualified dividend rate should be considered, while also taking into account local country corporate income and withholding taxes.
The permanent enactment of a reduced rate of either 15 or 20 percent with respect to QDI income may allow for tax-planning opportunities for U.S. businesses with certain export transactions. For those U.S. entities engaged in the export transaction, the use of an Interest Charge- Domestic International Sales Corporation, or IC-DISC, can result in a reduced tax rate on export-related profits attributable to U S. manufactured products. One of the tax benefits of using an IC-DISC is that any IC-DISC dividends paid to individual shareholders are eligible for the qualified dividend rate discussed above.
IC-DISC’s are U.S. corporations that can be utilized in conjunction with both S corporations, partnerships (including a limited liability company taxed as partnerships), and closely held C corporations to achieve a favorable tax result related to a company’s profits attributable to products that are manufactured for export from the United States.
The history of the DISC dates back to 1971 and was intended to be an export incentive (and job creator) for U.S. businesses. IC-DISC’s are not subject to federal corporate income tax. In its simplest form, the benefit is attributable to the manufacturer (the related U.S. entity) being entitled to a deduction, at ordinary tax rates, for a “commission” paid to the IC-DISC and the subsequent distribution from the IC-DISC being eligible for the lower rate as it is treated as qualified dividend income in the hands of the shareholder.
The net result is that 50 percent or more of the export profits resulting from qualified export sales transactions are effectively taxed at the more favorable qualified dividend income tax rate (15 or 20 percent) rather than at ordinary tax rates that may be as high as 39.6 percent. This tax rate arbitrage may allow many businesses the opportunity to invest more cash and create more jobs in their businesses.
So, in the end, we didn’t fall off the cliff and there are some opportunities for enhancing after-tax returns for many businesses and their shareholders. The glass may indeed be half full.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed above are those of the author. The comments are general in nature and not to be considered specific tax or accounting advice. Readers are advised to consult with their professional advisers before acting on any items discussed.