Proposed Elimination of Qualified Dividend Treatment for IC-DISCs
Tax Alert, December 2006

At the beginning of October, we issued a Tax Alert that discussed the proposal included in the technical corrections bills pending before Congress (H.R. 6264 and S. 4026) designed to eliminate the qualified dividend treatment for dividends paid by IC-DISCs. On November 16, Senate Finance Committee Chair Senator Grassley announced that any action on a technical corrections bill would be postponed until the next session of Congress because of disagreements over whether certain provisions included in the bills were substantive (actual changes to the tax law) or truly technical corrections (to clarify the statute or correct errors in the original legislation to properly reflect the intent of Congress). The proposed changes to the rules regarding the IC-DISC dividends are among the provisions causing controversy and the resulting delay of the legislation.

While the delay in the legislation may be viewed as preserving the status quo, it leaves a significant amount of uncertainty regarding how to proceed for 2006. Without further guidance from Congress, it is unknown what will happen to the proposal, and if any changes are to be made, whether the effective date will be retroactive to the original date of September 29, 2006 or whether the changes will be prospective only. We have been monitoring updates, but it doesn't appear that any further information will be forthcoming between now and year end.

Depending on the facts and circumstances of your situation, two options for tax year 2006 should be considered:

1. take the ETI, or
2. pay your IC-DISC commissions and dividends prior to December 31, 2006.

If you choose to claim the ETI and you have an IC-DISC in place, steps will need to be taken as soon as possible prior to December 31, 2006 to disqualify the IC-DISC. In addition, taxpayers will need to take all steps necessary to insure that the foreign economic processes tests, if applicable, have been satisfied for 2006.

If IC-DISC benefits are selected, it is recommended that commissions and dividends be paid prior to December 31, 2006 instead of utilizing the 60-day window in January and February. If legislation is passed next year and is not retroactive, it is more likely to carry an effective date of December 31, 2006 (e.g., payments after December 31, 2006). If companies choose to delay transactions until 2007 under the assumption that legislation will not pass, or the effective dates will be prospective, they will need to understand that the entire IC-DISC benefit would be at risk.

Planning will be required to insure that any payments prior to year end maximize the possible IC-DISC benefit, since corrections after year end may be difficult to effect. While many companies use journal entries to record certain transactions between the IC-DISC and its related suppliers and shareholders, it will be imperative that the company books and records reflect sufficient evidence to support the timely payment of commissions and dividends. For this reason, consideration should be given to the use of cash transactions to avoid questions of timely payment.