IRS Chief Counsel Addresses Treaty Benefits for Distributions from Domestic International Sales Corporations
The Office of Chief Counsel of the US Internal Revenue Service (IRS) issued a memorandum clarifying that foreign taxpayers are not permitted to claim a reduced rate of US tax of their Domestic International Sales Corporation (DISC) distributions under article 10 (Dividends) of an applicable US income tax treaty by taking the position that, pursuant to article 5 (Permanent Establishment), their DISC distributions are not at attributable to a permanent establishment within the United States. The IRS Chief Counsel released the memorandum (AM 2022-005, 4 November 2022) on 18 November 2022.
The DISC regime (sections 991 through 994 of the US Internal Revenue Code (IRC)) was added to the IRC in 1971 to promote exports of domestic goods by deferring corporate taxes on export income. IRC section 991 provides that a DISC is not generally subject to income tax. IRC section 996(g) requires foreign shareholders of a DISC to treat DISC distributions as attributable to a permanent establishment even though they are not so attributable under an applicable US income tax treaty.
US income tax treaties generally provide that, with respect to dividends, the country of residence of a shareholder has the primary right to tax and not the country of source. The country of source is generally limited to taxing a dividend at a reduced rate of 5% or 0% for certain corporate shareholders and 15% in all other cases.
Under article 10(6), however, these benefits do not apply if "the beneficial owner of the dividends, being a resident of a contracting country, carries on business in the other contracting country, of which the payer is a resident, through a permanent establishment situated therein, and the holding in respect of which the dividends are paid is effectively connected with such permanent establishment."
When foreign taxpayers choose the beneficial DISC regime under the IRC, either directly or indirectly, including as a founding shareholder or as a transferee of the DISC shares, they must forgo article 10 benefits (or any other treaty benefit that does not apply to income attributable to a permanent establishment) with respect to their DISC distributions. The well-established principle of US tax treaties that the IRC and treaty must be applied consistently prohibits foreign shareholders of DISCs from claiming treaty benefits applicable to income that is not attributable to a permanent establishment.
These foreign taxpayers must therefore report their DISC distributions as taxable under IRC section 871(b) or IRC section 882, as applicable.
Furthermore, the IRC and US income tax treaties prevent foreign shareholders of DISCs from claiming treaty benefits on DISC distributions, and thus the "later-in-time" rule codified in IRC section 7852(d) does not apply.