AM 2022-005 – Treaty Override Rejected for DISC Distributions to Foreign Shareholders
In IRS Advice Memorandum AM 2022-005, the Office of Chief Counsel reaffirmed that distributions from a Domestic International Sales Corporation (DISC) to foreign shareholders are treated as effectively connected income (ECI) under Internal Revenue Code § 996(g), even where an applicable U.S. income tax treaty would otherwise provide reduced withholding rates on dividends. This position underscores the IRS’s strict statutory interpretation and invokes the “later-in-time” rule to assert that domestic law prevails over conflicting treaty provisions. As of this writing, no U.S. court has ruled on this specific issue.
Background
The DISC regime, created under §§ 991–997, provides tax benefits for U.S. exporters. When a DISC distributes income to its shareholders, the distribution is generally subject to U.S. taxation. For foreign shareholders, § 996(g) mandates that such distributions be treated as ECI and thus taxable under § 871(b) or § 882.
Treaty Conflict
Several foreign taxpayers argued that U.S. tax treaties, specifically provisions under Article 10 (Dividends), should allow for a reduced withholding tax rate. These treaties often limit U.S. tax on dividends to 5% or 15% when paid to residents of treaty countries.
AM 2022-005 directly rejects this position. It holds that § 996(g), governs the character of DISC distributions and that they must be treated as ECI regardless of any treaty provision.
Legal Reasoning
- Statutory Mandate: § 996(g) categorically treats DISC distributions as ECI.
- No Treaty Override: Under § 7852(d), treaties and statutes are on equal footing; the “later-in-time” rule applies. If a statute is enacted after a treaty, the statute prevails.
- IRS Characterization: The IRS characterizes taxpayer reliance on treaty language to bypass § 996(g) as an “absurd interpretation.”
Case Law Landscape
To date, no court has directly ruled on whether a treaty provision can override § 996(g) for DISC distributions:
- Summa Holdings v. Commissioner (6th Cir. 2017) and Benenson v. Commissioner (1st Cir. 2018) support the integrity of the statutory DISC structure but do not address treaty conflict.
- No judicial authority has contradicted AM 2022-005.
Practitioner Implications
- Treaty-Based Return Positions: Advising foreign shareholders to claim reduced rates under a treaty could trigger IRS scrutiny and penalties.
- Withholding Compliance: Treat all DISC distributions to foreign shareholders as ECI. Apply full U.S. tax rates.
- Disclosure and Audit Risk: Clearly document non-reliance on treaty rates in filings and client communications.
Best Practices
- Confirm that foreign DISC shareholders are properly reported as having ECI.
- Avoid asserting treaty-based dividend rates on Form 1042 or Form 1120-F.
Conclusion
AM 2022-005 reaffirms the IRS’s position that statutory treatment under § 996(g) cannot be overridden by income tax treaties. In the absence of judicial challenge, taxpayers and advisors should adhere strictly to ECI treatment of DISC distributions to foreign shareholders.
For assistance structuring compliant IC-DISC strategies involving foreign ownership, contact Export Tax Management.
