Ohio Society of CPAs Manufacturing and Construction Conference August 17, 2012

1. Ohio Society of CPAs Manufacturing and Construction Conference August 17, 2012 Domestic and International Tax Incentives Michael A. Krajcer, JD, CPA

2. Topics of Discussion • Research and Development Tax Credits – Federal and State • Interest Charge Domestic International Sales Corporation – The Last Surviving Export Incentive

3. Federal & State Research & Development Tax Credits OVERVIEW: • Federal and state incentive intended to encourage domestic spending on research and development. • Taxpayer favorable legislation has simplified the calculation of the credit and made it available to a larger population of taxpayers. • Taxpayer favorable regulation has expanded the definition of research and development, so now more activity qualifies for the credit. • Taxpayer favorable rulings from the courts have provided guidance on documentation requirements and clarification on several technical issues.

4. LEGISLATIVE HISTORYTHE HIGHLIGHTS • Enacted in 1981, as a temporary provision. • 1986 – added additional requirements to the definition of qualified activity. • 1989 – replaced base period with base amount concept. • Alternative Simplified Credit (“ASC”) added for years ending after December 31, 2006. • ASC rate increased to 14% and AIRC eliminated, for years ending after December 31, 2008. • Credit extended 15 times; currently to 12/31/2011.

5. BENEFITS OF THE CREDIT FEDERAL: • A federal income tax credit equal to 20% or 14% of the qualifying expenses. • Percentage depends on the calculation methodology elected • R&D expenses must be reduced by the amount of the credit earned. • The credit is non-refundable. • The credit generally cannot offset AMT. • Part of the General Business Credit – thus subject to a one year carryback and 20 year carryforward. • Previous years unclaimed credits can be secured via amended returns • Subject to IRS Tier 1 scrutiny

6. BENEFITS OF THE CREDIT STATE: • The majority of the states offer a credit. • Some state credits exceed the federal amount. • Ohio provides for a 7% credit on the amount that qualifying expenditures . • The Ohio R&D Tax Credit does not flow to shareholder as in other states but can be used to offset the CAT tax. • Mr. Krajcer is working with State Legislators to revise flow-through and refund provisions.

7. FOR WHAT INDUSTRIES IS THE CREDIT APPLICABLE? • Manufacturing • Construction • Software Developers • Financial Institutions • Life Sciences • Architecture & Engineering Firms • Oil & Gas • Aerospace • Polymer Sciences • Pharmaceuticals

8. WHAT ACTIVITIES QUALIFY FOR THE CREDIT? Activities must meet a four-part test: • Business Component Test • Technical Uncertainty • Process of Experimentation • Scientific Principles

9. WHAT ACTIVITIES QUALIFY FOR THE CREDIT? Activities must meet a four-part test: • Business Component Test • A business component is any product, process, computer software, technique, formula, or invention, which is to be either held for sale, lease, or license by the company or used in the company's trade or business. The improvement must be a functional improvement rather than an aesthetic change. • Functionality • Performance • Reliability • Quality

10. WHAT ACTIVITIES QUALIFY FOR THE CREDIT? Activities must meet a four-part test: • Technical Uncertainty • Activities must be intended to discover information not available to the taxpayer And • Eliminate uncertainty about the capability or method of developing or improving the business component, or about its appropriate design. • Success is NOT required.

11. WHAT ACTIVITIES QUALIFY FOR THE CREDIT? Activities must meet a four-part test: 3. Process of Experimentation • A process must be utilized, which is designed to evaluate one or more alternatives where the capability or method of achieving a result is uncertain and not readily determinable at the beginning of the research activities.

12. WHAT ACTIVITIES QUALIFY FOR THE CREDIT? Activities must meet a four-part test: • Scientific Principles • Process of experimentation must rely fundamentally on the principles of : • Physical or Biological Sciences • Engineering • Computer Science The following “soft” sciences would not qualify: • Humanities • Management Sciences • SocialSciences

13. WHAT EXPENSES QUALIFY FOR THE CREDIT? Qualifying Research Expenditures (“QREs”) • Wages • Subject to withholding • Excluded: • 401K Contributions • Non-taxable Insurance Premiums • Supplies • Prototype materials • Test inventory • Molds - TG Missouri Corporation v. Commissioner, 133 T.C. 278 (Nov. 12, 2009) • Contract Research • Vendor research and testing • Limited statutorily to 65% of the expense

14. What is an IC-DISC? • Interest Charge Domestic International Sales Corporation. • Federal tax incentive created by Congress to encourage exports. • Exported product must be substantially Manufactured, Produced, Extracted or Grown (MPEG) in the United States. • Maximum incentive is a 20% permanent income tax rate reduction on exported items (i.e. 35% ordinary income tax rate vs. Qualified Dividend rate of 15%). • Incentive is computed on the profits on exported items.

15. LEGISLATIVE HISTORYTHE HIGHLIGHTS • The DISC has been around since 1971. • In 1984 the Interest Charge was added to the title allowing companies to defer the profits on 10 million in exports. • Other export incentives were introduced in the last 25 years and were objected to by the European Union and World Trade Organization. The WTO threaten large tariffs on US products if the incentives were not eliminated. • Incentives eliminated included the Foreign Sales Corporation 1985-2000 and the ETI (Extraterritorial Income Exclusion) 2000-2006. • In 2001 the Bush tax cuts made the IC-DISC an attractive incentive.

16. IC-DISC – What Qualifies? • Goods ultimately used outside the U.S. that was Manufactured, Produced, Extracted or Grown (MPEG) within the U.S. Exports to Puerto Rico, Guam and U.S. Virgin Islands do not qualify. • Made in the USA may include foreign parts, but there is a limit. Foreign Content Test Applies. No more than 50% of foreign content is allowed, which includes mark up. • Products must not be further manufactured within the U.S. by another party before being exported. Further manufacturing outside of the U.S. generally qualifies.

17. IC-DISC – What Qualifies?Non-Traditional Exports • IC-DISC eligible sales are often not traditional “export’ sales. Customers need not be foreign. • For Example the following items have qualified for export incentives: • Property sold to U.S. Military used overseas. • Transportation property used predominantly outside the U.S. • Components sold to U.S. Companies and initially shipped to a U.S. location. • Equipment rental outside the U.S. • Architectural plans proposed for overseas work.

18. Steps to Implement an IC-DISC • Requires setup of a C Corp. which elects treatment as an IC-DISC by filing Federal Form 4876-A within 90 days of setting up a corporation. • Creation of specific inter-company agreements between the IC-DISC and the IC-DISC owners. • Requires computation of the IC-DISC Commission (Multiple methods to compute the DISC commission). • Annual filing of a 1120-IC-DISC tax return. Return due 9/15 each year. No extension required. • No change in business operations needed. Transparent to customers. • Requires journal entries and movement of cash between entities.

19. Typical IC-DISC Structure Individual Owner(s) US Operating Company Taxed at Ordinary Rates, Typically 35% IC-DISC Commission Deduction Dividend, 15% Tax rate IC-DISC Tax Exempt Entity

20. Example of DISC Benefits

21. Typical Structure for C Corps. Dividend, 15% Tax Rate US Operating Company IC-DISC Tax Exempt Entity IC-DISC Commission Deduction Taxed at Ordinary Rates, Typically 35%

22. IC-DISC Commission • IC-DISC commissions need to be computed by qualified DISC experts. • Certain firms and CPAs will do the most basic calculations to compute a DISC commission but they are not capturing all of the DISC benefit. • Sophisticated calculation engines can maximize tax savings by dramatically increasing the IC-DISC benefit using the intended, allowable, complex methods in the regulations (TxT Analysis).

23. IC-DISC Commission • Loss Exclusion – Loss transactions may be excluded, allowing benefit to be derived from profitable transactions. • Marginal Costing – In conjunction with TxT Analysis, marginal costing is an element of the IC-DISC regulations which allows less profitable transactions to derive IC-DISC benefit largely as if they were as profitable as an average transaction. • Marginal costing can be applied at transactional, product, product line levels. Software is needed to optimize marginal benefits in conjunction with the loss exclusion.

24. IC-DISC – Marginal Costing Example IC-DISC Commission Methods: 4% of Sales Method (100*.04) = $4 50% Net Income Method (8*.50) = $4 Marginal Costing Method (28/200 *100*.50) = $7

25. Legislative Backdrop and Outlook • The qualified dividend rate expires with the bush tax cuts on December 31, 2012. • Bothe political parties have indicated strong support of the qualified dividend rate and encouraging exports. • As long as the spread remains between the ordinary income tax rate and qualified dividends the DISC will be alive well past December 31, 2012.

26. Questions Thank You Michael Krajcer, JD, CPA 3979 Idlewild Drive Cleveland, OH 44116 Office: (440) 331-0714 Cell: (216) 308-1564