By Edward Tanenbaum, Esq.
Alston & Bird LLP, New York, NY
In a detailed and well-analyzed opinion, the Tax Court in Rodriguez v. Comr.1 held that inclusions in U.S. residents' gross income under the Subpart F provisions of the Code (in particular, inclusions with respect to their controlled foreign corporation's (CFC's) investments in U.S. property) did not constitute "qualified dividend income" under §1(h)(11). This case puts to bed any hope or expectation that such inclusions would be entitled to the current favorable rates of taxation. The court's holding clearly confirms the 2004 guidance provided by the IRS on precisely this issue.
The U.S. shareholders of the CFC were U.S. permanent residents/Mexican citizens who together owned 100% of the stock of a Mexican corporation. The taxpayers had included in their gross income amounts representing the CFC's earnings invested in U.S. property (taxable pursuant to §§951(a)(1)(B) and 956) and treated the income inclusions as qualified dividend income subject to a preferential income tax rate under §1(h)(11)(B). The court determined that these amounts, however, were taxable at ordinary income tax rates.
Pursuant to §1(h)(11)(B),2 qualified dividend income that is taxed at the favorable adjusted net capital gains rates includes dividends received during the taxable year from "qualified foreign corporations." A qualified foreign corporation is a foreign corporation: (1) that is eligible for the benefits of a comprehensive income tax treaty which includes an exchange of information program; or (2) whose stock with respect to which the dividend is paid is readily tradable on an established securities market in the United States (provided that the foreign corporation is not a "passive foreign investment company" in the year the dividend is paid or in the prior year). Although there was no disagreement that the CFC was considered to be a qualified foreign corporation, the issue turned on whether the income inclusions under the Subpart F rules represented "dividends."
Adhering to the basics, the court first applied the §316(a) definition of a dividend, which requires a "distribution" of property by a corporation to its shareholders. Although the court acknowledged that a dividend can be formally declared or that it may be constructive, a "distribution" is always required, said the court, citing a Supreme Court ruling (Comr. v. Gordon, 391 U.S. 83 (1968)) stating that "a distribution entails a change in the form of ownership of corporate property separating what a shareholder owns [as a] shareholder from what he owns as an individual."
The court disagreed that a Subpart F inclusion involved a change in ownership of corporate property. According to the court, a Subpart F income inclusion didn't arise from a distribution of property by a CFC, but from the CFC's investment in U.S. property. Because there is no distribution, there is no dividend. (Of course, an actual dividend distribution from a CFC's non-previously-taxed income would constitute a qualified dividend, which the court acknowledged.)
The court refused to equate a Senate report (S. Rpt. 1881, 87th Cong., 2d Sess. (1962)) relied upon by the taxpayers (which had accompanied the Subpart F legislation stating that "earnings brought back to the U.S. are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them") with Congress's decision not to expressly treat Subpart F inclusions as dividends or distributions, as Congress had done in other contexts. For example, the court noted that, in those situations in which Congress meant an "inclusion" to be treated as a dividend, it expressly so provided, e.g., §851(b), §904(d)(3)(G), §960(a)(1), and §1248, observing that this was not the case with §951(a)(1)(B) and §956 inclusions.
Furthermore, the court also noted that §956 income inclusions represent earnings that CFCs have retained and reinvested in U.S. property rather than paying out as dividends; thus, characterizing them as qualified dividend income wouldn't further the legislative purpose of §1(h)(11)-to remove a perceived disincentive for corporations to pay out earnings as dividends instead of retaining and reinvesting them. The court also referred to Notice 2004-703 pursuant to which the IRS indicated that §951 inclusions do not constitute qualified dividends under §1(h)(11), noting, in particular, that in its General Explanation of §1(h)(11), the Joint Committee on Taxation cited the IRS Notice with apparent approval.
Finally, in response to the taxpayer's reliance on the 2004 Instructions to Form 5471, which provided that the §951 inclusions are to be reported as ordinary dividend income, the court flatly stated that taxpayers cannot rely on IRS instructions to justify a reporting position which is otherwise inconsistent with controlling statutory provisions.
This was an uphill battle for the taxpayers as they took a position that the court held was inconsistent with the statutory definitions, the statutory purpose, and statutory construction.
This commentary also will appear in the March 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Frias, 764 T.M., Dividends - Cash and Property, Yoder, Lyon, and Noren, 926 T.M., CFCs - General Overview, and Madole, 929 T.M., Controlled Foreign Corporations - Section 956, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.
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