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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL
Section 951(a) requires a "United States shareholder" (hereafter, "U.S. shareholder") of a controlled foreign corporation (CFC) to "include in [its] gross income" its pro rata share of the CFC's Subpart F income and certain investments in U.S. property.1 An issue that has been around since Subpart F2 was enacted in 19623 is whether a Subpart F inclusion is treated as a dividend for purposes of various Code sections that provide special rules for dividends.
Several Code provisions expressly treat Subpart F inclusions as dividends. In the absence of a specific rule, however, the answer is unclear. The IRS issued a number of private rulings treating an inclusion under Subpart F as a dividend for purposes of §512, and Congress apparently agrees with that conclusion. On the other hand, a recent case-Rodriguez v. Comr.4-held that a Subpart F inclusion was not a dividend for purposes of §1(h)(11) in the absence of a rule providing for such characterization.
While Subpart F does not expressly characterize an inclusion as a dividend, the Subpart F regime treats the amount included in the U.S. shareholder's gross income essentially like a dividend. The amount of a Subpart F inclusion is directly linked to the earnings and profits (sometimes referred to here simply as "earnings") of a CFC in the same way as a dividend, and is treated like a dividend for foreign tax credit purposes.5 A CFC's earnings that were subject to tax under Subpart F are not taxed again when distributed to the U.S. shareholder.6 Subpart F also provides for an increase in the basis of the CFC's stock to avoid double taxation of the already taxed earnings in the event the CFC's stock is sold, which basis is reduced upon distributions of the previously taxed earnings.7 This set of rules operates in a manner to effectively treat the earnings currently taxed under Subpart F as if they had been deemed distributed to the U.S. shareholder and then contributed back to the CFC as capital.
Subpart F inclusions have commonly been referred to as "deemed dividends." In describing its Subpart F proposal, the Kennedy Administration stated that "deferral would be eliminated, and the annual undistributed profits of any controlled foreign corporation … would be deemed distributed as a dividend to American shareholders."8 The President's Tax Message further stated that "[t]he amount includible in a U.S. shareholder's income would be determined by reference to the corporation's earnings and profits in the same manner as applicable under present law in computing taxable dividends."9
Similarly, in describing the new Subpart F regime, the House Ways & Means Committee Report stated, "This Subpart F income under the bill is attributed to 10-percent U.S. shareholders and taxed to them in largely the same manner as a dividend."10 The Senate Finance Committee Report describes the new Subpart F inclusions as "undistributed earnings being treated as if they were distributed and taxed to the U.S. shareholders of controlled foreign corporations… ."11
The IRS on a number of occasions in its informal guidance has described Subpart F inclusions as deemed dividends. GCM 39153 states that "[a]mounts described in sections 951(a)(1)(B) and 951(a)(1)(A) are included in gross income of U.S. shareholders as `deemed' dividends." Again, in GCM 36965 the IRS states, "under Code §951 U.S. shareholders are deemed to have received dividends from controlled foreign corporations attributable to the receipt of Subpart F income, as defined in Code §952(a), or to the increase in earnings invested in U.S. property, as defined in Code §956." In PLR 9217039 the IRS states that "amounts included under section 951(a)(1)(A) and (B) are treated as deemed dividend payments."
Cases addressing various Subpart F issues have similarly referred to Subpart F inclusions as deemed dividends. For example, in Koehring v. U.S., the district court states that "[i]f the corporation in question is [a] Controlled Foreign Corporation, §951 of the Code provides that a U.S. shareholder's pro rata share of the Subpart F income of the Controlled Foreign Corporation is to be included in the income of that U.S. Shareholder as a dividend deemed paid in money on the last day of the taxable year of the Controlled Foreign Corporation."12 As discussed below, cases addressing issues involving Subpart F inclusions resulting from a CFC's investment in U.S. property describe the inclusions as constructive dividends.
Several provisions of the Code expressly provide that Subpart F inclusions are to be treated as dividends. For foreign tax credit purposes, §902 is applied to provide deemed paid credits with respect to an inclusion under Subpart F as if the inclusion were treated as a dividend.13 Also, like dividends, look-through rules are provided for Subpart F inclusions for purposes of identifying the §904 foreign tax credit limitation category.14
While a Subpart F inclusion is referred to as a "deemed dividend" and certain Code provisions expressly treat such inclusions as dividends, should a Subpart F inclusion be treated as a dividend for purposes of a particular Code section when the provision does not so specify?
The IRS was asked to consider the treatment of Subpart F income that was included in a tax-exempt entity's gross income. Generally "dividends" are excluded from unrelated business taxable income (UBTI), but there was no rule addressing whether a Subpart F inclusion should be treated as a dividend for this purpose.15 The IRS issued several private rulings treating Subpart F inclusions arising from insurance income as dividends for purposes of computing UBTI, holding that such inclusions were not UBTI.16 In one ruling the IRS states, "Subpart F income is taxed in largely the same manner as a dividend. The mere fact that the timing of income recognition is accelerated under the Subpart F provisions … does not result in treating the Subpart F inclusion any differently than distribution of an actual dividend in the absence of these rules, unless specifically provided elsewhere in the Code." 17
The Small Business Job Protection Act of 1996 subsequently added a provision providing look-through treatment for certain Subpart F insurance income for purposes of applying the tax-exempt rules.18 Nevertheless, the legislative history indicates that it is appropriate to generally treat Subpart F inclusions as dividends for purposes of calculating UBTI.19
In a case of first impression, the Tax Court in Rodriguez addressed whether, in the absence of a specific rule, Subpart F inclusions should be treated as dividends for purposes of §1(h)(11). The Tax Court reached the opposite conclusion as the holdings in the above rulings.
The taxpayers in Rodriguez, husband and wife, were citizens of Mexico and permanent tax residents of the United States. They owned together 100% of the stock of a Mexican corporation ("MexCo"), which was a CFC.20 MexCo engaged in the real estate and printing press businesses.
During the years at issue MexCo held significant investments of real estate and tangible personal property located in the United States, which constituted investments in U.S. property within the meaning of §956. As a result, the taxpayers reported $1.6 million and $1.5 million on their federal tax returns for 2003 and 2004, respectively, as inclusions under Subpart F. Absent a special rule, such amounts would have been subject to tax as ordinary income at the individual tax rate of 35%.
Section 1(h)(11) provides a 15% tax rate for "qualified dividend income." Qualified dividend income includes dividends received from a qualified foreign corporation. MexCo was a qualified foreign corporation for purposes of this rule.21
The taxpayers treated the Subpart F inclusions as qualified dividend income under §1(h)(11)(B) subject to the 15% tax rate. The IRS challenged this position, asserting that the Subpart F inclusions were not "dividends" for this purpose. The Tax Court agreed with the IRS.
Section 1(h)(11) does not indicate whether Subpart F inclusions should be treated as dividends for purposes of the 15% tax rate. The legislative history likewise does not discuss this issue.
In the absence of specific guidance, the Tax Court first looked to the basic definition of a "dividend." Section 316(a) defines a "dividend" for purposes of subtitle A of the Code (which includes §1) to mean "any distribution of property made by a corporation to its shareholders" out of the corporation's current or accumulated earnings and profits.22
The Tax Court, quoting from a Supreme Court case, states that a "distribution" entails a "change in form of … ownership" of corporate property, "separating what a shareholder owns qua shareholder from what he owns as an individual."23 The Supreme Court's opinion observes that a shareholder "owns" a fraction of the assets of the corporation in which it owns stock, including corporate assets that reflect accumulated earnings. In general, the earnings are not taxed to the shareholder when they accrue to the corporation, but instead when they are distributed to the shareholders as dividends. The Supreme Court states that "the question is not whether the shareholder ends up with `more' but whether the change in form of his ownership represents a transfer to him, by the corporation, of assets reflecting its accumulated earnings and profits."24
The Tax Court's opinion points out that a §951 inclusion does not involve a change in ownership of corporate property. There was no distribution of property made by MexCo to Mr. and Mrs. Rodriquez. Rather, the inclusion in income arose from the CFC's investment in U.S. property. Because there was no distribution, the court held that there was no "dividend" within the meaning of §316(a).
The opinion also refers to the operative language of §951(a) which provides that Subpart F amounts are "included in the gross income" of the U.S. shareholders. In contrast, other Code sections providing for deemed inclusions of a foreign corporation's earnings in the income of shareholders expressly state that the amounts are treated as dividends. For example, §1248, which treats gain on the sale of stock in a CFC as ordinary income to the extent of the CFC's earnings and profits, states that the U.S. shareholders include the ordinary income amount in income as a dividend.25 Also, earnings included in income under §367 are expressly treated as dividends.26 The court further notes that, unlike §1(h)(11), several other Code provisions expressly provide that Subpart F inclusions should be treated as dividends, as discussed above.
Following the above discussion, the Tax Court states, "To disregard this careful legislative design and treat section 951 inclusions as dividends in the absence of an express provision would tend to render these provisions superfluous or unnecessary, contrary to well-established tenets of statutory construction." The opinion continues by saying that "[t]his consideration reinforces our conclusion that section 951 inclusions are not to be treated as dividends absent express provisions in the Code or the regulations."
The Tax Court refers to Notice 2004-7027 which expressly provided that §951 inclusions do not constitute qualified dividend income under §1(h)(11). The court states that it agrees with the conclusion in the notice for the reasons it finds that such amounts are not dividends. Interestingly, the court does not rely on the notice for its conclusion.28
The taxpayers argued, among other things, that the Subpart F inclusion should be treated as a dividend because the instructions to Form 5471 indicated that individual CFC shareholders should report §951 inclusions as "ordinary dividend income." The court responded that it is settled law that taxpayers cannot rely on instructions to justify a position that is plainly inconsistent with controlling statutory provisions.29
The court was not persuaded by the references in the legislative history and prior Tax Court cases referring to Subpart F inclusions as deemed dividends. In particular, the opinion takes note that inclusions resulting from investments in U.S. property have been described as equivalent to dividends. It refers to legislative history that states, "generally, earnings brought back to the United States are taxed to the shareholders on the grounds that this is substantially equivalent to a dividend being paid to them."30 The opinion quotes from Gulf Oil31 which observes that under the 1962 legislation "Subpart F treats the amount of the increased investment [§956 amount] much like a constructive dividend to the U.S. shareholders." The Tax Court, however, did not view this history as requiring it to treat Subpart F inclusions as dividends for purposes of §1(h)(11).
The Tax Court does not mention the IRS private letter rulings that treat Subpart F inclusions as dividends for purposes of §512, which conclusion was implicitly supported by Congress. Like §11, there is no rule in the tax-exempt provisions treating a Subpart F inclusion as a dividend. Accordingly, the Rodriguez opinion is inconsistent with those rulings.32
The opinion does not tell the complete U.S. tax story. MexCo will be subject to U.S. corporate income tax on any gain when it sells the U.S. real estate.33 MexCo may also be subject to U.S. taxation with respect to income derived from its activities in the United States in connection with its ownership of the U.S. real estate and personal property located in the United States as income attributable to a U.S. permanent establishment. So, the property that caused the Subpart F inclusion could also result in income subject to U.S. taxation at the corporate level, and any such earnings will be subject to another level of U.S. tax when ultimately distributed to Mr. and Mrs. Rodriquez, possibly at the 15% rate if it still applies.34
In hindsight, the funds invested in the U.S. property by MexCo could have first been distributed to Mr. and Mrs. Rodriquez, which dividend would have qualified for the 15% tax rate under §1(h)(11), and then the couple could have used the funds to purchase the U.S. property. This would also have provided one level of U.S. taxation on any gain from a subsequent sale of the real estate and on other income that would have been subject to U.S. taxation at the corporate level.
The Tax Court opinion treats inclusions under Subpart F as unique items of income. In particular, such deemed distributions of earnings are not deemed dividends for purposes of §1(h)(11). The court reaches its conclusion by literally interpreting the rules that apply to Subpart F inclusions in accordance with the plain meaning of the statute, not relying on legislative history or the treatment of Subpart F inclusions under analogous provisions. This strict interpretation approach is consistent with prior Subpart F cases.35 The result, however, is harsh. A more appropriate result would have been for the IRS Notice to treat deemed inclusions in a U.S. shareholder's income of a CFC's earnings under §951(a) as deemed dividends for purposes of §1(h)(11), as the IRS did for purposes of applying the tax-exempt provisions.36
This commentary also will appear in the May 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, Lyon, and Noren, 926 T.M., CFCs - General Overview, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.
1 §951(a); Regs. §1.951-1.
3 Section 965 was added in 2004.
4 137 T.C. No. 14 (2011).
5 §§952(c)(1), 960(a).
6 §959(a), (d) (distributions of previously taxed income generally not treated as a dividend).
8 Message from the President of the United States, H.R. Doc. No. 140, 87th Cong., 1st Sess. 6-8, 54, reprinted in Committee on Ways and Means, 90th Cong., 1st Sess., 1 Legislative History of H.R. 10650, at pp. 191-95 (1967).
10 H. Rep. No. 1447, 87th Cong., 2d Sess., as reprinted in 1 Legislative History of H.R. 10650, at pp. 1192-1193.
11 S. Rep. No. 1881, 87th Cong., 2d Sess., as reprinted in 2 Legislative History of H.R. 10650, at p. 2439.
12 433 F. Supp. 929, 932 (E.D. Wis. 1977), aff'd, 583 F.2d 313 (7th Cir. 1978).
14 §904(d)(3)(B), (G). See also §904(h)(10) (treats Subpart F inclusions as dividends in certain circumstances). Cf. Regs. §1.951-1(a)(3) and Rev. Rul. 76-403, 1976-2 C.B. 229 (look-through rules apply to Subpart F inclusions for purposes of determining whether a domestic corporation is a personal holding company under §542).
16 PLR 9407007, PLR 9027051, PLR 9024086, PLR 9024026, PLR 8922047, PLR 8836037, PLR 8819034. The IRS alternatively ruled that a Subpart F inclusion was treated as if the underlying insurance income were realized directly by the U.S. shareholder. PLR 9043039.
17 PLR 9024026. See also PLR 9217039 ("Amounts included under section 951(a)(1)(A) and (B) are treated as deemed dividend payments."). The IRS also ruled that an inclusion under Subpart F satisfied the following requirement in §851(b)(2) to qualify as a regulated investment company: that the entity derive at least 90% of its income from "dividends….and other income derived with respect to its investment in such stock…." PLR 201129002, PLR 201206015.
19 H. Rep. No. 586, 104th Cong., 2d Sess. 136 (1996) 1996-3 C.B. at 136, n. 14; Staff of Joint Committee on Taxation, 104th Cong., 2d Sess., General Explanation of Tax Legislation Enacted in the 104th Congress, at 214, n. 159 (1996). The legislative history expressly states that it views the holding in PLR 9043039, which applied a look-through concept to Subpart F inclusions, as incorrect. See PLR 199952086 (describing the support in the legislative history for generally treating Subpart F inclusions as dividends).
20 Mr. and Mrs. Rodriquez were U.S. shareholders in MexCo because they were permanent U.S. residents, and therefore MexCo was a CFC. §§951(b), 957(a).
22 Regs. §1.316-1.
23 Comr. v. Gordon, 391 U.S. 83, 90 n. 5 (1968).
25 §1248(a); Regs. §1.1248-1(a), (d). Cf. §245(a)(11) (the term "dividend" does not include any amount treated as a dividend under §1248).
26 See, e.g., Regs. §1.367(b)-3(b), Regs. §1.367(b)-2(e)(2). See also former §551(b) (deemed inclusions under the foreign personal holding company rules were expressly treated as dividends).
27 2004-2 C.B. 724, 726.
28 The court notes that the Joint Committee on Taxation cited Notice 2004-70 with apparent approval. Staff of the Joint Committee on Taxation, General Explanation of the Tax Legislation Enacted in the 108th Cong., at p. 25 n. 44 (2005).
29 See Montgomery v. Comr., 127 T.C. 43, 65 (2006).
30 S. Rpt. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 794.
31 Gulf Oil Corp. v. Comr., 87 T.C. 548, 571 (1986), aff'd in part, rev'd in part and rem'd, 914 F.2d 396 (3d Cir. 1990). The opinion also refers to The Limited, Inc. v.Comr., 11 T.C. 169, 185 (1999), rev'd, 286 F.3d 324 (6th Cir. 2002) (observed that a "dividend equivalency" rationale underlies the 1962 legislation).
32 See Dover v. Comr., 122 T.C. 324 (2004) (Tax Court rejected IRS position that was inconsistent with the analysis in its published rulings); Yoder, "Pre-Sale Branch Election for CFC Target: Dover v. Comr. Says No Subpart F Income," 33 Tax Mgmt. Int'l J. 474 (8/13/04).
34 See §956(c)(2)(H) (special exclusion for U.S. effectively connected income).
35 See Yoder and Christensen, "The Limited, Inc. v. Comr.: Appellate Court Slams Tax Court's Narrow Interpretation of §956 Bank Deposits Exception," 31 Tax Mgmt. Int'l J. 453 (9/13/02); Yoder, "The Limited Case: A Refresher in Statutory Interpretation," 2 J. of Tax'n of Global Trans. 3 (Winter 2003); Yoder, "Schering-Plough Corp. v. United States: Subpart F Analysis Gone Awry," 38 Tax Mgmt. Int'l J. 705 (12/11/09); Yoder, "Section 956: Subsequent Schering-Plough Opinions Retreat from Subpart F Policy Discussion," 40 Tax Mgmt. Int'l J. 480 (8/12/11).
36 Another area of uncertainty is whether Subpart F inclusions would qualify for the dividends received deduction. See Yoder, "CFC Sandwich Structures: Applying the DRD to Subpart F Income and CFC Dividends," 40 Tax Mgmt. Int'l J. 616 (12/14/11) (argues that it would be appropriate for the IRS to treat a Subpart F inclusion as a dividend for purposes of the dividends received deduction to avoid double corporate taxation). With respect to the temporary 85% dividends received deduction under §965, the Congress made it clear in legislative history that the statute's use of the term "dividend" was not intended to embrace Subpart F income or any other item not expressly included in gross income as a dividend under the Code. H.R. Rep. 108-755, 108th Cong., 2d Sess., at 314-15 (stating that amounts included in gross income under the Code as dividends, for example, under §302 or §304, could qualify, but that "items that are not included in gross income as dividends, such as subpart F inclusions or deemed repatriations under section 956," did not qualify).
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