Dividends from Foreign Corporations Part III: “Controlled Foreign Corporations”
As will be recalled from the previous blog posting that discussed so-called “Controlled Foreign Corporations” (CFC), a United States shareholder of a CFC can possibly be treated as having received “dividend” income at various times. These are when the US shareholder (i) has current income inclusions from the CFC under the anti-deferral regime (Subpart F income); (ii) has amounts actually distributed to him that had not been previously taxed as Subpart F income (these are ‘actual’ dividends); (iii) has amounts actually distributed to him that had been previously taxed as Subpart F income and (iv) recognizes gain on the sale of his CFC stock and the CFC has undistributed earnings and profits.
The question arises whether any of these amounts (i)-(iv), can be treated as “qualified dividend income”? Full details about the tax beneficial treatment of “qualified dividend income” can be found here.
Qualified Dividend Income Treatment for Amounts from a CFC?
In 2004 the IRS issued Notice 2004-70 and addressed these points, concluding as follows:
“Qualified dividend income” treatment is accorded to both the actual dividends distributed to an individual shareholder from a CFC’s non-previously taxed earnings and profits (category (ii), above), as well as to the amounts treated as dividends upon sale of the CFC stock (category (iv), above), provided the CFC is otherwise a “qualified foreign corporation” as mandated under specific provisions of the Internal Revenue Code. Simply put this means, either that the corporation is eligible for treaty benefits under a comprehensive income tax treaty with the United States; or is a foreign corporation that is incorporated in a possession of the United States; or that the dividend was paid by the foreign corporation with respect to stock that is readily tradable on an established securities market in the United States.
With regard to category (i), these are current income inclusions from the CFC taxed as Subpart F income to the US shareholder under the anti-deferral regime. The IRS stated that these amounts are not characterized as “dividends” in the statutory provisions of the Internal Revenue Code. Rather, they are characterized as current income inclusions. As such, the IRS determined that such current inclusions are not dividends and therefore cannot constitute “qualified dividend income”. This means the amounts are taxed at the normal graduated income tax rates (currently as high as 39.6% and, don’t forget the possible application of the additional 3.8% Medicare surcharge, or NIIT!).
The position of the IRS was supported many years later by the Tax Court in the case of Osvaldo and Ana M. Rodriguez v. Commissioner, 137 T.C. No. 14 (2011). The Tax Court’s holding was premised on the fact that under the Internal Revenue Code, a “dividend” involves a change in ownership of corporate property (i.e., there is a transfer of property from the corporation to its shareholder). The current inclusion of a CFC’s earnings in its shareholder’s income involves no such change of ownership. Subpart F income is taxable to a CFC’s US shareholder pursuant to statutory provisions, without any actual distribution of the income from the corporation. Thus, the Tax Court held that Subpart F income cannot qualify as a dividend and accordingly cannot be “qualified dividend” income.
With regard to category (iii), these are distributions of previously taxed Subpart F income that are not taxed again when actually paid to the shareholder pursuant to a specific section of the Internal Revenue Code (Section 959(a)). The IRS determined that since these amounts are specifically excluded from a shareholder’s gross income, they are not subject to tax and so, are not “dividends”. As such, they cannot constitute “qualified dividend income”.
