As will be recalled from the previous blog posting discussing the basics of 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 has (i) current income inclusions from the CFC under the anti-deferral regime (Subpart F income or GILTI income); (ii) amounts actually distributed to him that had not been previously taxed under the anti- deferral regime (these are ‘actual’ dividends); (iii) amounts actually distributed to him that had been previously taxed as Subpart F income and (iv) recognized gain on the sale of the taxpayer’s CFC stock at a time when 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. Before getting into the nitty-gritty, I invite readers to pay close attention to how the US shareholder of a CFC is hopelessly undone by the US tax system.
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” (QFC) as mandated under specific provisions of the Internal Revenue Code. It will be recalled from my earlier blog that a QFC is a foreign corporation that meets one of the following parameters: it is eligible for treaty benefits under a comprehensive income tax treaty with the United States; it is incorporated in a possession of the United States; or it is readily tradable on an established securities market in the United States.
What About Other Amounts from a CFC?
Current Income Inclusions Subpart F and GILTI
Under Section 951(a)(1)(A) of the Internal Revenue Code, United States shareholders of CFCs are required to include in gross income currently their pro rata share of certain income of the CFC (referred to as “subpart F income”), without regard to whether the income is distributed by the CFC to its shareholders in the year the income is earned. As a general matter, a GILTI inclusion amount is treated in the same manner as an amount included under IRC section 951(a)(1)(A). See Treas. Reg. 1.951A-5(b)(1).
With regard to a shareholder distribution that falls under category (i), these are current income inclusions from the CFC taxed 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 37% and, don’t forget the possible application of the additional 3.8% Medicare surcharge, or NIIT!). I will point out here that Notice 2004-70 was issued prior to the introduction of the GILTI tax regime in 2017 with the Tax Cuts and Jobs Act, but it appears (at least to little old me) that GILTI inclusions will be treated in the same manner as Subpart F inclusions (thus, ineligible for qualified dividend treatment).
The IRS position that current income inclusions from CFCs are not qualified dividends was supported many years later by the Tax Court and subsequently affirmed by the Fifth Circuit. In the case of Osvaldo and Ana M. Rodriguez v. Commissioner, 722 F3d 306 (July 5, 2013), 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 (and GILTI income) are taxable to a CFC’s US shareholder pursuant solely to statutory provisions, without any actual distribution of the income from the corporation. As such these amounts cannot qualify as a dividend and accordingly cannot be “qualified dividend” income.
Previously Taxed Income
With regard to category (iii), these are actual distributions to a shareholder 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”. Since it appears GILTI inclusions will be treated in the same manner as Subpart F inclusions, I believe that amounts previously taxed under the GILTI rules will also be ineligible for qualified dividend treatment.
Posted January 18, 2024
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