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Monday, December 12, 2011


Under the Controlled Foreign Corporation (CFC) rules, U.S. shareholders of foreign corporations will have to include in their income their pro rata share of the CFC’s income on a pass-through basis under certain circumstances. Such inclusion can be required in the year the income is earned, or in a later year if and to the extent the CFC invests its untaxed earnings in U.S. property. Such income is included in the shareholder’s income at ordinary income rates, like a dividend.

Hmm, like a dividend. Does that mean the U.S. shareholder can pay tax on this income at the preferential 15% rates presently allowed for qualified dividend income under Code §1(h)(11) if the CFC is otherwise a qualified foreign corporation?

I think most international tax planners would tell you the answer is no. While the Code taxes these inclusions as ordinary dividend like a dividend, it does not actually characterize them as dividends. There are plenty of other situations in the Code when it will specifically characterize a deemed distribution or other amount as a deemed dividend, but that language is not present in the CFC rules.

This analysis didn’t stop at least one taxpayer from reporting this income relating to the reinvestment of CFC earnings in U.S. real property as a dividend to be taxed under the reduced rates, to the tune of about $3 million in income. The IRS challenged the treatment, and the taxpayer took the issue to the Tax Court. The Tax Court took the side of the IRS, and disallowed the application of the 15% maximum tax rate.

The Tax Court noted the items above, such as the lack of an explicit dividend label to the CFC income inclusion, and that Congress has given that label in other areas when it intends such treatment. The taxpayer did note that the 2004 instructions to Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, indicated that individual CFC shareholders should report section 951 inclusions as “ordinary dividend income.” Nonetheless, the Court noted that there were other instructions to the contrary that accompanied that Form, and further that “taxpayers cannot rely on Internal Revenue Service instructions to justify a reporting position otherwise inconsistent with controlling statutory provisions.”

Osvaldo Rodriguez, et ux. v. Commissioner, 137 T.C. No. 14,

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