In Rodriguez v. Comm., 112 AFTR 2d 2013-XXXX, (CA5) (07/05/2013), the U.S. Court of Appeals for the 5th Circuit answered the vexing question of whether a subpart F inclusion constitutes qualified dividend income under §1(h)(11). If the inclusion constitutes a qualified dividend, then the associated income is subject to the dividend tax rate of 15 percent. This issue has caused angst for taxpayers, because in other situations the Internal Revenue Code (“IRC”) and Internal Revenue Service (“IRS”) have stated that a subpart F inclusion is a deemed dividend, but they have been silent whether such an inclusion is a deemed dividend for purposes of §1(h)(11). In Rodriguez, the 5th Circuit affirmed the Tax Court’s ruling that a subpart F inclusion is not a qualified dividend for §1(h)(11).
In this case the taxpayers, who are husband and wife, collectively owned the stock of a Mexican corporation (“MexCo”), which is a controlled foreign corporation. In 2003 and 2004, the taxpayers received nearly $3 million of income from MexCo as subpart F inclusions and treated this income as qualified dividends, which is subject to tax at 15 percent instead of the ordinary income tax rate of 35 percent. Both the 5th Circuit and the Tax Court found that this income by its very nature does not meet the statutory definition of a dividend. Specifically, the income does not involve a change in ownership, and there was no distribution of property from MexCo—both of which are required for this income to be defined as qualified dividends. The 5th Circuit noted that the taxpayer could have avoided this outcome by forcing MexCo to issue a dividend instead of providing them gross income from their investments.
One of the taxpayer’s arguments for treating this income as qualified dividends was that the Form 5471 instructions stated that such income should be reported as ordinary dividend income. The Tax Court responded that it is settled law that taxpayers can’t rely on instructions that are plainly inconsistent with controlling statutory provisions. Additionally, the 5th Circuit did not rule in favor of the taxpayers on the grounds that in other situations a subpart F inclusion is considered a dividend. For example, in PLR 9217039, the IRS specified that “amounts included under section 951(a)(1)(A) and 951(a)(1)(B) are treated as deemed dividend payments”, and with respect to foreign tax credits the IRC treats Subpart F inclusions as deemed dividends.” Thus, taxpayers should keep in mind that the ruling in Rodriguez is limited to §1(h)(11) and does not disturb how subpart F inclusions are treated with respect to other provisions of the IRC.
Taxpayers who receive similar payments from controlled foreign corporations should treat those payments as ordinary income, but should remember that there are legal ways to avoid such a harsh outcome.
The views expressed in this article are those of the authors and do not necessarily reflect the position or policy of Berkeley Research Group, LLC.
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