Can CFC Dividends be Treated as Qualified Dividend Income?

Do Foreign Dividends from a CFC Get Qualified Tax Treatment

Are Foreign Dividends from a CFC Qualified for Preferential Tax Treatment

One of the most complicated aspects of having ownership or interest in a foreign corporation is when the foreign corporation is considered a Controlled Foreign Corporation. That is because, unlike other types of foreign corporations, with a Controlled Foreign Corporation (CFC) the U.S. taxpayer has additional reporting requirements — as well as being subject to a very specific tax regime in accordance with the Subpart F income and GILTI tax rules. One common question we receive about taxes and CFCs is that when a U.S. shareholder of a Controlled Foreign Corporation receives a dividend from a CFC — can that dividend be considered a qualified dividend sufficient so that the taxpayer may obtain preferential tax treatment at a 15% or 20% tax rate depending on which tax bracket they fall into? Let’s look at the basics of whether a CFC dividend may be qualified.

TL; DR

A Controlled Foreign Corporation Dividend can be Qualified if the company meets the requirements of being a qualified foreign corporation. A CFC dividend is not automatically excluded from Qualified Dividend treatment. The issue will concern actual dividends vs 951(a)/Subpart F distributions that are not, by definition, considered to be ‘dividend income.’ There are also are cross-over issues involving PFIC, FIC, and FPHC.

What is a Foreign Qualified Dividend?

For a dividend from a foreign corporation to be considered qualified it must meet certain requirements.

26 U.S.C. 1(h)(11)

In pertinent part

(B) Qualified dividend income For purposes of this paragraph—

• • • (i)In general The term “qualified dividend income” means dividends received during the taxable year from—

    • (I)domestic corporations, and

    • (II) qualified foreign corporations.

(C) Qualified foreign corporations

• • • In general: Except as otherwise provided in this paragraph, the term “qualified foreign corporation” means any foreign corporation if—

      • such corporation is incorporated in a possession of the United States, or

      • such corporation is eligible for benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory for purposes of this paragraph and which includes an exchange of information program.

(ii) Dividends on stock readily tradable on United States securities market

• • • A foreign corporation not otherwise treated as a qualified foreign corporation under clause (i) shall be so treated with respect to any dividend paid by such corporation if the stock with respect to which such dividend is paid is readily tradable on an established securities market in the United States.

(iii) Exclusion of dividends of certain foreign corporations

Such term shall not include—

• • • (I)any foreign corporation which for the taxable year of the corporation in which the dividend was paid, or the preceding taxable year, is a passive foreign investment company (as defined in section 1297), and

    • (II)any corporation which first becomes a surrogate foreign corporation (as defined in section 7874(a)(2)(B)) after the date of the enactment of this subclause, other than a foreign corporation which is treated as a domestic corporation under section 7874(b).

(iv) Coordination with foreign tax credit limitation

Rules similar to the rules of section 904(b)(2)(B) shall apply concerning the dividend rate differential under this paragraph.

Notice 2004-70

The Notice 2004-70 summarizes key aspects of Qualified Dividend Treatment, including CFCs. This Notice pre-dates GILTI and the TCJA but the concept remains intact. Let’s walk through the key provisions:

Distributions of Amounts Not Previously Taxed

• • • Section 1(h)(11) of the Code does not exclude CFCs from the definition of “qualified foreign corporations.”

      • Thus, actual dividends from a CFC’s non-previously taxed earnings and profits to an individual shareholder are qualified dividend income provided that the CFC is otherwise a qualified foreign corporation under section 1(h)(11)(C) and the other requirements of section 1(h)(11) are met.

      • Similarly, amounts treated as dividends under section 1248(a) are qualified dividend income provided that the CFC is otherwise a qualified foreign corporation under section 1(h)(11)(C) and the other requirements of section 1(h)(11) are met.4 See section 1248(a) (stating gain recognized on the sale or exchange of stock in certain foreign corporations shall be included in the gross income of a shareholder as a dividend).

      • In addition, amounts treated as dividends under section 1.367(b)-2(e)(2) of the regulations (i.e., section 1248 amounts and all earnings and profits amounts) are qualified dividend income provided that the CFC is otherwise a qualified foreign corporation under section 1(h)(11)(C) and the other requirements of section 1(h)(11) are met.

In other words, if a dividend from a CFC is an actual dividend from non-previously taxed income (and other requirements are met), the dividend from a CFC may be qualified. This is in contrast to when 951(a) income is not distributed — and not technically a dividend — but taxed to the shareholder due to Subpart F and the rateable share concept. Section 1248 refers to the sale or exchange of foreign stock and 1.367(b) refers to certain transfers of foreign corporations.

26 U.S.C. 951(a)(1) Amounts included in gross income of United States shareholders

Section 951 (Subpart F Income) becomes the issue.

“(a) Amounts included

• • • (1) In general

      • If a foreign corporation is a controlled foreign corporation at any time during any taxable year, every person who is a United States shareholder (as defined in subsection (b)) of such corporation and who owns (within the meaning of section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends—

      • (A) his pro rata share (determined under paragraph (2)) of the corporation’s subpart F income for such year, and

      • (B) the amount determined under section 956 with respect to such shareholder for such year (but only to the extent not excluded from gross income under section 959(a)(2)).”

Section 951(a)(1) Inclusions (From Notice 2004-70)

The issue with qualified dividends and Subpart F income for CFC is where the main issue is:

• • • “Neither section 951(a)(1) nor the corresponding regulations characterize a section 951(a)(1) inclusion as a dividend.

      • In contrast, deemed inclusions under the FPHC and PFIC regimes are characterized as dividends throughout the statutory provisions governing these regimes. See, e.g., section 551(b) (stating that undistributed foreign personal holding company income is included in a foreign personal holding company shareholder’s gross income as a dividend).

      • Moreover, while section 1248 requires inclusions in gross income as a dividend, section 951 simply requires inclusions in gross income.6 Accordingly, for purposes of section 1(h)(11), section 951(a)(1) inclusions are not dividends and therefore cannot constitute qualified dividend income.”

Subpart F Income

In other words, since Subpart F Income specifically is not categorized as dividends income per se, the Qualified Dividend rules would not apply.

As provided by the IRS:

• • • Under Subpart F, certain types of income earned by a CFC are taxable to the CFC’s U.S. shareholders in the year earned even if the CFC does not distribute the income to its shareholders in that year. Subpart F operates by treating the shareholders as if they had actually received the income from the CFC.

    • The income of a CFC that is currently taxable to its U.S. shareholders under the Subpart F rules is referred to as “Subpart F income.”

    • Under I.R.C. § 951(a), a U.S. shareholder is required to include in income currently its pro rata share of the CFC’s Subpart F income (“Subpart F inclusion”). The Subpart F inclusion will generally bring an indirect foreign tax credit with it under I.R.C. § 960.

    • Note that the Subpart F inclusion is not a dividend and consequently does not qualify for the lower rate of tax under I.R.C. § 1(h)(11). See Rodriguez v. Commr., Fifth Circuit Court of Appeals, July 5, 2013, 2013 TNT 130-11 and Notice 2004-70.

Smith Case and Qualified Dividend Treatment Argument

In 2018, there was a very important Tax Court case, Smith vs Comm’r. This case is important to show that the Tax Court is reluctant to deem a dividend as a qualified dividend. In that case, the taxpayer was seeking to obtain a qualified dividend as a result of the structure he established involving multiple entities (including CFCs) in different countries. It is important to note that in Smith, the Petitioners not only had a complicated entity structure, but they made a 962 election (which impacts previously taxed E&P under 959) and required the inclusion of certain income. In addition, based on the 962 election, the Taxpayers claimed the dividend was not a foreign dividend but a domestic dividend (based on the distribution by way of the 962 election to be treated as a domestic corporation).  Alternative arguments were made as well regarding the extension of the US/China tax treaty to Hong Kong (which was unsuccessful). For purposes of this article, the case is important to show which arguments may be difficult to prove to the Tax Court.

The Tax Court noted the following:

‘Extended’ Treaty Argument Did Not Work

Taxpayers took the position that for any dividend that may qualify as a dividend and possibly qualified if the foreign corporation was ‘qualified,’ Hong Kong should qualify as part of the U.S./China tax treaty. The court shot down this argument because Hong Kong has an independent tax system. In other words, any relationship between China and Hong Kong would not necessarily extend the US/China treaty to include Hong Kong.

Cyprus as a Qualified Foreign Corporation

When the dividend was distributed, the taxpayers claimed that they claimed that it should be a qualified dividend, because the dividend was paid out by the Cyprus company — which should qualify as a qualified foreign corporation as there is a tax treaty with Cyprus and taxpayers allege that they obtained a Tax Residency Certificate. The Tax Court did not grant summary judgment on the issue of whether Cyprus was a qualified foreign corporation since certain aspects of the argument had not yet been addressed by the parties and whether the entity was a Cyprus company sufficient to meet the definition of a qualified dividend.

Act of State Doctrine

Petitioners argued that the Act of State Doctrine would mean that the court would have to accept the summary judgment position by taxpayers that the entity would be considered a resident of Cyprus, but the court concluded that they do not have to accept that position because taxpayers did not meet their burden.

• • • “Petitioners seek summary judgment on the second question, and respondent opposes that motion on the ground that material factual disputes exist concerning the Cypriot CFC’s residency. Petitioners urge that they are entitled to judgment as a matter of law on the theory that the “act of state” doctrine requires us to accept, as dispositive of the Cypriot CFC’s status as a bona fide resident of Cyprus, a certification from the Cyprus Ministry of Finance (Ministry) to that effect. Viewing the facts and inferences drawn from them in the light most favorable to respondent as the nonmoving party, we conclude that petitioners have not established that the act of state doctrine applies. Because there exist genuine disputes of material fact  concerning the Cypriot CFC’s residency, we will deny petitioners’ motion for partial summary judgment on the second question.”

A Few Takeaways

A few key takeaways about qualified dividends from foreign corporations that are CFC is that first, for taxpayers who are considering taking dividend distributions from Controlled Foreign Corporations, in general, these distributions will not automatically be considered qualified dividends per se. Taxpayers may be able to make certain arguments depending on how the companies were structured — but they should be sure that they are dealing with a treaty country and that ancillary arguments about how other territories related to the treaty country should extend the treaty to that additional territory may not apply. Likewise, just establishing a company in a treaty country after the fact does not guarantee that a dividend will be considered a qualified dividend and that instead, the court will look to the totality of the circumstance.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.