US Outbound: Fifth Circuit holds section 951 inclusions not qualified dividend income

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US Outbound: Fifth Circuit holds section 951 inclusions not qualified dividend income

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Sean Foley and Landon McGrew, KPMG

The US Court of Appeals for the Fifth Circuit recently held in Rodriguez v. Commissioner, 13 No. 12-60533 (July 2013), that income inclusions under Subpart F of the Internal Revenue Code do not constitute qualified dividend income within the meaning of section 1(h)(11). As a result, the taxpayers in that case were required to pay US tax on their subpart F income inclusions at the higher ordinary income rate of 35%%, rather than the preferential qualified dividend income rate of 15%.

In the Rodriguez case, the taxpayers were married US residents that owned all of the stock of a Mexican controlled foreign corporation called Editora Paso del Norte, SA de CV (Editora). Editora in turn owned a branch in the US. Under the US subpart F rules, the taxpayers were required to include in gross income as investments in US property under section 951(a)(1)(B) and 956 certain amounts attributable to Editora's investment in the US branch. As a result, the taxpayers included in gross income approximately $1.59 million and $1.48 million on their tax returns for 2003 and 2004, respectively.

The dispute in the Rodriguez case turned on how the taxpayers characterised that income. Specifically, the taxpayers reported both amounts as qualified dividend income subject to a preferential 15% tax rate, rather than the 35% rate at which ordinary income is taxed. In March 2008, the Internal Revenue Service (IRS) issued a notice of deficiency arguing that section 951 inclusions do not constitute qualified dividend income within the meaning of section 1(h)(11). After an unsuccessful challenge in the US Tax Court (137 T.C. No. 14, December 2011), the taxpayers filed an appeal with the Fifth Circuit.

In affirming the US Tax Court's decision, the Fifth Circuit began by noting that section 316(a) defines a "dividend" as "any distribution of property made by a corporation to its shareholders". Furthermore, section 1(h)(11) defines a "qualified dividend" as "dividends received during the taxable year". Based on these statutory definitions, the court determined that to constitute an actual dividend, there must be "a distribution by a corporation and receipt by the shareholder; there must be a change in ownership of something of value". Because an inclusion under section 951 does not involve a transfer of ownership or distribution to shareholders, the court held that such an inclusion does not constitute an actual dividend.

The court also rejected the taxpayers' claim that the section 951 inclusions should be treated as deemed dividends for purposes of section 1(h)(11). The court found the argument unpersuasive "because, when Congress decides to treat certain inclusions as dividends, it explicitly states as much, and Congress has not so designated the inclusions at issue here".

The court also acknowledged that, as Editora's sole shareholder, the taxpayers could have caused Editora to issue an actual dividend in the amount of the section 951 inclusions. In that case, the income would have "unquestionably qualified as dividend income subject to the lower 15 rate". The court held, however, that the taxpayers "cannot now avoid their tax obligation simply because they regret the decision they made".

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG.

Sean Foley (sffoley@kpmg.com) and Landon McGrew (lmcgrew@kpmg.com)

KPMG, Washington, DC

Tel: +1 202 533 5588 Fax: +1 202 315 3087

Website: www.us.kpmg.com

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