In Rodriguez v. Commissioner, the Court of Appeals for the Fifth Circuit on July 5, 2013, affirmed that amounts required to be included in gross income under Section 951 (Section 951 inclusions) do not constitute “qualified dividend income” under Section 1(h)(11). As a result, such amounts are taxable as ordinary income and are not eligible to be taxed as net capital gain. The Fifth Circuit’s decision supports the IRS’s position with respect to this issue as reflected in Notice 2004-70. The decision is also consistent with Proposed Treasury Regulations under Section 1411, which provide that the 3.8 percent tax on dividends and other net investment income under such Section generally does not apply to Section 951 inclusions.
Section 951 Inclusions
Under Section 951, a domestic taxpayer that owns 10 percent or more of the voting power of the stock of a controlled foreign corporation is generally required to include in income such taxpayer’s pro rata share of the foreign corporation’s subpart F income and Section 956 amounts (i.e., the taxpayer’s Section 951 inclusions). Subpart F income generally includes dividends, interest and certain other types of passive income. Section 956 amounts generally include amounts invested by the foreign corporation in United States property.
Qualified Dividend Income
Under Section 1(h)(11), “qualified dividend income” recognized by an individual is generally taxed at the long-term capital gains rate of 20 percent rather than as ordinary income (39.6 percent maximum for individuals).
Net Investment Income
Under Section 1411, a tax of 3.8 percent is imposed on the “net investment income” of an individual. The term “net investment income” generally includes dividends, interest and certain other types of passive income (other than such types of income derived in the ordinary course of a trade or business). Proposed Treasury Regulations under Section 1411 generally provide that Section 951 inclusions do not constitute net investment income. However, distributions of previously taxed income are generally treated as distributions for purposes of determining net investment income. Thus, under the Proposed Treasury Regulations, generally only actual distributions are treated as dividends for purposes of the net investment income rules.
The taxpayers in Rodriguez were permanent U.S. residents that together owned all of the stock of a controlled foreign corporation. During the years at issue, the corporation invested in U.S. property within the meaning of Section 956 and included the invested amounts in gross income under Section 951. The taxpayers treated such amounts as qualified dividend income and reported such amounts as net capital gain rather than ordinary income. The issue was whether this treatment was proper. The Tax Court had held that such amounts do not constitute qualified dividend income and are therefore taxable as ordinary income.
The IRS’s position was that the taxpayer’s Section 951 inclusions do not constitute qualified dividend income. This position was consistent with Notice 2004-70, in which the IRS took the same position.
The taxpayers argued that the Section 951 inclusions constitute either actual dividends or deemed dividends and therefore constitute qualified dividend income. The taxpayers also argued that failure to treat Section 951 inclusions as qualified dividend income would be an “absurd, harsh, and unjust result” because the taxpayers could have caused the corporation to make an actual distribution and the resulting income would have constituted qualified dividend income.
The Court concluded that Section 951 inclusions do not constitute actual dividends because actual dividends require a change of ownership of something of value and Section 951 inclusions do not involve any change of ownership. The Court also concluded that Section 951 inclusions do not constitute deemed dividends. The Court’s principal reason for this conclusion was that where Congress intends to treat certain inclusions as dividends, it explicitly states as much (and the Court cited several sections of the Internal Revenue Code in support of this statement). The Court also noted that the original version of Section 956 specifically stated that Congress did not intend amounts calculated thereunder to constitute dividends.
The taxpayers’ argument that the Section 951 inclusions should constitute qualified dividend income because the taxpayers could have caused actual distributions to have been paid did not impress the Court. The Court noted that the taxpayers could also have paid themselves a salary or invested the corporation’s earnings outside of the United States. The Court stated that each of these decisions would have carried different tax consequences and the taxpayer cannot avoid the resulting tax consequences because they regret the decision they made.
For the above reasons, the Court affirmed the decision of the Tax Court and held that the taxpayers’ Section 951 inclusions did not constitute qualified dividend income (and were therefore taxable as ordinary income).
The main point of Rodriguez is that Section 951 inclusions are taxed as ordinary income and do not constitute qualified dividend income. In this respect, the holding of Rodriguez is consistent with the IRS’s position in Notice 2004-70 and with the Proposed Treasury Regulations under Section 1411.
More generally, Rodriguez serves as an illustration of the importance of the form utilized to effect a transaction. The taxpayers in Rodriguez may have been able to avoid the unfavorable tax consequences at issue if the transaction had been structured in a different manner. However, unfortunately for the Rodriguezes, they were bound by the form they chose.