In Rodriguez v. Commissioner (July 5, 2013), the United States Court of Appeals for the Fifth Circuit upheld a prior decision of the Tax Court denying the lower dividend tax rate to certain income passed through to a United States taxpayer from a foreign corporation. If more than 50% of the stock of a foreign corporation is owned by United States taxpayers, the foreign entity is referred to as a “controlled foreign corporation” or “CFC.” Any United States shareholder who owns 10% or more of the stock is subjected to a pass-through income taxation regime on certain types of income generated by the CFC, including most forms of investment income.

The purpose of these rules is to prevent United States taxpayers from avoiding US tax liability by having their investments or foreign business interests held by foreign corporations formed in jurisdictions that do not have income taxes or have very low income tax rates. Under the applicable CFC rules, the United States shareholder must pay tax on his share of this income every year, whether or not it is distributed to him. The kinds of income that are subject to this passthrough taxation scheme are commonly referred to by tax practitioners as “Subpart F income.” These United States shareholders are also taxed currently if the foreign corporation invests its earnings within the United States, even if the earnings came from the conduct of an active business and would not be considered Subpart F income. The policy behind this rule is that tax deferral should end if foreign earnings are effectively repatriated by the investment of those earnings in United States property.

In Rodriguez, the husband and wife taxpayers were Mexican citizens, but they were United States taxpayers because they were permanent residents of the United States. They owned all the stock of a Mexican corporation that had historically been in the business of publishing newspapers in Mexico. The earnings from publishing newspapers in Mexico were not Subpart F income or otherwise taxed to the United States shareholders on a pass-through basis. The corporation subsequently changed its business to the development of real property, and some of the property it acquired was located in the United States. The taxpayers reported the amount of earnings invested in the United States property as income on their Form 1040 but treated it as qualified dividend income, which at the time was taxed at a 15% rate rather the 35% rate that applied to other forms of ordinary income.

The IRS challenged this treatment, and the Tax Court agreed with the IRS. The taxpayers appealed to the Fifth Circuit. The Court of Appeals upheld the Tax Court’s decision, ruling that income of a CFC that is taxed to a United States shareholder on a pass-through basis is not a “dividend” because a dividend requires an actual distribution or some economic benefit to pass from the corporation to the shareholder, whereas Subpart F income and foreign earnings invested in the United States are taxed to the shareholder whether or not those earnings are distributed.

This case resolves the issue of whether Subpart F income and other earnings of a foreign corporation that are taxed on a pass-through basis qualify for the more favorable tax rates applied to dividend income. A somewhat related issue is whether capital gain income that is Subpart F income passes through in kind to its shareholders and is subject to taxation at the lower capital gain tax rate. While no court has yet addressed this issue, it is widely believed that this is not the case and that capital income recognized by a CFC is nevertheless taxed at the higher ordinary income tax rate when passed through to the United States shareholder under Subpart F. The regulations do provide that tax-exempt interest received by a CFC loses its special character and becomes taxable when it passes through to a United States shareholder under Subpart F. It would seem likely that capital gain income also loses its special character under Subpart F.