Short-term Section 962 election benefit outweighed by outcome

Tax Hot Topics newsletterThe Tax Court, in Smith v. Commissioner, 151 T.C. No. 5 (2018), held dividends paid to the taxpayers from their controlled foreign corporation (CFC) were taxable as ordinary dividend income and not as qualified dividend income, which would have been eligible for a reduced tax rate under Section 1(h)(11). It further held that cancellation of a CFC’s accounts receivable owed to it by the taxpayers’ S Corporation was a constructive dividend to the taxpayers.

The taxpayers in Smith owned 100% of an S corporation through two grantor trusts. In turn, this S corporation owned other entities, including 100% of the stock of a Hong Kong CFC (HK CFC).

As part of winding down their business operations in 2007, taxpayers sold the operating assets of the S corporation and HK CFC to a third party. The taxpayers planned to have HK CFC’s cash (from prior operations and the sale proceeds) distributed to them in a dividend. In a tax-free reorganization under Section 368(a)(1)(f), HK CFC merged into a new Cyprus entity (Cyprus CFC) which inherited HK CFC’s assets, including its cash and a large outstanding amount owed to HK CFC by the S corporation.

In 2009, Cyprus CFC paid a cash dividend of $57 million to S Corporation, which the taxpayers reported as qualified dividend income, based on Cyprus CFC’s tax residency certificate from the Cyprus tax authorities. Also in 2009, Cyprus CFC wrote off the outstanding accounts receivable of approximately $21 million, cancelling S corporation’s debt. The taxpayers did not report this cancellation of debt as a constructive dividend.

Citing genuine disputes of fact concerning residency, the Tax Court denied the taxpayers’ motion for summary judgment with respect to whether the Cyprus CFC was a “qualified foreign corporation” and hence whether the $57.1 million dividend was qualified dividend income. The taxpayers also advanced a combination of statute of limitations and double taxation arguments to contest the constructive dividend treatment. The court did not find these arguments persuasive and ruled that the cancellation of debt amounted to a constructive distribution of approximately $21 million.

Separate from its reorganization activities, HK CFC paid a dividend of $18.4 million to the taxpayers in mid-2008 (an amount equal to their Section 956 inclusions for 2004 and 2005 which had been determined on IRS audit). As part of the audit, HK CFC was deemed to have an investment in U.S. property in 2004 and 2005 through its outstanding accounts receivable from S Corporation. As owners of HK CFC, the taxpayers were required to include those amounts in their gross income. They elected to use Section 962 treatment for those inclusions, which allows certain individuals to elect to be taxed on Subpart F income as if a domestic corporation. As a result, the taxpayers paid approximately $6.1 million of tax on their Section 956 inclusions for 2004 and 2005.

Subsequently, in 2008, the taxpayers failed to include in income a dividend of $12.3 million when the Cyprus CFC distributed the previously taxed income. They contended the dividend should be characterized as qualified dividend income by virtue of HK CFC’s E&P “mov[ing] up” to a fictional domestic corporation inserted for purposes of the Section 962 election.

Using plain language interpretation and reviewing the relevant legislative history, the Tax Court rejected the taxpayers’ argument and held that this dividend should be taxed at ordinary income rates. The Tax Court held that Hong Kong CFC was neither a domestic corporation nor a “qualified foreign corporation” under Section (1)(h)(11)(C)(i). A “qualified foreign corporation” is a corporation eligible for benefits of a comprehensive income tax treaty with the United States which includes an exchange of information program. No such agreement exists between the United States and Hong Kong.

Section 962 elections, particularly in light of new sections enacted by the Tax Cuts and Jobs Act, must be carefully considered to ensure a short term benefit is not outweighed by the eventual tax outcome.

David Sites
Partner, Washington National Tax Office
T +1 202 861 4104

David Zaiken
Managing Director, Washington National Tax Office
T +1 202 521 1543

Cory Perry
Senior Manager, Washington National Tax Office
T +1 202 521 1509

Mike Del Medico
Manager, Washington National Tax Office
T +1 202 521 1522

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