The U.S. Tax Court of Appeals for the Fifth Circuit has recently ruled that Subpart F income should be taxed as ordinary income rather than as qualified dividend income eligible for reduced tax rates.
Normally, dividends received (directly, or indirectly through partnerships or “S” corporations) by individuals from qualified foreign corporations are currently taxed in the U.S. at a maximum federal tax rate of 20%. Qualified foreign corporations are generally corporations that qualify for benefits under a comprehensive income tax treaty with the U.S.
In Rodriguez v. Comr., the Court addressed the question of whether income inclusions under Subpart F (often referred to as “deemed dividends”) also qualify for the lower tax rates on qualified dividend income. The Court held that Section 951 inclusions do not qualify as actual dividends because they do not involve any transfer of ownership or any actual distribution to the shareholders.
The Court’s ruling will also put a damper on a fairly popular tax planning strategy that has been used to avoid withholding taxes on dividend income from foreign countries. The strategy involved making a loan from the foreign corporation to the U.S. shareholder. The loan would be taxed as a deemed dividend under Subpart F rules, but there would be no withholding tax in the foreign country because the distribution was structured as a loan and not a dividend. Now, in view of the Court’s ruling, if an individual shareholder of a foreign corporation were to employ this strategy, the deemed dividend from the loan would not be eligible for the lower tax rate, but would be taxed as ordinary income at rates up to 39.6%.
Subpart F was added to the Internal Revenue Code as a deterrent for taxpayers trying to accumulate and retain income offshore in low-tax jurisdictions. The Court’s ruling in Rodriguez adds another compelling reason to avoid its application.
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