Fifth Circuit to Consider Whether Section 951 Inclusions Are Qualified Dividends
August 6, 2012
The taxpayers have appealed to the Fifth Circuit from the Tax Court’s decision in Rodriguez v. Commissioner, No. 13909-08 (Dec. 7, 2011), which rejected qualified dividend treatment for certain amounts included in their income pursuant to Code Section 951. In 2003, Congress established a preferential tax rate for “qualified dividend income,” which includes dividends received from a qualified foreign corporation. Separately, section 951 contains provisions designed to limit tax deferrals by a “controlled foreign corporation” (CFC). Section 951 requires a taxpayer to include in income earnings of a CFC that are derived from investments in U.S real estate. The taxpayers in this case included such earnings in their income but sought to have them taxed at the favorable qualified dividend rate. In a comprehensive opinion, the Tax Court held that they were not “dividends” and hence should be taxed as ordinary income.
The taxpayers’ position was largely policy-based, arguing that the effect of the income inclusion was similar to that of a dividend, but their argument lacked strong direct support in the statutory text. As the Tax Court noted, legislative history and case law had described the section 951 inclusions as substantially equivalent to receiving dividends. See, e.g., Gulf Oil Corp. v. Commissioner, 87 T.C. 548, 571 (1986) (“Subpart F treats the amount of the increased investment much like a constructive dividend to the U.S. shareholders”). But the Tax Court concluded that this similarity did not resolve the case, observing that “to say that section 951 treats a CFC’s investments in U.S. property ‘much like’ a constructive dividend is a far cry from saying that such amounts actually constitute dividends.”
Instead, the Tax Court focused on a textual analysis. First, the court said that the section 951 inclusion did not meet the statutory definition of a dividend (Code section 316(a)) because there was no “distribution” by the corporation; a distribution cannot occur unless there is a “change in ownership of corporate property.” The court noted that the Code expressly provides that section 951 inclusions should be treated as a dividend for certain other purposes, but there is no such express provision for qualified dividend rates. See I.R.C. §§ 851(b), 904(d)(3)(G), 960(a)(1). The court also pointed to several provisions directing that other kinds of non-dividend income, such as redemptions and undistributed foreign personal holding company income, should be treated as dividends. See, e.g., I.R.C. §§ 302(a), 551(b). Given these examples of explicit dividend treatment elsewhere in the Code, the Tax Court concluded that the lack of an explicit textual basis for dividend treatment was a fatal flaw in the taxpayers’ position.
The Tax Court acknowledged that the taxpayers’ position drew support from the original 1962 Senate Report, which explained that, under Subpart F, “earnings brought back to the United States are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them.” S. Rep. No. 1881, 87th Cong., 2d Sess. 794 (1962). But the court found that this sentence was not controlling, pointing to other ways in which treatment of section 951 inclusions differs from dividends (for example, effect on earnings and profits). The court added that affording qualified dividend treatment would not advance the stated legislative purpose for the preferential interest rate.
The impact of this decision is not necessarily confined to the context of qualified dividends. Rather, its reasoning seems applicable to other contexts in which one might argue that section 951 inclusions should be treated as dividends, but where there is no explicit provision to that effect. And the shoe might be on the other foot. For example, the new health care surtax on investment income for taxpayers earning more than $250,000 defines “net investment income” as including “income from interest, dividends, annuities, royalties, and rents.” I.R.C. § 1411(c)(1)(A)(i). If the IRS would like to impose the surtax on section 951 inclusion income, its victory in Rodriguez would appear to pose an obstacle to that position.