On July 5th, the Court of Appeals for the Fifth Circuit affirmed the Tax Court decision in a case demonstrating the tax consequences to the U.S. shareholders of a controlled foreign corporation (CFC) investing directly in the United States. In Rodriguez, the taxpayers were permanent residents of the United States who owned all of the stock of a Mexican company, Editora. The taxpayers filed returns for 2003 and 2004 reporting substantial income resulting from Editora’s investment in real and personal property in the United States, triggering income inclusion under the anti-deferral “Subpart F” rules of the Internal Revenue Code. The IRS did not challenge the amount of income reported but did dispute the rate at which it should be taxed. Both the Tax Court and the Fifth Circuit ruled for the government that the income was taxable as ordinary income and not as dividends qualifying for a lower rate. As a result of Editora’s direct investment in U.S. property, the taxpayers wound up paying more tax than if they had structured their business differently.
When the provision was initially enacted, the tax rates for ordinary income and dividend income were the same. The Jobs and Growth Tax Relief Reconciliation Act of 2003 enacted a lower tax rate for qualified dividend income. The taxpayers in Rodriguez argued that the income inclusion was equivalent to a dividend and should qualify for the lower tax rates. The IRS disagreed and had issued guidance to that effect in 2004. Both courts agreed with that conclusion, based on a literal reading of the Internal Revenue Code. A dividend requires an actual distribution of corporate property to the shareholders. For certain purposes, some transactions are treated as though they were dividends. But these “deemed dividend” provisions are explicitly set forth in the Code, and there was no such provision for income recognized under the Subpart F rules. Absent a clear choice by Congress to that effect, “income inclusion” was not the same as a “dividend” and did not qualify for the lower tax rates.
If the taxpayers had caused Editora to pay a dividend, and then used the dividend to invest in U.S. property themselves, they may have been eligible for the lower tax rate on the dividend. Rodriguez demonstrates the importance of careful planning for cross-border investments to avoid unfortunate tax consequences. We will discuss some of these planning issues in future blog posts.
If you have any questions about this issue, please contact one of the undersigned or any of the other Tax lawyers at Thompson & Knight.