U.S. shareholders of a controlled foreign corporation (CFC) must take into account certain income of the CFC in the year it is earned, even if the CFC has not made a cash distribution to its shareholders. When individual taxpayers are made to recognize such deemed income inclusions (commonly known as Subpart F income), the amounts are generally taxable at ordinary tax rates up to 37 percent. This is because such income does not qualify for the special capital gains rates that apply to so-called “qualified” dividends. However, individuals may elect to be taxed as if their Subpart F income is paid to a domestic corporation, making their Subpart F income taxable at 21 percent corporate rates and allowing them to claim a foreign tax credit for the foreign taxes paid by the CFC. However, in exchange for these benefits, the electing shareholder must recognize the Subpart F income a second time, when the CFC actually distributes the cash.
In Barry M. Smith, et ux. v. Commissioner, 151 T.C. No. 5, the taxpayer argued that such a distribution should be taxed as a qualified dividend subject to a 20 percent tax rate on the theory that the distribution should be viewed as having been made by a domestic corporation. The Tax Court disagreed and held that the distribution should be treated as made by a foreign corporation.
The taxpayers in Smith held investments in CFCs incorporated in Hong Kong and in Cyprus. They made section 962 elections with respect to their Subpart F inclusions from these CFCs, and thus paid tax on those inclusions at corporate rates. When the Hong Kong CFC later distributed the earnings previously recognized by the taxpayers under Subpart F, the Smiths claimed qualified dividend treatment notwithstanding that distributions from Hong Kong corporations are not generally eligible for qualified dividend treatment. In support of this position, the Smiths argued that the section 962 election created a hypothetical domestic corporation in between the taxpayer and the Hong Kong CFC, and that the distribution was therefore made by a domestic corporation. Since dividends from domestic corporations are generally qualified dividends, the taxpayers argued that the lower qualified dividend rate applied to the actual distributions from the Hong Kong CFC.
The Tax Court rejected the taxpayers’ argument, noting that nothing in section 962 actually deems a domestic corporation to exist for federal tax purposes. As a result, the court ruled that qualified dividend treatment was not available since the Hong Kong CFC was neither a domestic corporation nor did it qualify under the special rules that apply to dividends paid by foreign corporations.
Since the tax reductions of the 1980s, section 962 had become a largely forgotten corner of the tax law. However, the Tax Cuts and Jobs Act (TCJA) has made Section 962 elections more relevant for a variety of reasons. First, under the TCJA, a section 962 election can result in dramatically reduced current taxation of Subpart F income. In addition, the election can result in reduced taxation of a new category of income, Global Intangible Low Taxed Income (GILTI). However, a taxpayer who makes a Section 962 election may lose the benefit of certain deductions, so it is imperative for taxpayers to carefully analyze whether the election will provide them a net benefit.