The Smith vs. IRS ruling: the 962 election leads to dividends taxed at ordinary rates, unless….
The 2017 tax reform created the Transition and GILTI taxes. These taxes result in individual U.S. Shareholders of controlled foreign corporations (“CFC”) being personally liable for various past (Transition tax) and future (GILTI tax) earnings of the CFC. The Internal Revenue Code (IRC) 962 election allows an individual U.S. Shareholder of the CFC to be treated as a domestic U.S. corporation for purposes of these two new taxes. In many cases, making a 962 election for a specific year may result in better tax treatment for that year. But as has been pointed out in prior articles, the 962 election has one major drawback: when the earnings previously included in the “deemed domestic corporation” under the 962 election are actually distributed as dividends, they are subject to U.S. tax. The question addressed by the Smith vs. IRS case was how the dividend should be taxed: as (i) an ordinary dividend taxed at higher ordinary rates, or (ii) a qualified dividend, taxed at lower capital gains rates.
The simplified facts of the Smith vs. IRS case are as follows: Smith was an individual US shareholder of two CFCs – one incorporated in Cyprus and one in Hong Kong. In 2004, the CFCs had significant Subpart F income. To pay lower corporate taxes in that year rather than higher personal tax rates, Smith made 962 elections for both corporations. In 2008, the CFCs distributed the 2004 CFC earnings to Smith by way of dividend. In his return, Smith claimed capital gains rates, which the IRS disputed.
Fast forward 9 years. In late September 2018 the court, in a summary proceeding, ruled that the dividends from the Hong Kong CFC should be taxed at ordinary income rates.
Why? First, as the distributions were made out of earnings and profit, the distributions were deemed as dividends as opposed to capital gain or return of capital. Next, the court discussed IRC 1(h)(11)(B), which allows preferential “Qualified Dividend” tax treatment if the dividend is received from either a “domestic corporation” or “qualified foreign corporation”. A “qualified foreign corporation” is defined as a corporation that is incorporated in a possession of the U.S., or is “eligible for benefits of an income tax treaty with the U.S.” Finally, the Court stated that dividends not qualifying as “Qualified Dividends” are taxed as ordinary income.
In the Smith case, in 2008, no tax treaty existed between the US and Hong Kong. Accordingly, the court ruled that the dividends received from the Hong Kong CFC were taxable at ordinary rates.
As to Cyprus, a U.S.-Cyrus Treaty did exist (“Treaty”). However, Smith resided in the U.S. and not Cyrus. In analyzing Article 26(1) of the Treaty dealing with Limitation of Benefits, the court found that Smith was not a Cyrus resident and thus the Cyrus CFC did not qualify for Treaty benefits. However, Article 26(2) of the Treaty stated that even if a Cyprus company failed the Article 26(1) test it could still benefit from the Treaty if “it is determined that the establishment, acquisition and maintenance of the corporation did not have as a principle purpose obtaining benefits under the Treaty.” As to the “principle purpose” test, the court decided that a full trial, rather than a summary proceeding, was required to reach a decision as to this point.
To summarize, the IRC 962 election has gained significant attention with the creation of the Transition and GILTI tax regimes. The 962 election may generate tax savings in the year in which income is earned by the CFC and otherwise taxable to the individual U.S. shareholder. However, IRC 962 creates potential U.S. tax liability when the earnings are distributed by dividends. As the Smith court rules, how the dividend will be taxed depends on numerous factors, such as the existence and terms of Tax treaties.