Tax Court Rules that a “Section 962(d) Distribution” from a Hong Kong CFC is not Subject to Qualified Dividends Tax Rates

October 2018

Summary

Recently, the U.S. Tax Court granted motions for summary judgement in Smith v. Comm’r, 151 T.C. No. 5 (2018) (hereinafter the Tax Court Case) finding that a “Section 962(d) distribution” from a Hong Kong controlled foreign corporation (CFC) was not qualified dividend income but instead, subject to ordinary tax rates.
 

Details

The petitioners in the Tax Court Case owned, through a pair of grantor trusts and an S corporation, CFCs incorporated in Hong Kong and later in Cyprus. In 2008, the Hong Kong CFC paid the petitioners a dividend of $12.3 million. In 2009, the Cypriot CFC paid the petitioners a dividend of $57.1 million. In 2009, the Cypriot CFC also cancelled an account receivable owed by the petitioner’s S-corporation. That account receivable had an outstanding balance of $21.1 million when it was cancelled.[1]
 
One of the key issues addressed in the Tax Court Case was whether the $12.3 million dividend that the Hong Kong CFC paid petitioners in 2008 should be subject to a reduced rate of tax as a “qualified dividend” under Section 1(h)(11)(B)(i)(I).
 
Section 962(a)(1) provides that an individual U.S. shareholder may elect to be taxed on his or her Section 951(a) inclusions at the corporate tax rates specified in Section 11. This election may also entitle the individual to claim deemed-paid foreign tax credits (FTCs) under Section 960, which would otherwise be unavailable.[2] The petitioners made Section 962 elections with respect to Section 951(a)(1) inclusions from the Hong Kong CFC in prior years.
 
Section 962(d) creates an exception to Section 959(a)(1), which generally excludes from a U.S. shareholder’s gross income a CFC’s previously taxed earnings and profits (E&P). Section 962(d) provides that, if a U.S. shareholder has elected the benefits of Section 962(a) with respect to prior Section 951(a) inclusions, the related E&P of the CFC, when actually distributed to the U.S. shareholder is, notwithstanding the provisions of Section 959(a)(1), included in gross income to the extent that such E&P so distributed exceed the amount of tax previously paid by the U.S. shareholder (a Section 962(d) distribution).
 
Section 1(h)(11) makes preferential tax rates available for qualified dividend income. Qualified dividend income includes dividends received during the taxable year from domestic corporations and “qualified foreign corporations.” A “qualified foreign corporation” is a corporation that is “incorporated in a possession of the United States” or is “eligible for benefits of a comprehensive income tax treaty with the United States.”[3] Dividends that do not qualify as qualified dividend income under these provisions are subject to tax at the rates applicable to the taxpayer’s ordinary income.
 
As mentioned above, one of the key issues addressed in the Tax Court Case was whether the Section 962(d) distribution from the Hong Kong CFC qualified for preferential tax rates under Section 1(h)(11).
 
Hong Kong does not have an income tax treaty with the United States, so the petitioners did not argue that the Hong Kong CFC was a qualified foreign corporation.[4] Rather, the petitioners argued the $12.3 million Section 962(d) distribution from the Hong Kong CFC was distributed by a “notional” domestic corporation, that the dividend thus constituted qualified dividend income under Section 1(h)(11)(B)(i)(I), and that the dividend should thus be taxable at reduced rates specified in Section 1(h)(11). By virtue of the Section 962 elections, the petitioners argued that the Hong Kong CFC’s E&P was essentially distributed to a notional domestic corporation, which later paid the $12.3 million dividend as a domestic corporation consistently with the terms of Section 1(h)(11)(B)(i)(I).[5]
 
The Tax Court could not find support for this theory in the statute, the legislative history, the regulations, or judicial precedent. The Tax Court found that the relevant statutory texts were not ambiguous and stated that in drafting Section 962, Congress adopted the counterfactual hypothesis that the Section 951(a) inclusions were received by a domestic corporation, rather than by the individual U.S. shareholder, for the sole and limited purpose of enabling that person to elect beneficial tax treatment under Section 962(a). The Tax Court further provided that there is nothing in the statutory text to suggest that Congress intended this counterfactual hypothesis to apply for any other purpose under the Code, least of all for purposes of Section 1(h)(11), which was not enacted until 41 years later.
 

BDO Insights

The holding in the Tax Court Case provides clear guidance regarding the tax implications on a Section 962(d) distribution from a foreign corporation that is not a qualified foreign corporation. BDO can assist clients with analyzing the tax implications to a Section 962 election and a Section 962(d) distribution.
 
 
CONTACT
 
Joe Calianno
Partner and International Tax Technical Practice Leader
National Tax Office
  Monika Loving
Partner and International Tax Practice Leader
 

 
Annie Lee
Partner
  Chip Morgan
Partner

 
Robert Pedersen
Partner
  Jerry Seade
Principal

 
Natallia Shapel
Partner
 
  Sean Dokko
Senior Manager
National Tax Office
 
[1] The Tax Court also addressed two additional issues not discussed in this Tax Alert. First, the Tax Court held that summary judgment was not appropriate on the question of whether the Cypriot CFC was a “qualified foreign corporation” and whether the $57.1 million dividend paid to the petitioners in 2009 was “qualified dividend income” under Section 1(h)(11)(B)(i)(II). In addition, Tax Court also held that the petitioners received from the Cypriot CFC in 2009 a constructive distribution of $21.1 million that was taxable to them as a dividend under Sections 301(c)(1) and 316(a).
[2] Section 962(a)(2).
[3] Section 1(h)(11)(C)(i). Also, Section 1(h)(11)(C)(ii) provides that a foreign corporation not otherwise treated as a qualified foreign corporation under Section 1(h)(11)(C)(i) shall be so treated with respect to any dividend paid by such corporation if the stock with respect to which such dividend is paid is readily tradable on an established securities market in the United States.
[4] Although there is an income tax treaty between the United States and the People’s Republic of China, it does not cover Hong Kong, which has an independent taxation system. See Agreement for the Avoidance of Double Taxation and the Prevention of Tax Evasion With Respect to Taxes on Income, China-U.S., art. 2(1), Apr. 30, 1984, T.I.A.S. No. 12,065 (stating that the taxes to which the treaty applies are those in the United States and “in the People’s Republic of China”); Notice 97-40, 1997-2 C.B. 287.
[5] The petitioners relied in part on certain language included in a tax treatise which states that the effect of Section 962(d) is to treat a subsequent distribution of taxable 962 E&P “essentially as though it was first received by the hypothetical domestic corporation and then redistributed to the individual taxpayer.” Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, para. 69.12, at 69-84 (3d ed. 2005).