Capital gains treatment for dividends from foreign corporations

Editor: Michael Wronsky, CPA, MST

Sec. 1(h)(1) generally provides that an individual taxpayer’s net capital gain for any tax year is subject to a prescribed maximum capital gains tax rate (for higher-income taxpayers, most commonly 20%). For this purpose, the term “net capital gain” means net capital gain increased by qualified dividend income (Sec. 1(h)(11)).

“Qualified dividend income” is defined as dividends received during the tax year from domestic corporations and qualified foreign corporations (Sec. 1(h)(11)(B)(i)). Though qualified dividend income treatment can appear straightforward for dividends received from domestic corporations (aside from limited exceptions not discussed here), determining which dividends received from a foreign corporation might qualify can require more careful consideration. This item takes a closer look at that latter qualification which, in light of more recently issued guidance, is due for a revisit.

‘Qualified foreign corporation’ determinations

A foreign corporation can generally be considered a qualified foreign corporation if it meets one of the following three tests:

1. The corporation is incorporated in a possession of the United States (Sec. 1(h)(11)(C)(i)(I));

2. The corporation is eligible for benefits of a comprehensive income tax treaty with the United States that the Treasury secretary determines is satisfactory and includes an exchange-of-information program (Sec. 1(h)(11)(C)(i)(II)); or

3. The stock of the corporation with respect to which such dividend is paid is readily tradeable on an established securities market in the United States (Sec. 1(h)(11)(C)(ii)).

The discussion that follows focuses on the second test requiring that the foreign corporation be eligible for benefits under an acceptable treaty, as this treaty test is by far the most prevalent for qualification purposes. Given that this treaty test intentionally depends upon the Treasury secretary’s approval, the IRS has periodically published via notices a list of countries having a satisfactory income tax treaty with the United States.

On Dec. 28, 2023, the IRS issued Notice 2024-11, updating the list of countries having treaties that meet the requirements of Sec. 1(h)(11)(C)(i)(II). From the previously published list in Notice 2011-64, three notable changes in Notice 2024-11 are:

1. Chile has been added to the list, effective for all dividend payments made on or after Dec. 19, 2023, following the entrance into force of a comprehensive income tax treaty with the United States;

2. Hungary has been removed from the list, effective for all dividend payments made on or after Jan. 8, 2023, following the termination of the U.S.–Hungary income tax treaty; and

3. Russia has been removed from the list, effective for all dividend payments made on or after Jan. 1, 2023, following Treasury’s announcement that the IRS has paused information exchange activities with Russia. Note that the U.S.–Russian Federation income tax treaty remains in force, but the Sec. 1(h) (11) (C)(i)(II) requirements for an active exchange-of-information program are no longer met.

This latest issued guidance is an important reminder that qualification under the treaty test might not be a one-and-done exercise. Apart from the changes that can occur at any time at the diplomatic level related to the availability of an inforce treaty or active exchange-of-information program, establishing a foreign corporation’s eligibility for benefits under an available treaty (mere availability of a treaty alone is not enough) for qualified dividend income treatment is itself an item subject to change and one that might require a recurring analysis from one dividend to the next.

In particular, it is important to review and consider the residency and limitation-on-benefits articles within the relevant treaty and how any changes in the foreign corporation’s domicile, shareholder ownership, and/or activities may have altered its eligibility for benefits. For eligibility determination purposes, it matters not whether the foreign corporation itself derives any U.S.-source income that might be the subject of treaty relief whereby it will be treated as eligible for treaty benefits if it would qualify for benefits under the treaty (see H.R. Conf. Rep’t No. 108-126, 108th Cong., 1st Sess. 42 (2003)).

Exclusion of dividends of certain foreign corporations

Notably, Sec. 1(h)(11)(C)(iii) specifically excludes dividends of the following two types of corporations from qualified dividend income treatment:

1. Any foreign corporation that is a passive foreign investment company (PFIC), as defined in Sec. 1297 (Sec. 1(h)(11)(C)(iii)(I)) for the tax year of the corporation in which the dividend was paid or the preceding tax year; and

2. Certain surrogate foreign corporations (as defined in Sec. 7874(a)(2) (B) ), other than a foreign corporation that is treated as a domestic corporation under Sec. 7874(b) (Sec. 1(h) (11) (C)(iii)(II)).

The second exclusion has a narrow application to situations where a relevant inversion transaction has been completed and is not taken up in any further detail in this discussion.

The first exclusion, however, has a much broader application due to the number of individual taxpayers that might be considered to hold an investment in a PFIC. A foreign corporation is generally considered a PFIC for U.S. tax purposes when either (1) 75% or more of its gross income is passive (Sec. 1297(a)(1)) or (2) 50% or more of the average percentage of assets held by it during the tax year produces passive income or is held to produce passive income (Sec. 1297(a)(2)).

A notable exception to PFIC status is provided under Sec. 1297(d), whereby a foreign corporation that is a controlled foreign corporation (CFC) generally is not treated as a PFIC with respect to a shareholder during the qualified portion of the shareholder’s holding period in the stock of the foreign corporation (even if the corporation meets the income test or asset test). As described under Sec. 957(a), a CFC is a foreign corporation more than 50% of the vote or value of which is collectively owned by U.S. shareholders. A U.S. shareholder is described under Sec. 951(b) as a U. S. person that directly, indirectly, or constructively owns 10% or more of the foreign corporation by vote or value.

The qualified portion generally is the portion of the shareholder’s holding period that is after Dec. 31, 1997, and during which the shareholder is a U.S. shareholder (i.e., a 10%-or-more owner) and the foreign corporation is a CFC. Commonly referred to as the “CFC overlap rule,” this exception might not apply in situations where there is a disqualified portion of the shareholder’s holding period (e.g., shareholdings existing prior to the 1998 applicability date) and the foreign corporation is otherwise treated as a PFIC under the “once a PFIC, always a PFIC rule” of Sec. 1298(b)(1). As the determination of whether a foreign corporation is a PFIC is made on a shareholder-by-shareholder basis, a foreign corporation may be treated as a PFIC with respect to some shareholders but not others. In cases where a dividend is received by an individual shareholder from a CFC that would be treated as a PFIC with respect to such individual but for application of the CFC overlap rule, the dividend is treated as qualified dividend income, provided that the CFC is otherwise a qualified foreign corporation under Sec. 1(h)(11)(C) and the other requirements of Sec. 1(h)(11) are met (see Notice 2004-70).

New guidance might alter eligibility for dividends received through domestic passthrough entities

Where a U.S. partnership is interposed as the direct owner of a CFC, the IRS has ruled that the CFC overlap rule is applied at the level of the U.S. partnership, with the result that even a less-than-10% U.S. partner was eligible for the exception (see IRS Letter Ruling 200943004). A similar result would ensue where there is an interposed U. S. S corporation that is treated as a partnership under Sec. 1373 for purposes of applying the foreign income provisions of the Internal Revenue Code.

This had historically made sense when the U.S. partner included in its taxable income (no matter its indirect ownership percentage in the CFC) a Sec. 702 distributive share of the partnership’s deemed inclusion income from the CFC (e.g., Subpart F income under Sec. 951(a)). However, with the introduction of the global intangible low-taxed income (GILTI) deemed-inclusion rules under Sec. 951A as part of the Tax Cuts and Jobs Act, P.L. 115-97, and a subsequent alignment of the Subpart F deemed-inclusion rules (under final regulations (T.D. 9960), generally effective for tax years of foreign corporations beginning on or after the Jan. 25, 2022, issue date of those regulations), domestic partnerships are now treated as aggregates of their partners for purposes of applying the current-inclusion rules under the CFC regime.

As a result, only those U.S. partners that are themselves U.S. shareholders (i. e., 10%-or-more owners) of CFCs held through domestic partnerships would now have GILTI or Subpart F deemed inclusion amounts through that investment. Hence, for the less-than-10% U. S. partner, the policy concern that the CFC overlap rule looks to address (i.e., precluding application of both the CFC and PFIC regimes with respect to the same stock) has been eliminated where that partner is no longer subject to the CFC regime.

Proposed PFIC regulations (REG-118250-20, issued concurrently with the final Subpart F regulations on Jan. 25, 2022, but still pending finalization) similarly align with an aggregate approach with respect to domestic partnerships that, for purposes of applying the PFIC rules, would result in the domestic partnership’s no longer being viewed as a shareholder in the PFIC but, instead, with its partners being treated as the direct owners. If finalized in their current form, these PFIC regulations (generally applicable to tax years beginning on or after the date they are finalized, but with the potential for prescribed transition-period relief, as applicable) would fundamentally alter the application of the CFC overlap rule in the context of foreign corporations held through intermediary domestic passthrough entities.

This is anticipated to result in a larger number of individual taxpayers (who are not themselves 10%-or-more owners) no longer being eligible for the Sec. 1297(d) exception and, in turn, being ineligible for qualified dividend income treatment on their distributive share of actual dividends received from foreign corporations that are treated as PFICs with respect to those shareholders. This will add to the need for (scope of) a recurring analysis for qualified dividend income treatment that extends beyond qualification under the treaty test of Sec. 1(h)(11)(C)(i)(II) to also include, absent further revisions to the guidance, a proliferation of annual testing for PFIC status under the income and asset tests of Sec. 1297(a) in making those partner-level determinations (further introducing complexities not previously evident under an entity approach to the treatment of domestic passthrough entities).

Planning observations regarding certain commonly made tax elections

For post-2017 tax years, the introduction of the GILTI regime has increased the regularity with which individual taxpayers (that are U.S. shareholders of CFCs, whether direct or indirect through intermediary domestic passthrough entities) are faced with the prospect of a current deemed inclusion of CFC income. For U. S. federal income tax purposes, such inclusions are not treated as dividends and would be taxed as ordinary income at rates up to the current top marginal rate of 37% for those individuals. This represents a significant rate differential from the 20% tax rate that might apply if the related earnings were actually distributed as a taxable dividend to the shareholder and the conditions for qualified dividend income treatment were met. With that, individual taxpayers have most commonly looked at two principal tax elections that potentially might work to help ameliorate the impact of that rate disparity.

The first is the high-tax exception election under Sec. 954(b)(4), in which CFC income is excluded from Subpart F income and (through cross-reference under Regs. Sec. 1.951A-2(c)(7) to Sec. 954(b)(4)) GILTI, where the related income is subject to foreign income tax at an effective rate greater than 18.9% (90% of the currently highest U.S. federal corporate tax rate of 21%). Where available, this election has the effect of deferring U.S. taxation of the CFC income until a later actual distribution of the related earnings as taxable dividend income, which, for individual taxpayers (who are ineligible for separate Sec. 245A participation exemption), may be eligible for qualified dividend income treatment should the requirements of Sec. 1(h)(11) be satisfied at the time of that later distribution.

The second is an election under Sec. 962, whereby the individual taxpayer would still have a current deemed inclusion of computed GILTI or Subpart F income from the CFC but might be more favorably taxed on that deemed inclusion when treated as though it were a domestic C corporation recognizing the amount. That fiction then results in the deemed inclusion’s being taxed at the likely much lower current corporate rate of 21% and might also provide for each a credit for foreign taxes deemed paid under Sec. 960 (on the taxpayer’s proportionate share of underlying taxes paid at the CFC level) and, specific to GILTI, a 50% deduction under Sec. 250 (none of which is available to an individual taxpayer in the absence of making a Sec. 962 election) in further reducing the present-day tax otherwise due on the deemed inclusion.

However, carrying the fiction of a Sec.962 election through to its natural completion (where the shareholder would be subject to a second level of tax if it had actually held the CFC through an interposed domestic C corporation), a later actual distribution of those underlying CFC earnings (net of any residual U.S. federal income tax paid on the earlier deemed inclusion) remains a taxable distribution of Sec. 962 earnings and profits (E&P) to the individual shareholder. In Smith, 151 T.C. 41 (2018), the Tax Court held that when an individual taxpayer later receives an actual distribution of Sec. 962 E&P, it is treated as a taxable dividend not from the fictitious domestic C corporation but instead from the CFC itself. The result is that the later distribution might itself be eligible for qualified dividend income treatment should the requirements of Sec. 1(h)(11) be satisfied at the time of that distribution.

As might readily be apparent, the effectiveness of these elections likely hinges on the ability to obtain qualified dividend income treatment for the individual taxpayer upon a later receipt of a taxable dividend from the CFC. Perhaps less apparent, these elections could potentially result in a net detrimental impact to the electing shareholder should qualified dividend income treatment not be available later (e.g., where ordinary income rates are on the rise, where residual U.S. income tax arises on a deemed inclusion under the Sec. 962 election).

Given the number of variables at play in obtaining qualified dividend income treatment (which are subject to change through recurring analysis), careful modeling should be performed prior to making these elections, as they might not ultimately prove to be the panacea initially thought. Furthermore, consideration might be given to accelerating the repatriation of prior CFC earnings covered under these elections where that is determined to be most tax-efficient.

Editor Notes

Michael Wronsky, CPA, MST, is managing director of Baker Tilly’s Washington Tax Council.

For additional information about these items, contact Wronsky at michael.wronsky@bakertilly.com.

Contributors are members of or associated with Baker Tilly US, LLP.