Dividend Deduction’s End Spells Few Changes for Taxpayer Guidance

The IRS clarified in a memorandum made public last month that controlled foreign corporations aren’t entitled to a dividends-received deduction under Section 245A of the tax code. Taxpayers may owe taxes, interest, and penalties if they had CFCs that took this deduction.

The memo says that if Congress intended for Section 245A to allow the deduction, it would have included the deduction in the plain language of the code. While taxpayers and practitioners have cited sections of the code and regulations to argue that the deduction should be permitted, the IRS rejected these claims.

Taxpayers who improperly used the dividends-received deduction in the past may now find themselves with Subpart F inclusions that are taxable in the year earned.

Here’s one hypothetical example of the potential impact: Let’s say we have a US corporation with a 100%-owned CFC that receives a $1 million dividend from a non-CFC. A dividend received deduction for $1 million is claimed by the CFC, which is reflected in the US corporation’s original tax return.

Realizing the mistake, the US corporation files an amended return to adjust out the deduction and recognize $1 million of Subpart F income. Assuming no additional credits or deductions are available, the US corporation now owes 21% corporate tax, potential state and local taxes, and interest and penalties on the late payment of tax on the $1 million.

The impact on individual taxpayers could be even larger. Individuals are subject to ordinary income tax rates up to 37%, plus potential state taxes on Subpart F inclusions. Subpart F inclusions subject to tax at ordinary tax rates in the year earned are generally tax-free when distributed and avoid double taxation.

Individuals may be able to reduce the impact of Subpart F income through a Section 962 election, which taxes Subpart F income at US corporate tax rates and allows the use of foreign tax credits.

Individuals should be mindful of making a Section 962 election when it comes to repatriating earnings. Earnings previously taxed under a Section 962 election are taxable dividends when distributed. Individuals should also assess whether the dividend may qualify for reduced qualified dividend tax rates or whether they are subject to full ordinary rates.

While a 962 election may result in double taxation, it can allow for reduced taxes on Subpart F inclusions using lower corporate tax rates and foreign tax credits. If foreign tax credits are sufficient to offset taxes calculated under corporate tax rates, an individual could defer US tax until earnings are repatriated.

To mitigate risk of a Subpart F inclusion, taxpayers may consider changing their US entity classification election from foreign corporation to partnership. While this election change is only for US tax purposes, taxpayers should note that additional consent from the foreign corporation’s shareholders may be needed before an election can be filed, and relief will only be available on a prospective basis. After an election is made, taxpayers will recognize their share of the partnership’s income each year going forward.

When it comes to prior-year tax returns, the IRS may not consider Form 5471, Information Return of US Persons With Respect to Certain Foreign Corporations, “substantially complete” if taxpayers of CFCs incorrectly reported the foreign dividends-received deduction.

If Form 5471 isn’t considered substantially complete, there could be negative consequences. For example, the statute of limitations for the entire tax return for which Forms 5471 are attached may remain open indefinitely. The three-year statute of limitations doesn’t start until completed Forms 5471 are included with a tax return.

The IRS could also assess potential penalties of $10,000 per incomplete Form 5471 and additional $10,000 penalties if its request to complete the form goes unfulfilled within prescribed time limits.

If past tax returns claiming the foreign dividends-received deduction are inconsistent with IRS guidance, taxpayers and practitioners should evaluate the presence of unreported Subpart F income, the completeness of Forms 5471, and the need for filing amended tax returns.

Moving forward, with the plain language stance of CFC regulations, taxpayers shouldn’t expect a change in current guidance or a foreign dividends-received deduction unless Congress modifies the language of the code.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Robert Malmstadt is senior manager on Plante Moran’s international tax team, focusing on tax compliance, M&A, and planning for private-equity and middle-market businesses.

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