Taxation of Undistributed Income of a Controlled Foreign Corporation

August 25, 2013

In a case recently decided by the Fifth Circuit U.S. Court of Appeals, permanent U.S. residents were subject to U.S. federal individual income taxation at ordinary income tax rates on undistributed income of a controlled foreign corporation.  In Rodriguez vs. Commissioner, the U.S. taxpayers were a husband and wife who owned a Mexican corporation.  Although not fully explained in the case opinion, the Mexican corporation had earnings invested in U.S. property.  This caused the U.S. shareholders to be subject to U.S. taxation on undistributed earnings of the foreign corporation.  The U.S. shareholders took the position on their U.S. federal tax return that the undistributed income from the foreign corporation should be subject to U.S. federal taxation at the lower 15% qualified dividend tax rate.  The Fifth Circuit affirmed the decision of the U.S. Tax Court and it held that the income was neither an actual nor a deemed dividend.

Such undistributed income is known as a “Section 951 inclusion,” based on the applicable provision of the U.S. Internal Revenue Code.  Section 951 is what is known as an “anti-deferral” provision.  This means that a U.S. shareholder of a controlled foreign corporation (‘CFC”) is limited in being able to defer U.S. federal taxation on income of the CFC until a dividend distribution is actually repatriated.  A foreign corporation is a controlled foreign corporation if more than 50% of the vote or value is owned by U.S. shareholders who each own at least 10% of the voting stock.  The U.S. anti-deferral regime causes a U.S. shareholder who owns at least 10% of a CFC to be subject to U.S. taxation on certain undistributed income of the CFC, even though the earnings are not actually distributed in the form of a dividend distribution.

With the proper U.S. international tax planning, the advantage of deferral can be preserved so that a U.S. shareholder of a CFC is not subject to current U.S. federal taxation on undistributed income of a CFC.

For more information, please contact our international tax advisor at 301.231.6200.