Osvaldo & Ana M. Rodriguez, Petitioner

137 T. C. No. 14 UNITED STATES TAX COURT OSVALDO AND ANA M. RODRIGUEZ, Petitioners v. COMMISSIONER OF IN'fERNAL REVENUE, Respondent Docket No. 13909-08.

Filed December 7, 2011.

Ps, citizens of Mexico and permanent residents of the United States, were the sole shareholders of E, a controlled foreign corporation. Pursuant 951 (a) (1) (B) and 956, gross income amotints of E' s earnings that were invested in U.S. property. (cid:16)042 Ps characterized these inclusions as qualified dividend income subject income tax rates under sec . recharacterized these amounts as ordinary income subject to nonpreferentihl to preferential I . R . C.

they inc luded in their income tax rates.

1 (h) (11) , to secs.

I . R . C .

R , Held:

Inclusions in gross income as required under secs. 951(a) (1) (B) and 956, constitute qualified dividend income under sec. 1(h) (11) , I.R..C., do not I . R. C.

Patrick R. Gordon and Juan H. Gil II, for petitioners.

Robe rt a L . Shumway, f or re s pondent .

$$$ED DEC -7200

OPINION

THORNTON, Judge: Respondent determined deficiencies of $316,950 and $295,530 in petitioners' Federal income taxes for taxable years 2003 and 2004, respectively.

The issue for decision is whether amounts included in petitioners' gross income pursuant to sections 951(a) (1) (B) and 9561 with respect to their controlled foreign corporation's investmënts in U.S. property (for brevity, section 951 inclusions) copstitute qualified dividend income under section 1(h) (11).

ackground The parties submitted this case fully stipulated pursuant to Rule 122. When they petitioned the Court, petitioners resided in Texas.

At all relevant times petitioners were citizens of Mexico and permanent residents of the United States.

Together they owned 100 percent of the stòck of Edito a Paso del Norte, S.A. de C.V.

(Editora).2 Editora had been incorporated in 1976 under the laws of Mexico.

In 2001 it had established operations in the United States as a branch uòder the namd Editora Paso del Norte, S.A. de C.V., Inc.

1All section references are to the Internal Revenue Code (Code) are to the Tax Court.Rules of Practice and Procedure.

in effect for the yeÈrs in issue, and all Rule references 2Petitioner husband owÈed 90 percenh of Editora's stock, and petitioner wife owned the other 10 percent.

Originally, Editora's primary business was publishing newspapers and selling.newspaper advertising in Mexico.. By the end of 2002 Editora had con ert.ed its primary business to developing, constructing, managing, and leasing commercial real estate and printing presses in Mexico and the United States.

Editora also derived interest income from loans and royalty income from licensing intellectual property. During the years at issue Editora held significant investments of real and tangible personal property in the United 3States.

On their. amended 2003 and original 2004 Federal income tax returns, which they filed October 15, 2005, petitioners included in gross income $1,585,527 and $1/478,202, respectively, representing amounts of Editora's earnings invested in U.S.

property and taxable directly.to petitioners pursuant to sections 951(a) (1) (B) and 956. Petitioners treated the section 951 inclusions as qualified divi end income subject to preferential income tax rates under sectiòn 1(h) (11) (B).

In the notice of deficiency respondent determined that the section 951 inclusions are taxable at ordinary income tax rates.

Discussion As enacted in the Jobs 2.nd Growth Tax Relief Reconciliation Act of 2003, Pub. L. 108-27, sec.

j302, 117 Stat. 760, section 1(h) (11) provides preferential tax rates for "qualified dividend income". Qualified dividend income includes dividends received -'4 - from a qualified foreign corporation.

Sec. 1(h) (11) (B) (i) (II).

The parties agree that duri&g the years t issue Editora was a qualified foreign corporation within the meaning of the statute.

Section 951, enacted by the Revenue Act of 1962, Pub. L. 87- 834, sec. 12(a), 76 Stat. 10)06 (the 1962 legislation), is part of subpart F of part III, subchapter N, chapter 1 of the Code.

Through subpart F '(sections 951 through 964), Congress sought to limit tax deferrals by any foreign corporation that meets the definition of a "controlled foreign corporation" (CFC), as provided in section 957(a). Elec. Arts, Inc. v. Commissioner, 118 T.C. 226, 272 (2002). Under section 951, subject to various restrictions and qualificat ons, U.S. shåreholders of a CFC are taxed directly on the CFC's yearnings that are invested in certain types of assets in the United States.³ Secs. 951(a) (1) (B), 956(a).

The parties agree that during the years at issue Editora was a controlled foreign co poration as defined in section 957(a) 3More specifically, the sec. 951 inclusion represents the (b) the lesshr of the average amounts of the end of each quarter of the CFC's earnings invested The sec. 951 inclusion is the U.S.

U.S. shareholder's pro rata share of in U.S. property holdings. shareholder's pro rata sharé of The excess of (a) U.S. property as of over sec. 951 inclusions; or earnings", as defined in sec. 956(b) (1), the CFC's current and accum lated earnings and profits that have not already been included iÊ its U.S. shareholders' gross incomes. Estates and Gifts, par. 69.11.1, at 69-72 through 69-74 (rev. 3d ed. 2005).

the CFC's earnings and profits representing previous the amount of See Bittker & Lokken, Federal Taxation of the CFC's "applicable representing essentially the CFC's investments in the taxable year two amounts:

Income, (1) (2) and that petitioners were U.!S. shareholders with respect to Editora.

They also agree as to the amounts of petitioners' section 951. inclusions.

They disagree as to whether the section 951 inclusions constitute qualified dividend income.

The answer turns on whether a section 951 inclusion is properly characterized as a dividend.

Section 316(a) defines "dividend" for purposes of subtitle A of the Code (which includes section 1) to mean "any distribution of property made by a corpor tion to its shareholders" out of the corporation's current or accµmulated earnings and profits.

A dividend may be formally declared or it may be constructive, involving the shareholder's informal receipt of corporate property.

See Boulware v. United States, 552 U.S. 421, 429-430 (2008); Truesdell v. Comm1ssloner, 89 T.C. 1280, 1295 (1987).

But in either event there. must be, in the first instance, a "distribution" by the corporation.

See Boulware v. United States, supra at 437 n.12.

A "distribution" entails a "change in the form of * * * ownership" of corporate prop rty, "separating what a shareholder owns gua shareholder from what he owns as an individual."

Commissioner v. Gordon, 391 U.S. 83, 90 n.⁵ (1968).

As the Supreme Court noted:

Any common shareho der in some sense "owns" a fraction of holds stock, accumulated corporate e rnings. Earnings are not including hose assets that reflect the assets df ·the corporation in which he taxed instead when they are passed to shareholders to the shareholder when: they accrue to the corporation, but individually through dividends. not whether a shareholder ends up with "more" but whether the change in the form of his ownership represents a transfer tÊ him, by thÊ corporation, of assets reflecting its abcumulated earnings and profits. [Id.]

The question is * * * A section 951 inclusion involves no change in ownership of corporate property.

It aris%s not from any distribution of property by a CFC but from its investment in "United States property held (directly or indirectly) by the controlled foreign corporation".

Sec. 956(a) (l() (A).

Because there is no distribution, there is no dividend within the meaning of section 316(a), unless some special rule or qualification applies.

The Code and the regulations cogtain no specfal rule or qualification to treat a section 951 inclusion as a dividend for purposes of section 1(h) (11).

In limited instances--not involving|characterization as qualified dividend income under section 1(h) (11)--in which Congress has intended section 951 inclusions to be treated as dividends, it has made express provlslony See, e.g., sec. 851(b) (providing that for purposes of the qualification rules for regulated investment companles, section 951 inclusions are "treated as dividends" to the extent that under section 959(a) (1) there is a distribution out of earnings and profits of the taxable year which ar"e attributable to the amounts so included); sec. 904 (d) (3) (G) (providing that for p rposes of applying limitation rules with respect to foreign tax credits, the term "dividend" includes amounts included in income pursuant to section.951(a) (1) (B)); sec. 960(a) (1) (providing that for purposes of rules applicable to indirect foreign tax·credits under section 902, section 951 inclusions shall be treated "as if the amount so included were dividend paid").

To disregard this careful legislative design a2d treat section 951 inclusions as dividends in the absence of express provision would tend to .

render these provisions superfluous or unnecessary, contrary to .well-established tenets of s atutory construction.

See, e.g., Weinberger v. Hynson,.Westcott &.Dunning, Inc., 412 U.S. 609, 633-634 (1973).

This consideration reinforces our conclusion that section.951 inclusions are not torbe _treated as dividends absent express provision in the Code or the regulations.

Unlike section 951, various other Code sections expressly characterize certain types o items as distributions or dividends.

See, e.g., sec. S4A(g) (as,enacted in 2008, providing that allocation to S corporation·shareholders of a tax credit.

with respect to certain bonda "shall be treated as a distribution"); secs. 302(a) 304(a), 305(c) (all providing identically that certain redemptions "shall be treated as a .

distribution"); sec. 551(b) 'providing that certaïn undistributed foreign personal holding company income is inc.luded.in the shareholder's gross income "fas a dividend").4 Of particular note, the same 1962 legislation that enacted section 951, which does not provide for dividend treatment, also enacted section 1248, which provides that in certain circumstances gain from disposition of CFC stock "shall be included in the gross income of such person as a dividenä, to the ext nt of the earnings and profits of the foreign·corpóration".

SeÖ. 1248(a).

The absence, in the same legislation, of "any corresponding provision for section 951 inclusions seems purposeful. Consistent with this legislative scheme, the regulations carefully distinguish "deemed dividends" under sections 551 and 1248 from "deemed inclusions" under section 951(a).

Sec. )1.902-1(a) (1 ), Income Tax Regs.

(providing that for purposeÊ of the deem d paid foreign tax credit under section 902, the term "dividends" does not include deemed inclusions under section 951(a)).

In support of their position that section 951 inclusions should be characterized as dividends, petitioners cite this statement from a Senate rep rt that acco panied the 1962 legislation that enacted su part F:

"Generally, earnings brought back to the United States are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them." ! S. Reþt. 1881, 87th Cong., 2d Sess.

(1962), 'Sec. 551 was repealed by the American Jobs Creation Act of 2004 (AJCA 2004), Pub. L. 108-357, sec. 413(a) (1), 118 Stat. 1506.

1962-3 C.B..707, 794. This Court has sometimes cited this legislative history as evidencing the general purpose of the 1962 legislation.

For instance, in Limited, Inc. & Consol. Subs. v.

Commissioner, 113 T.C. 169, 185 (1999), revd. 286 F.3d 324 (6th Cir. 2002), this Court obser ed that a "dividend equivalency" rationale underlies the 1962 legislation.

And in Gulf Oil Corp.

v. Commissioner, 87 T.C. 548, 571 (1986), affd.

in part, revd.

in part and remanded 914 F.2d 396 (3d Cir. 1990), this Court observed that under the 1962 legislation "Subpart F treats the amount of the increased inve$tment much like a constructive dividend to the U.S. shareholders."5 But to say that section 951 sIn Gulf Oil Corp. v. Commissioner, 87 T.C. 548 (1986),.this its In an resulting in deemed inclusions in U.S. property within the meaning of resulting in di%idend income to petitioner".

increases in intercompany payables on the books Id. at And jthe headnote to Gulf Oil states that Court held that of a U.S. corporate shareholder represented earnings of foreign controlled subsidiaries, in the U.S. shareholder's income under secs. 951 and 956. introductory paragraph the OÒinion framed.the issue as being whether the uncollected balances ln the payables account "constitute investment section 956, 550 (fn. ref. omitted). the increases to the payable balances "represent earnings of a controlled foreign corporati n invested in U.S. property at close of 549. address whether the. deemed i clusions under secs. 951 and 956 should be considered to constitute dividend income, nor was any such conclusion essential Commissioner's determination that recognize deemed inclusions under secs. 951 and 956. 563. Notably, however, "complete and indefinite control over" subsidiaries' earnings that w re reflected in the payables on the taxpayer's own books, Court viewed these earnings as constituting constructive the taxable year 1974 and dividend income to P."

the Opinion, however, does not expressly id. at 574, possibly suggesting that See id. at the taxpayer had to the decision upholding the the taxpayer was required to the C urt observed that its foreign controlled the Id. at The body of the (continued...)

treats a CFC's investments in U.S. prope$ty "much like" a constructive dividend is a far cry from saying that such amounts actually constitute dividendb.

In fact, the statutory structure and operating rules in the Cpde, particu arly as they have evolved over time, stfongly suggest that these amounts do not constitute dividends under t e Code.

The formula for determi ing a CFC's investment of earnings in U.S. property, for purposes of a section 951 inclusion, is found in section 956(a).

As originally enacted in 1962, section 956(a) (1) provided that the section 951 inclusion was to be made by reference to the amount of U.S. property that the CFC held at the end of the taxable year to the extenÊ this amount "would have constituted a dividend * * * if it had been distributed."

The clear import of this language is that because this amount has not been distributed, it does ndt in fact co stitute a dividend.

In 1993 Congress eliminated the just-quoted provision ("would have constituted a dividend" etc.) as part of an amendment modifying the ope ation of sec ion 956. Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66, sec. 13232(a) (1) and (2), 107 Stat. 501 (the 1993 legislation).

The legislative 5(...continued) dividends for reasons apart 956. In any event, Gulf Oil was decided under the pre-1993 version of sec. 956(a), which, as discussed infra, differed materially from the versionjof sec. 956( years at issue. as establishing any rule for determining the issue before us.

·In these circumstances we do not view Gulf Oil from the operation of secs. 951 and in effect for the ) history indicates that the purpose of this 1993 amendment was to conform the operating rules for section 956 to the operating rules in new section 956A, enacted by the same legislation.

Subject to certain qualifications, section 956A required U.S.

shareholders to-include in income a pro rata share of a CFC's earnings invested in "excess passive assets", defined generally as assets that the CFC holds for the production of passive income.

See H. Rept. 103-111, at 691-695 (1993), 1993-3 C.B.

167, 267-271.

The legislative history indicates that the purpose of section 956A was to curb CFCs' deferrals of U.S.

taxation.'

The 1993 legislation conformëd the sec. 956(a) operating rules to section 956A because the pro isions are "in some ways, conceptually parallel".

Id. at 692, 1993-3 C.B.. at 268.

There is no mention in the 1993 legislative history of any dividend equivalency rationale with respect to either amended section 956(a) or new section 956A.

The stated reason for e acting sec. 956A was to "impose on controlled foreign corporatigns a new type of tax on accumulating deferred earnings" because "deferral of U.S. accumulated active business profits is not necessary to maintain the competitiveness of busin ss activities conducted by controlled foreign corporations where such accumulated profits are held in the form of excessive accumulations of passive assets." 267-268.

H. Rept. 103-111, at 691-692 (1993), 1993-3 C.B. 167, limitation on 7Sec. 956A was repealed n 1996, leaving intact the revised structure and operating rules of sec. 956(a) as in effect for the years at issue.

Further evidencing the Gistinction b tween dividends and section 951 inclusions, the Code subjects them to different operating rules.

For instance, whereas dividend distributions reduce the earnings and profits of the distributing corporation, see sec. 316(a), section 951 inclusions do not--the undistributed earnings remain with the CFC, see sec. 956(a) (2), I!

(b) (1); sec.

1.952-1(c) (1), Income Tax Regs.⁸ As another example, whereas a dividend results in no increáse to the shareholder's stock basis, a section 951 inclusion does.⁸ Sec. 961(a); sec. 1.961-1, Income Tax Regs.

In the light of these various considerations, the sentence in question from the 1962 legislative history does not control the issue of whether section 951 inclusions should be characterized as dividends for purposes of section 1(h) (11).

The Code gives no hint that a section 951 inclusion, which as we have seen does not represent a "Êistribution" should be treated as a "dividend" within the meaning of section 1(h) (11).

8When the CFC eventually distributes the amounts previously included in the U.S. shareholder's gross income pursuant to sec. 951, the distribution" then reduces the CFC's earnings and profits. shareholder, shareholder's gross income.

the actual dis ribution is Èxcluded from the To avoid double taxation to the See sec. 959(d).

See sec. 959(a).

9This increase in the U.S. shareholder's stock basis is counteracted if and when th¼ CFC eventuÓlly distributes to the shareholder the amounts repkesented by the sec. 951 inclusions. See sec. 961(b) (1); sec. 1.961-2, Income Tax Regs.

According to its legislative history, section 1(h) (11) was intended in part to remove à perceived disincentive for corporations to pay out earnings as dividends instead of retaining and reinvesting them." Because income inclusions under section 951(a) (1) (B) epresent earnings that CFCs have retained and reinvested in U.S. property instead of paying them out as dividends, characterizing these amounts as qualified dividend income would not appear to..further the stated legislative purpose.

Further evidencing an absence of legislative purpose to treat section 951 inclusions as qualified dividend income, certain technical rules of section 1(h) (11) are a poor fit for section 951 inclusions.

For instance, section 1(h) (11) (B) (iii), in coordination with section 246(c), imposes upon the taxpayer a holding period requirement with respect to the stock on which The legislative history states in part:

law, by the Commit ee finds that present If dividend are discouraged, shareholders In addition, taxing dividend income at a higher rate than income from capital gains, encourages corporations to retain earnings rather than to distribute them as taxable dividends. may prefer that corpora e management retain and reinvest earnings rather than pay out dividends, even if the shareholder migh the funds that could offer a higher rate of return than that earned on the reta ned earnings. source of higher pre-tax returns Is bypassed in favor of pre-tax returns. 3 C.B. 35, 65.]

inefficiency s the opportunity to earn [H. Rept. 108-94, at 31 (2003), 2003- have an alternative use for This is another lower dividends are paid.

This holding periodiis based on the shareholder's ex-dividend date.

See sec. 246(c) (1).

Because a section 951 inclusion 'implicates no declaration or payment of a dividend, there is no ex-dividend date bÿ which to measure the holding period.

As enacted in 2003, section 1(h) (11) (C) expressly excluded from the definition of "qualified foreign corporation" foreign personal holding companies (as defined iç former section 552(a)) (FPHCs), foreign investment companies (as defined in former section 1246(b)) (FICs), and passive foreign investment companies (as defined in section 1297(a)) (PFICs).

Petitioners suggest that because section 1(h) (11) does not similarly exclude section 9.51 inclusions, it must treat them as qualified dividend income.

This reasoning is fallacious.

That the statute excludes certain types of corporations (not including Editora) from the definition of qualified foreign corporation has little bearing on the question of whether section 951 inclusiohs relating to a corporation (such as Editor ) that is a ualified foreign corporation should be chara terized as qualified dividend income.

In Notice 2004-70, 2004-2 C.B. 724, 726, the Internal Revenue Service (IRS). provided guidance that section 951 "Secs, 552 and 1246 weke repealed s part of AJCA 2004 sec. it also 413(a). When Congress repealed the FPHC regime in 2004, amended sec. 1(h) (11) (C) (iii) by elimindting the reference to FPHCs and FICs.

See AJCA 2004 sec. 413(c) (1) (B), 118 stat. 1507.

inclusions do not constitute.qualified dividend income under section 1(h) (11)." For the reasons previously discussed, we agree with this conclusion.

Petitioners argue that section 951 inclusions should be treated as dividends becausè the 2004.instructions to Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, indicate that individual CFC shareholders should report section 951 inclusions as ordinary dividend income.

On brief respondent acknowl dges that the 2004 instructions are "ambiguous", pointing out that the 2004 instructions also instruct corporate taxpayers to report section 951 inclusions not as dividends but as "other income"." But whatever ambiguity or inaccuracy might be found in the 2004 instructions, it cannot affect the operation of the tax statutes or petitioners' obligations thereunder.

.See Weiss v. Commissioner, 129 T.C. 175, 177 (2007).

"It is settled law that taxpayers cannot rely on Internal Revenue Service instructions to justify a reporting "In its postenactment general explanation of sec. 1(h) (11), the Joint Committee on Taxation cited Notice 2004-70, 2004-2 C.B. 724, with apparent approval. Staff of Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress, at 25 n.⁴⁴ (J. Comm. Print 2005).

the Joint Comm. on Respondent asserts that when the 2004 instructions were drafted, before passage of t e Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. 108-27, sec. 302, 117 Stat. 760, the distinction between dividend income and other ordinary income was of little import, all of it being taxed at the same rate.

position otherwise inconsistent with con rolling statutory provisions . " Montgomery v . Commis sioner , 127 T . C. 43, 65 (2006) ; see .Johnson v. Commissioner, 620 F.2d 153, 155 (7th Cir. 1980), affg. T.C. Memo. 1978-426. Moreover, as respondent notes, the IRS provided detailed guidanpe about this issue in Notice 2004- 70, supra, published about a year before petitioners filed their amended 2003 and original 2004 returns .

We conclude and hold that petitione s are not entitled to treat their section 9(cid:0)540linclusions as qualif ied dividend income under section 1(h) (11) (B) .

Decision will be entered for espondent.