Controlled foreign corporations (CFCs) in Hong Kong and Cyprus paid actual and constructive dividends to the taxpayers who indirectly owned them. The distributions from the Hong Kong CFC also did not qualify for lower tax rates as qualified dividend income.
However, the court could not determine the character of the Cypriot CFC’s distributions because its residency was in dispute. Finally, the Cypriot CFC made a constructive distribution to the taxpayers when it cancelled a debt that their S corporation owed.
Qualified versus Ordinary Dividend Income
The taxpayer’s distributions from their Hong Kong CFC were taxed as ordinary income tax because the distributions were not qualified dividend income. Qualified dividend income must come from:
- a domestic corporation, or
- a qualified foreign corporation.
Since a Hong Kong corporation made the distributions, they did not come from a domestic corporation. Moreover, the corporation was not a qualified foreign corporation because the United States did not have an income tax treaty with Hong Kong. Further, the taxpayers’ election to be taxed as a corporation on their subpart F inclusions did not make them a notional domestic C corporation.
Residency of Cypriot CFC
In contrast, it was not clear if the Cypriot CFC’s distributions were qualified dividend income. The taxpayers argued that the CFC was a qualified foreign corporation because it was eligible for benefits under a United States tax treaty with Cyprus. They also claimed that certificates of residency from the Cyprus Ministry of Finance established residency under the act of state doctrine. However, the existence of the treat made that doctrine inapplicable. Moreover, even if the doctrine applied, the issuance of residence certificates was not an act of state. Thus, the court would have to determine the CFC’s residency under the treaty.
Finally, the Cypriot CFC’s cancellation of a debt owed by the taxpayers’ S corporation was a constructive distribution. Thus, it was taxable as a dividend paid to the taxpayers. Inclusions under Code Sec. 956 for the CFC’s investment in U.S. property in earlier years did not result in double taxation. The inclusion and the debt cancellation were separate taxable events. The constructive dividend was attributable to accumulated E&P that had not previously been included in income.