Couple Failed to Show That "Act of State" Doctrine Applied to Foreign Distributions

(Parker Tax Publishing September 2018)

The Tax Court held that a couple was required to include in ordinary income a $12.3 million dividend received from a Hong Kong controlled foreign corporation (CFC) as well as a constructive distribution that resulted from the cancellation of an account receivable owed by the couple's S corporation to a Cypriot CFC. The court also held that the couple failed to show that the "act of state" doctrine applied in their case and thus summary judgment was inappropriate on the question of whether the Cypriot CFC was a qualified foreign corporation and whether a $57.1 million dividend it paid to the couple was qualified dividend income. Smith v. Comm'r, 151 T.C. No. 5 (2018).

Barry and Rochelle Smith owned, through a pair of grantor trusts and an S corporation, controlled foreign corporations (CFCs) incorporated in Hong Kong and later in Cyprus. In 2008, the Hong Kong CFC paid the Smiths a dividend of $12.3 million. In 2009, the Cypriot CFC paid the Smiths a dividend of $57.1 million. In 2009, the Cypriot CFC also canceled an account receivable owed by the Smiths' S corporation. That account receivable had an outstanding balance of $21.1 million when it was canceled.

The Smiths reported the $57.1 million dividend from the Cypriot CFC as qualified dividend income, subject to the reduced rate of tax under Code Sec. 1(h)(1), on the basis that the Cypriot CFC was a qualified foreign corporation. The Smiths did not include the $12.3 million dividend received from the Hong Kong CFC in income for 2008. The Smiths also did not report the cancelation of the $21.1 balance of the account receivable owed by the Smiths' S corporation.

Under Code Sec. 1(h)(11)(C), a qualified foreign corporation is defined to mean a company that is either incorporated in a possession of the United States or is eligible for benefits of a comprehensive income tax treaty with the United States. Dividends from a qualified foreign corporation are subject to a reduced rate of tax.

Upon audit, the IRS determined that the Cypriot CFC was not a qualified foreign corporation under Code Sec. 1(h)(11)(C) and, thus, the $57.1 million dividend the Cypriot CFC paid the Smiths in 2009 was taxable as ordinary dividend income, not as qualified dividend income subject to a reduced rate of tax. The IRS also determined that the dividend paid by the Hong Kong CFC in 2008 was taxable as ordinary dividend income, to the extent of the difference between the amount the Hong Kong CFC had distributed to the Smiths in 2008 and the tax they had previously paid on account of prior Code Sec. 951(a) inclusions in income. Finally, the IRS determined that the cancellation of the account receivable balance owed to the Cypriot CFC was taxable to the Smiths in 2009 as a constructive dividend under Code Secs. 301(c)(1), 316, and 1366.

The case landed before the Tax Court which was asked to decide (1) whether the $12.3 million dividend paid to the Smiths from the Hong Kong CFC was a qualified dividend subject to a reduced rate of tax; (2) whether the $57.1 million dividend paid to the Smiths by the Cypriot CFC was a qualified dividend received from a qualified foreign corporation so as to be subject to a reduced rate of tax; and (3) whether the Smiths received a constructive dividend of $21.1 million in 2009 when the Cypriot CFC canceled the debt owed to it by the Smiths' S corporation.

The IRS and the Smiths agreed that there were no disputed issues of material fact concerning the first and third questions. However, with respect to the second question, the Smiths requested summary judgment as a matter of law based on the theory that the "act of state" doctrine required the court to accept, as dispositive of the Cypriot CFC's status as a bona fide resident of Cyprus, a certification from the Cyprus Ministry of Finance (the Ministry) to that effect.

The Ministry issued four residency certificates for the Cypriot CFC. Each certificate consisted of two sentences and stated that the Cypriot CFC, for 2008, 2009, 2010, and 2011, "is a resident of Cyprus within the meaning of the double taxation convention between the Republic of Cyprus and the United States of America." Each certificate bore a stamp with the name of the certifying official. The Smiths argued that these certificates established that, for treaty purposes, the Cypriot CFC was a resident of Cyprus at all relevant times. Under the act of state doctrine, the Smiths contended, the determination set forth in the certificates is binding on the Tax Court and cannot be disturbed. The IRS argued that the Smiths were not entitled to summary judgment on this point because they had not supplied sufficient evidence to show that the act of state doctrine applied or that management and control of the Cypriot CFC was exercised in Cyprus.

The Tax Court held that the Hong Kong CFC was neither a domestic corporation nor a qualified foreign corporation under Code Sec. 1(h)(11)(C) and thus the 2008 distribution of $12.3 million was taxable to the Smiths at ordinary income rates.

With respect to the distribution from the Cypriot CFC, the Tax Court held that the Smiths had not satisfied their burden of showing that the act of state doctrine applied. To begin with, the court questioned whether the issuance of the residency certificates rose to the level of an "act of state." The court noted that the certificates were issued five days after the application was filed and the application consisted of unsubstantiated representations by a director of the Cypriot CFC who checked "yes" boxes on the application form. Apart from confirming the filing of tax returns - the Cypriot CFC's returns for 2008-2011 were submitted the day before the application, they were at least four years late, and two of them were unsigned - the Tax Court found no evidence that the Ministry verified any of the applicant's factual representations. On the facts, the court said, the issuance of the residency certificates appeared to have been a clerical act analogous to (and arguably less substantive than) the grant of a patent. Thus, the court concluded that the Smiths failed to show that the act of state doctrine applied in their case such that the court was required, at this stage of the case, to accord those certificates dispositive effect.

Finally, as a result of the cancellation of the account receivable due to the Cypriot CFC by the Smiths' S corporation, the court held that the Smiths received from the Cypriot CFC in 2009 a constructive distribution of $21.1 million that was taxable to them as a dividend under Code Sec. 301(c)(1) and Code Sec. 316(a).

For a discussion of the preferential tax treatment of qualified dividends, including dividends from a qualified foreign corporation, see Parker Tax ¶71,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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