Recipients of Controlled Foreign Corporation Dividends Should Consider California Ramifications

Recipients of dividends from controlled foreign corporations under Internal Revenue Code Section 965 should consider the ramifications of state income tax laws regarding dividend exclusions or deductions as well as taxation of interest income earned on the repatriated cash pending investment pursuant to the Section 965 domestic reinvestment plan. This article provides an overview of the California tax rules.

Internal Revenue Code Section 965 authorizes an 85 percent dividends received deduction for an electing U.S. shareholder with respect to certain cash dividends made by a controlled foreign corporation (CFC) to a U.S. shareholder during a designated one-year period. A CFC is a foreign corporation more than 50 percent of whose stock (by vote or value) is owned (directly or indirectly) by U.S. shareholders who each own (directly or indirectly) 10 percent or more of the CFC.

California Has Not Conformed to Section 965

California has not adopted the provisions of Section 965; however, California law does contain other provisions authorizing dividend exclusions or deductions. Dividends paid from the income of a unitary business between members of a unitary group are eliminated from the income of the recipient. Also, with certain exceptions, dividends received by members of a water’s edge group from a controlled foreign affiliate are eligible for a 75 percent exclusion. Thus, the California dividends received deduction on amounts paid by a controlled foreign affiliate will generally be smaller than the federal deduction allowed pursuant to Section 965 if the U.S. parent has made a water’s edge election. Finally, it is possible that a dividend subject to Section 965 might not qualify under the unitary group rule or the water’s edge group rule, in which case there would be no California exemption.

A prerequisite to obtaining the Section 965 dividends received deduction is that the management of the U.S. shareholder receiving the dividend must adopt a domestic reinvestment plan for the repatriated funds. The domestic reinvestment plan must provide with "reasonable detail and specificity" for application of the divided proceeds to permitted United States expenditures.

The list of acceptable United States activities to which the repatriated funds must be applied includes:

worker hiring and training;

infrastructure and capital investments;

research and development;

financial stabilization of the recipient corporation for the purpose of U.S. job retention or creation;

acquisition of interests in business entities with U.S. assets;

advertising and marketing; and

acquisition of rights to intangible property.

A non-exclusive list of expenditures that do not satisfy the reinvestment requirements of Section 965 includes executive compensation, stock redemptions, and portfolio investments.

California Taxation of Interest Earned on Dividends Pending Reinvestment

The California Franchise Tax Board recently issued Legal Ruling 2005-02 which examines the California implications of a taxpayer that receives a dividend eligible for Section 965 federal relief. Legal Ruling 2005-02 addresses, among other things, the treatment of income earned on the dividend proceeds while such proceeds are awaiting reinvestment in the United States pursuant to terms of the domestic reinvestment plan. Of particular importance to a taxpayer may be the characterization of such earnings as business income or nonbusiness income.

Legal Ruling 2005-02 provides that if the domestic reinvestment "plan specifies that the taxpayer intends to use the repatriated dividends to acquire a business entity in the same line of business as the taxpayer’s unitary trade or business, the earnings on the interim investment of I.R.C. Section 965 dividends will constitute apportionable business income to the unitary trade or business." Conversely, "if the repatriated funds are earmarked for a nonbusiness function, or are earmarked for a line of business separate from the taxpayer’s unitary trade or business, any income earned on those funds would not constitute business income apportionable to the unitary trade or business."

A taxpayer may obtain the federal tax benefits of Section 965 by reinvesting repatriated funds in an activity conducted in the United States. As described above, there are a number of "safe harbor" expenditure activities to which dividends received from a CFC may be applied in order to obtain the benefits of Section 965. A taxpayer may be faced with a situation where its possible future expenditures include some activities that have a non-business function and other activities that have a unitary business function. Where such contemplated expenditures in the aggregate significantly exceed the amount of the dividend, the taxpayer should consider whether it will benefit more by the generation of interest treated as business income or nonbusiness income on repatriated amounts. In such a situation, a taxpayer may be able to identify activities in its domestic reinvestment plan that result in the more favorable type of interest income.

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.