Former Couple Seeks Partial Summary Judgment Regarding Dividend Income

BARRY M. SMITH and ROCHELLE SMITH,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

Judge Lauber

PETITIONERS' CROSS-MOTION FOR PARTIAL SUMMARY 
JUDGMENT AND INCORPORATED MEMORANDUM OF LAW

Petitioners, Barry M. Smith and Rochelle Smith, pursuant to Tax Court Rule 121, cross move for partial summary judgment concerning the following issues which are in dispute: (1) whether distributions of earnings and profits that Hopper Radio of Florida, Inc. ("Hopper US"), an S corporation under I.R.C. § 1361, received in 2008, in the amount of $12,307,591 were qualified dividends to Petitioners for U.S. tax purposes, and (2) whether Hopper US received a constructive dividend in the amount of $21,055,123 in 2009. In support of this Motion, Petitioners states as follows:

I. INTRODUCTION

Petitioners have brought this action to challenge Respondent's determination that Petitioners are liable for income tax deficiencies in the amount of $6,308,329 for the year ending December 31, 2008, and $18,743,201 for the year ending December 21, 2009.

A significant portion of the deficiency for 2008 is attributable to Respondent's position that distributions of earnings and profits made to Petitioners during 2008 were not qualified dividends for U.S. federal income tax purposes. In taking this position, Respondent ignores the basic purpose and intent behind Section 962, and argues that these were distributions from a Hong Kong company and should have been taxed at ordinary income tax rates. It is clear, however, based on controlling legal precedent and legislative history, that when Petitioners made an election under Section 962 for the 2004 and 2005 tax years, the earnings and profits of Memcorp HK that were includible in Petitioners' income during those years under Section 951(a) moved up to a deemed U.S. C corporation that is created by the Section 962 election. When those earnings and profits subsequently were distributed to Petitioners during 2008, pursuant to Section 962(d) any resulting dividend was attributable to this U.S. C corporation, and as such those dividends were taxable at qualified dividend rates under Section 1(h)(11). This is the only outcome that is consistent with the Congressional intent underlying Section 962.

Similarly, a significant portion of the 2009 deficiency relates to Respondent's position that certain intercompany balances between Memcorp US and Memcorp HK that were written off during 2009 should be treated as constructive distributions to Petitioners. Respondent bases this position on case law that deals purely with the domestic context and that should not be applied in a cross-border context such as the case of Petitioners. Any U.S. tax imposed on the relevant intercompany balances should have been imposed pursuant to Section 956 during the years the balances were created. Allowing Respondent to argue for inclusion now under this domestic common law reasoning would permit Respondent to improperly circumvent the statute of limitations provided by Section 6501(a).

As a matter of law, therefore, Petitioners are entitled to partial summary judgment concerning these issues.

II.  STATEMENT OF UNDISPUTED FACTS

In support of this Motion, Petitioners rely upon the facts set forth in the First Stipulation of Facts executed by both parties, which was forwarded to the Court for filing on June 3, 2016. A copy of the First Stipulation of Facts is attached hereto as Exhibit "A," and is cited in this Statement of Undisputed Facts as "Stip." followed by the corresponding paragraph number.

Petitioners

Petitioners Barry M. Smith and Rochelle Smith ("Petitioners") were married at all times during the tax years ending December 31, 2008, and December 31, 2009. (Stip., ¶ 4). Petitioners jointly filed a U.S. Individual Income Tax Return, Form 1040, for each of the tax years ending December 31, 2008, and December 31, 2009. (Stip., ¶ 5).

Hopper Radio of Florida, Inc.

Hopper Radio of Florida, Inc. ("Hopper US") was a Florida corporation since its incorporation on October 8, 1980. (Stip., ¶ 8). Hopper US made an election to be taxed as an S corporation, with an effective date of November 1, 1983. (Stip., ¶ 9). Since November 1, 1983, and during 2008 and 2009, Hopper US was taxed as an S corporation under Subchapter S of the Internal Revenue Code. (Stip., ¶ 10). On February 17, 2011, Hopper US was voluntarily dissolved. (Stip., ¶ 21).

On April 22, 2005, Petitioner Barry M. Smith established the Smith Irrevocable Trust, which constituted a grantor trust. As a result, for the tax years ending December 31, 2008, and December 31, 2009, Barry M. Smith was treated as the owner of the Smith Irrevocable Trust under Sections 671 through 679. (Stip., ¶ 11).

Since May 31, 2005, 98.35 percent of Hopper US was legally owned (not for U.S. Federal income tax purposes) by Petitioner Rochelle Smith, Jason H. Smith and Sean Smith, as co-trustees under the Smith Irrevocable Trust Agreement dated April 22, 2005. (Stip., ¶ 12). Since 2005, and for the tax years ending December 31, 2008, and December 31, 2009, Barry M. Smith was subject to U.S. Federal income tax on the income of the Smith Irrevocable Trust. (Stip., ¶ 14).

On November 8, 2001, Barry M. Smith established the Barry M. Smith Revocable Trust, which constituted a grantor trust. As a result, since November 8, 2001, and for the tax years ending December 31, 2008, and December 31, 2009, Barry M. Smith was treated as the owner of the Barry M. Smith Revocable Trust under Sections 671 through 679. (Stip., ¶ 15).

For the tax years ending December 31, 2008 and December 31, 2009, 1.65 percent of Hopper US was owned (for U.S. Federal income tax purposes) by Barry M. Smith, as trustee under the Barry M. Smith Revocable Trust Agreement dated November 8, 2001. (Stip., ¶ 16). Since 2001, and for the tax years ending December 31, 2008, and December 31, 2009, Barry M. Smith was subject to U.S. Federal income tax on the income of the Barry M. Smith Revocable Trust. (Stip., ¶ 18).

Hopper US filed an Income Tax Return for an S Corporation, Form 1120S, for each of the tax years ending December 31, 2008, and December 31, 2009. (Stip., ¶¶ 19-20).

For U.S. Federal income tax purposes, Barry M. Smith was treated as the sole owner of Hopper US from the date of its formation through the date of its dissolution, including the tax years ending December 31, 2008, and December 31, 2009. (Stip., ¶ 22).

Memcorp, Inc.

Memcorp, Inc. ("Memcorp US") was a Florida corporation since its incorporation on September 26, 1994. (Stip., ¶ 23). Since October 13, 1994, and during the tax years ending December 31, 2008, and December 31, 2009, Hopper US owned 100 percent of the stock of Memcorp US. (Stip., ¶ 24).

Memcorp US was a qualified subchapter S subsidiary during the tax years ending December 31, 2008, and December 31, 2009, and, thus, was a disregarded entity of Hopper US. (Stip., ¶ 25).

Barry M. Smith, who was treated as the sole shareholder of Hopper US for U.S. Federal income tax purposes, was required to take into account his pro rata share (i.e., 100 percent) of Hopper US's income, including the income received by Memcorp US, as if he directly recognized that income. See I.R.C. §§ 1361(a) and (b).

Memcorp Asia Limited

Memcorp Asia Limited ("Memcorp HK") was a corporation organized under the laws of Hong Kong since its date of incorporation on January 1, 1995, and during the 2008 and 2009 tax years. (Stip., ¶ 26).

Until November 18, 2008, Memcorp US, as a disregarded entity of Hopper US, owned 100 percent of the stock of Memcorp HK. (Stip., ¶¶ 27 and 28). Hopper US was, therefore, regarded as the sole shareholder of the stock of Memcorp HK for U.S. Federal income tax purposes.

Hopper US was treated as a partnership for purposes of subpart F under Section 1373(a)(1). As a domestic partnership for subpart F purposes, Hopper US was a "United States person" under Section 957(c), and a "United States shareholder" of Memcorp HK under Section 951(b). Memcorp HK was a controlled foreign corporation ("CFC") under Section 957(a) from the date of its incorporation in 1995 until November 18, 2008, because it was wholly owned by Hopper US. (Stip., ¶ 30).

As the United States shareholder that owned (within the meaning of Section 958(a)) all of the stock of Memcorp HK on the last day of Memcorp HK's tax year in which it was a CFC, Hopper US was required to include in gross income its pro rata share of any subpart F income under Section 951(a)(1)(A), and its share of any U.S. property held by Memcorp HK under Sections 951(a)(1) and 956. (Stip., ¶ 31).

Barry M. Smith was treated as a partner of Hopper US for purposes of subpart F under Section 1373(a)(2), and was required under Sections 702 and 951(a) to include in income his distributive share (100 percent) of amounts that Hopper US included in income under Sections 951(a)(1)(A) and (B) with respect to Memcorp HK. (Stip., ¶ 32).

Respondent audited Petitioners' U.S. Individual Income Tax Return, Form 1040, for the tax year ending December 31, 2004 ("the 2004 audit"). (Stip., ¶ 39).

As a result of the 2004 audit, Petitioners agreed to include $15,765,803 m gross income under Sections 951(a)(1)(B) and 956 ("2004 Section 956 inclusion") with respect to Memcorp HK. (Stip., ¶ 40).

The 2004 section 956 inclusion of $15,765,803 for the tax year ending December 31, 2004 ("2004 tax year") arose from an account receivable that Hopper US owed to Memcorp HK (United States property within the meaning of Section 956(c)). (Stip., ¶ 41). As a result of the 2004 audit, Petitioners filed an Amended U.S. Individual Income Tax Return, Form 1040X, for their tax year ending December 31, 2004. (Stip., ¶ 42).

For their 2004 tax year, Petitioners made an election pursuant to Section 962 ("Section 962 election") with respect to the 2004 Section 956 inclusion with the filing of their Amended U.S. Individual Income Tax Return, Form 1040X. As a result of the Section 962 election, under Section 962(a), the tax imposed on the 2004 section 956 inclusion of $15,765,803 was equal to the tax which would have been imposed under Sections 11 and 55 if the amount had been received by a domestic corporation, and the 2004 Section 956 inclusion was treated as if received by a domestic corporation for purposes of applying Section 960. Petitioners were, therefore, subject to U.S. Federal income tax at corporate rates on the 2004 Section 956 inclusion of $15,765,803, and entitled to a deemed-paid foreign tax credit under Sections 902 and 960 for foreign taxes paid by Memcorp HK with respect to the Section 956 inclusion. (Stip., ¶ 44).

Respondent accepted Petitioners' Section 962 election for 2004. (Stip., ¶ 46).

As a result, Petitioners paid $5,518,031 of tax on the 2004 Section 956 inclusion of $15,765,803. (Stip., ¶ 45).

Petitioners' 2005 Tax Year

Respondent audited Petitioners' U.S. Individual Income Tax Return, Form 1040, for the tax year ending December 31, 2005 ("2005 audit"). (Stip., ¶ 47).

As a result of the 2005 audit, Petitioners agreed to include $2,612,877 in gross income under Sections 702, 951(a)(1) (B) and 956 ("2005 section 956 inclusion"). (Stip., ¶ 48). The 2005 Section 956 inclusion of $2,612,877 for the tax year ending December 31, 2005 ("2005 tax year") arose from the account receivable that Hopper US owed to Memcorp HK (United States property within the meaning of Section 956(c)). (Stip., ¶ 49).

For their 2005 tax year, Petitioners made a Section 962 election with respect to the 2005 section 956 inclusion, and under Section 962(a) the tax imposed on the 2005 Section 956 inclusion of $2,612,877 was equal to the tax which would have been imposed under Sections 11 and 55 if the amount had been received by a domestic corporation. The 2005 Section 956 inclusion was treated as if received by a domestic corporation for purposes of applying Section 960. Petitioners were, therefore, subject to U.S. Federal income tax at corporate rates on the 2005 Section 956 inclusion of $2,612,877 in 2005, and were entitled to a deemed-paid foreign tax credit of $556,076 under Sections 902 and 960 for foreign taxes paid by Memcorp HK with respect to the 2005 Section 956 inclusion. Accordingly, Petitioners paid $553,058 of tax on the 2005 Section 956 inclusion of $2,612,877. (Stip., ¶ 50).

The 2008 Distributions

During 2008, prior to November 18, 2008, Hopper US received two distributions, totaling $18,378,680, of earnings and profits attributable to the 2004 and 2005 Section 956 inclusions (i.e., $15,765,803 on April 30, 2008 and $2,612,877 on August 14, 2008). (Stip., ¶ 53).

As a result of Petitioners' 2004 Section 962 election, Petitioners for their 2008 tax year can exclude from gross income $5,518,031 of the distribution of earnings and profits attributable to the 2004 Section 956 inclusion that Hopper US included for the 2004 tax year. Thus, under Section 962(d), with respect to the distribution of the earnings and profits attributable to the 2004 Section 956 inclusion ($15,765,803), Petitioners must include $10,242,772 in gross income in their 2008 tax year. (Stip., ¶ 54).

As a result of Petitioners' 2005 Section 962 election, pursuant to Section 962(d), Petitioners for their 2008 tax year can exclude from gross income $553,058 of the distribution of earnings and profits attributable to the 2005 Section 956 inclusion that Hopper US included for the 2005 tax year. Thus, under Section 962(d), with respect to the distribution of the earnings and profits attributable to the 2005 Section 956 inclusion ($2,612,877), Petitioners must include $2,059,819 in gross income in their 2008 tax year. (Stip., ¶ 55).

The 2009 Write-Off

Prior to the 2009 Write-Off, the records of Memcorp HK reflected an intercompany balance of $21,055,123 owed to Memcorp HK by Memcorp US. (Stip., ¶ 72).

During the 2009 tax year, Memcorp HK wrote-off from its books and records (the "2009 Write-Off") the remaining $21,055,123 intercompany balance owed to it by Memcorp US. (Stip., ¶ 71).

The outstanding intercompany balance that Memcorp US owed to Memcorp HK increased in each of years 2000 through 2005, and then decreased in each subsequent year before reaching zero in 2009. A record of the outstanding intercompany balances in each year from 1999 through 2009 is attached as Stip., ¶ 73, Exhibit 17-J.

For the 2000 through 2003 tax years of Hopper US, Respondent did not make any adjustments under Sections 951(a)(1)(B) and 956, (Stip., ¶ 74), even Memcorp HK had sufficient earnings and profits to support such adjustments.

At the conclusion of the 2004 audit, Respondent made an adjustment to Petitioners' income for tax year 2004 under Sections 951(a)(1)(B) and 956 in the amount of $15,765,803. (Stip., ¶¶ 40 and 41).

At the conclusion of the 2005 audit, Respondent made an adjustment to Petitioners' income for tax year 2005 under Sections 951(a)(1)(B) and 956 in the amount of $2,672,811. (Stip., ¶¶ 48 and 49).

III.  MEMORANDUM OF LAW

A. The Applicable Standard

"The purpose of summary judgment is to expedite litigation and avoid costly, time-consuming, and unnecessary trials." Briggs v. Comm'r, T.C.M. (RIA) 2016-086, at *7 (2016) (citing Fla. Peach Corp. v. Comm'r, 90 T.C. 678, 681 (1988)). "Under Rule 121(b) the Court may grant summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law." Briggs, T.C.M. 2016-086, at *7 (citing Sundstrand Corp. v. Comm'r, 98 T.C. 518, 520 (1992)). "In deciding whether to grant summary judgment, [courts] construe factual materials and inferences drawn from them in the light most favorable to the nonmoving party." Id. "However, the nonmoving party 'may not rest upon the mere allegations or denials' of his pleadings but instead 'must set forth specific facts showing that there is a genuine dispute for trial.'" Id.

B. The Taxable Portion of the 2008 Distributions Were Qualified Dividends to Petitioners for U.S. Tax Purposes

On or about April 30, 2008, Hopper US received an actual distribution of $15,765,803 of earnings and profits ("E&P") from previously taxed income relating to the 2004 Section 951(a) inclusions attributable to its ownership of Memcorp HK. (Stip., ¶ 53). A distribution of E&P made by a corporation to its shareholder is characterized as a dividend for U.S. federal income tax purposes. I.R.C. § 316. This $15,765,803 distribution of E&P, less previously paid U.S. taxes of $5,002,197, or $10,763,606, was for U.S. federal income tax purposes classified as a dividend realized by Petitioners. I.R.C. § 316. This $10,763,606 dividend should be treated for U.S. federal income tax purposes as a dividend from a U.S. C corporation that was deemed to exist as a result of Petitioners' Section 962 election.

Similarly, on or about August 18, 2008, Hopper US received an actual distribution of $2,612,877 of E&P from previously taxed income relating to the 2005 Section 951(a) inclusions attributable to its ownership of Memcorp HK. (Stip., ¶ 53). This $2,612,877 distribution, less the previously paid U.S. taxes of $553,058, or $2,059,819, was for U.S. federal income tax purposes classified as a dividend realized by Petitioners. I.R.C. § 316. This $2,059,819 dividend also should be treated for U.S. federal income tax purposes as a dividend from a U.S. C corporation that was deemed to exist as a result of Petitioners' Section 962 election. Such dividends from a U.S. C corporation are qualified dividends, which were taxable under Section 1(h)(11) at a rate of 15% for the relevant tax year (i.e., 2008). I.R.C. § 1(h)(11)(B)(i)(I).

Petitioners are not claiming that the dividends in this case were paid by a "qualified foreign corporation," but rather by a deemed U.S. C corporation, which Section 962 clearly creates. See § 962(a)(1), (a)(2). Section 962 allows an individual U.S. shareholder of a CFC to elect to be treated like a U.S. corporation for purposes of income inclusions under Section 951(a).

If an individual U.S. shareholder makes a Section 962 election, there are three main tax consequences. First, the individual is taxed on the E&P that is included in his gross income under Section 951(a) in the same manner as if the amounts were received by a domestic corporation. I.R.C. § 962(a)(1). Second, for purposes of computing the deemed-paid foreign tax credit under Sections 902 and 960, the amounts of E&P that are included by the U.S. shareholder are treated as if they were received by a domestic corporation. I.R.C. § 962(a)(2). Third, and most importantly, when an actual distribution of E&P is made and that E&P already has been included in gross income by the shareholder under section 951(a) in a prior year, the E&P is included in gross income again as a dividend to the extent it exceeds the amount of U.S. income tax paid by the shareholder at the time of the Section 962 election. I.R.C. § 962(d).

The issue in this case is whether, pursuant to Section 962(d), this subsequent distribution that is treated as a dividend should be subject to U.S. federal income tax at ordinary income tax rates or at qualified dividend rates. The resolution of this issue depends on whether the actual distribution should be treated as being received from Memcorp HK, a Hong Kong corporation, or from a deemed domestic C corporation that results from making the Section 962 election. Petitioners believe, and leading commentators agree, that the dividend must be treated as coming from the deemed domestic C corporation.¹

Initially, it should be noted that Section 1(h)(11) was enacted in 2003. Therefore, the tax rate differential that exists today between qualified dividends versus non-qualified dividends did not exist in 1962, when Section 962 first was enacted. The issue at hand could not have existed prior to the enactment of Section 1(h)(11), since all dividends were taxed at the same rate until that time. Therefore, it is not clear how Section 1(h)(11) and Section 962 are intended to interact. Neither Congress nor the Courts have addressed this issue.

In the absence of a clear resolution in the statute of how the subsequent distribution should be taxed, it is necessary to look to the legislative history behind Section 962 in order to make this determination. See Burlington N. R.R. v. Okla. Tax Comm'n, 481 U.S. 454, 461 (1987); Marvel Entertainment, LLC v. Commissioner, 145 T.C. 69 (2015); Fernandez v. Commissioner, 114 T.C. 324 (2000) at 329-330. This principle was made clear in United States v. American Trucking Association, 310 U.S. 534 (1940), where the U.S. Supreme Court stated:

There is, of course, no more persuasive evidence of the purpose of a statute than the words by which the legislature undertook to give expression to its wishes. Often these words are sufficient in and of themselves to determine the purpose of the legislation. In such cases we have followed their plain meaning. When that meaning has led to absurd or futile results, however, this Court has looked beyond the words to the purpose of the act. Frequently, however, even when the plain meaning did not produce absurd results but merely an unreasonable one 'plainly at variance with the policy of the legislation as a whole' this Court has followed that purpose, rather than the literal words . . . (emphasis added).

To treat the dividend in any manner other than as a qualified dividend in this case would be plainly at variance with the policy underlying Section 962, by leaving Petitioners with a heavier tax burden with respect to the undistributed foreign earnings than had they invested in Memcorp HK through a U.S. C corporation. According to Section's 962 legislative history,

[t]he purpose of [Section 962] is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. [Section 962] gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.

S. Rep. No. 1881, 87th Cong. 2d Sess. 92 (1962), reprinted at 1962-3 C.B. 703, 798.

In Petitioners' case, the "undistributed foreign earnings" with respect to which Section 962 seeks to provide equitable tax consequences are the $15,765,803 that was taxed to Petitioners under Section 951(a) in 2004, and the $2,612,877 that was taxed to Petitioners under Section 951(a) in 2005. Section 962 in substance provides that these undistributed foreign earnings must ultimately be taxable to the Petitioners at the same effective rate at which they would have been taxed had the Petitioners invested in a U.S. C corporation that in turn invested in Memcorp HK. This is the only possible way to ensure tax neutrality, as Section 962 commands.

Had Petitioners actually invested in Memcorp HK through a U.S. C corporation, the U.S. C corporation would have included the Subpart F income in its gross income under Section 951(a). The U.S. C corporation would have been liable for U.S. corporate income tax at a 35 percent tax rate on these undistributed foreign earnings. Against this tax liability, the U.S. C corporation would have been entitled to an indirect foreign tax credit under Section 902 for the Hong Kong taxes paid by Memcorp HK. When Memcorp HK distributed the remaining undistributed foreign earnings (after deducting Hong Kong taxes paid during 2004 and 2005) to the U.S. C corporation in 2008, that amount would have been received by the C corporation tax-free under Section 959. An actual distribution of the undistributed foreign earnings by the U.S. C corporation to Petitioners would then have been taxable to Petitioners as a qualified dividend under Section 1(h)(11) at a rate of 15 percent. To ensure equivalent tax results, under Section 962(d) Petitioners should be subject to the same 15 percent rate on the actual distributions of the previously taxed E&P.

The "dividend" Petitioners received had to come from E&P located somewhere. It is clear under Treas. Reg. Section 1.312-6(b) that the E&P of the deemed U.S. C corporation must be increased by all Section 951(a) inclusions regardless of whether the E&P actually is distributed ("Among the items entering into the computation of corporate earnings and profits for a particular period are all . . . items includible in gross income under section 61.")²

The Internal Revenue Service (the "Service") recently addressed this very issue in a Generic Legal Advice Memorandum, GLAM 2015-001, explaining the E&P implications to U.S. corporate shareholders that are taxed on income inclusions under Section 951(a). Specifically at issue was the timing of E&P account increases to a U.S. corporate shareholder of a CFC as a result of income inclusions under Section 951(a), and whether such E&P of the U.S. corporate shareholder was to be increased in the year of the Section 951(a) inclusion or instead in the year in which an actual distribution was received by the U.S. shareholder.

In the GLAM, the Service concluded that the U.S. corporate shareholder must increase its E&P by the amount of its income inclusion under Section 951(a) in the year of the inclusion, regardless of whether the U.S. corporate shareholder receives a distribution during that year. The GLAM noted that E&P generally follows taxable income, citing Treas. Reg. Section 1.312-6, Commissioner v. Wheeler, 324 U.S. 542 (1945), and Bangor & Aroostok v. Commissioner, 16 T.C. 578 (1951).

Based on Treas. Reg. Section 1.312-6(b), as cited in the GLAM, when Petitioners realized the Section 956 inclusions during the 2004 and 2005 tax years, the E&P that was included under Section 951(a) moved up to the deemed U.S. C corporation, increasing the E&P account of that U.S. C corporation. This E&P had to leave Memcorp HK when the amounts were included by the deemed U.S. C corporation. See I.R.C. § 312(a).³ There is only one place the E&P logically could have gone. Thus, when the actual distribution was made, any E&P associated with that distribution could not have come from Memcorp HK.⁴ Rather, the E&P came from the only source possible under these facts — the deemed U.S. C corporation created by Section 962 when Petitioners elected to have that provision apply for the 2004 and 2005 tax years.

When Section 962 was enacted in 1962, there was no concept of "qualified dividends" as exists today in Section 1(h)(11), nor of the related "qualified foreign corporation" concept. Thus, Congress cannot, in enacting Section 962, have intended that equal treatment be available only to those taxpayers who invest in foreign corporations that are resident in countries with which the United States has an income tax treaty. Yet, this is precisely the result in many cases if one treats the Section 962(d) dividend as coming, not from the deemed U.S. C corporation created by Section 962(a), but instead from the foreign corporation.

Because it is clear that Congress could not have anticipated this inequality issue when it enacted Section 962, and because Congress did not address the issue when it enacted Section 1(h)(11), the Court must consider the legislative intent behind these provisions in reaching a conclusion. See Burlington, 481 U.S. 454, 461 (1987); Marvel Entertainment, 145 T.C. 69 (2015); Fernandez, 114 T.C. 324 (2000) at 329-330. Based on the legislative history underlying Section 962, which is clear in its intention to provide equal tax treatment to affected taxpayers, the taxable portion of the 2008 distributions must be treated as qualified dividends to Petitioners for U.S. tax purposes.

C. There Was No Constructive Dividend to Memcorp US in 2009;
Rather, Any Argument for Inclusion of the Amounts at Issue
Relates to a Closed Year and is Barred by the Statute of Limitations

As of March 31, 2009, Memcorp HK's records reflected that an intercompany balance of $21,055,123 owed to Memcorp HK by its sole shareholder, Memcorp US, was written off the books of Memcorp HK. (Stip., ¶ 72.) Respondent argues in his Motion for Partial Summary Judgment that this write-off resulted in a constructive dividend to the Petitioners (through their ownership of Hopper US and Memcorp US) in 2009. This argument cannot be successful on Petitioners' facts, as any proper argument for inclusion of these amounts (regardless of the form such inclusion took) would need to have been made with respect to an earlier tax year(s) that is now closed by the statute of limitations.

Respondent previously audited Petitioners with respect to tax years 2004 and 2005. (Stip., ¶¶ 39 and 47). During the course of that audit, Respondent determined that Petitioners were required to include certain amounts in income under Section 956 as a result of intercompany loans made by Memcorp HK to Memcorp US. (Stip., ¶¶ 40 and 48). More specifically, the year-end intercompany balances were as follows in each relevant tax year: 1999 — zero; 2000 — $9,446,339; 2001 — $20,606,644; 2002 — $30,876,942; 2003 — $43,177,961; 2004 — $62,298,748; 2005 — $64,911,625. (Stip., ¶ 73; Exhibit 17-J).

Respondent has stipulated that the balance of these intercompany receivables reached its height at the end of 2005, and decreased in each subsequent year until reaching zero in 2009. (Stip., ¶ 73, Exhibit 17-J). Under Section 956, the lesser of (i) the average quarterly balance of U.S. property held by a CFC, less any amounts previously included and subject to Section 959(c)(1)(A) or (ii) the applicable share of E&P of the CFC, generally is taxable to the U.S. shareholders of such CFC each tax year. For this purpose, U.S. property includes loans from the CFC to its U.S. shareholders. I.R.C. §§ 956(a) and (c)(1)(C).

Thus, assuming sufficient E&P, where Memcorp HK made a loan to Memcorp US, Memcorp US could realize income that year pursuant to Section 956. If, in the following year, assuming sufficient E&P, Memcorp HK loaned additional funds to Memcorp US such that the balance of the payables increased over the amount outstanding in the prior year, those additional funds could result in an additional inclusion under Section 956 in that year. Respondent agreed with this interpretation in the past, as evidenced by Respondent's positions in the 2004 to 2005 audit, and the fact that Respondent sought to include only the increases for 2004 and 2005 in Petitioners' income.

It is well-settled that when Section 956 applies, the amount determined under Section 956 is treated as a "constructive distribution" or "constructive dividend" to the U.S. shareholders of the CFC. See, e.g., P.L. 99-514, 99th Cong., H.R. 3838 (May 4, 1987) at p. 54; H. Rept. 99-426, 99th Cong., 1st Sess., H.R. 3838 (December 7, 1985) at p. 65; Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, ¶ 15.62[4][a]. Section 956 applies, and thus a constructive distribution is triggered, even if the taxpayer does not actually include the Section 956 amounts in income for the relevant years. See McCulloch Corp. v. Commissioner, T.C. Memo. 1984-422; See also Rhoades & Langer, U.S. International Taxation and Tax Treaties, Section 4.01[1][c][i], Example 3 and surrounding text.

It is thus clear that, pursuant to Section 956, Petitioners constructively received income in each of tax years 2000 through 2005 under Section 956. This is because the balance of the intercompany receivables account between Memcorp HK and Memcorp US increased in each of those years and Memcorp HK had sufficient E&P to support such inclusions. Because the intercompany receivables balance between Memcorp HK and Memcorp US was highest at the end of tax year 2005, and in subsequent years only decreased, there can be no Section 956 inclusion relating to the receivables at issue here for any tax year after 2005. Additionally, Respondent cannot assess tax under Section 956 for any of the years prior to 2004, because the statute of limitations on those years has expired. I.R.C. § 6501(a).

During the more recent audit of tax years 2008 and 2009, Respondent made an entirely different argument for inclusion, alleging that the $21,055,123 of such intercompany receivables that were written off in 2009 resulted in a deemed distribution to Memcorp US for 2009. This write-off was attributable to the same cumulative balance created between 2000 and 2005, and with respect to which Respondent previously determined there was a Section 956 inclusion for each of 2004 and 2005. (Stip., ¶¶ 71-73; Stip., Exhibit 17-J).

The fact that Respondent did not (and could not) assess tax under Section 956 as to the entire cumulative loan balance during the course of the 2004 to 2005 audit does not give Respondent the right to assess such amounts now. Respondent reviewed these amounts in 2004 and 2005 and correctly determined that only the increases in the balances of the debt for each of the two years under audit were includible in Petitioners' income under Section 956. Petitioners recognized the amounts which represent the increases from 2003 to 2004, and from 2004 to 2005, and thus properly characterized as Section 956 inclusions for 2004 and 2005, in response to the previous audit of those years. The earlier years and amounts cannot be revisited now.

McCulloch Corp. v. Commissioner, T.C. Memo. 1984-422, addressed this very issue and supports the position that an increase for a particular tax year under Section 956 is determined without regard to the amount the U.S. shareholder actually included in gross income under sections 951(a)(1)(B) and 956 in the previous years.

In McCulloch, the taxpayer, a U.S. corporation, had a Canadian subsidiary that was a CFC (the "CFC"). The CFC made a series of loans to the taxpayer. The first loan was made in tax year 1970, but was not repaid until tax year 1971. The taxpayer did not report any inclusion under Section 956 for 1970. Four other loans were made in succeeding tax years, but those loans were in each case repaid before the end of the tax year in which the loan was made.

During 1974, the Service audited the taxpayer for years 1970 through 1973. By that time, the statute of limitations had run on tax year 1970. The Service argued that the series of loans between the CFC and the taxpayer should be viewed as a single loan, not repaid until 1974, and that the Service could apply Section 956 to tax these amounts since they had not yet been taxed. The taxpayer, on the other hand, argued that these were separate loans, and that each loan was closed out before the end of the tax year such that there was no includible loan balance at the end of any tax year, other than 1970. Thus, in the taxpayer's view, 1970 would have been the only possible year for a Section 956 inclusion, since that was the only year in which there was a year-over-year increase in the loan balance.

As to 1970, however, the statute of limitations was closed and thus no Section 956 inclusion was possible. The taxpayer thus argued that, although the taxpayer had never actually included the Section 956 amounts in income, there was no way for the Service to tax them once the statute of limitations had expired. The Tax Court agreed, stating, "if an adjustment under section 956 is appropriate at all, the adjustment should have first been made [in] the first taxable year . . . 1970." The fact that the taxpayer had not included the amounts in 1970, which was now time-barred by the statute of limitations, did not change the analysis or the result in McCulloch.

In Petitioners' case, as in McCulloch, ". . . a section 956 adjustment in the first year loans are made is the proper result." It does not matter that, because the statute of limitations expired, the amounts cannot now be included in the actual years of the relevant increases, which in this case were 2000 through 2003. As the court noted in McCulloch, Section 956 is explicit in directing this year-by-year approach.

The Service has agreed with and followed McCulloch in its published guidance. In 1996 FSA Lexis 277, in which the Service cited McCulloch, the Service advised one of its appeals officers on a similar issue, stating,

The issue in this case is how to measure the increase in earnings invested in U.S. property for a year when the U.S. shareholder failed to include in gross income, under section 951(a)(1)(B), its pro rata share of such an increase for the preceding year and the statute of limitations for that preceding year has now run. . . . The regulations under section 956 make clear that for purposes of determining a U.S. shareholder's pro rata share of the CFC's increase in earnings invested in U.S. property, the determination of the amount of earnings invested in U.S. property for the preceding year is made irrespective of the amount actually included in the U.S. shareholder's gross income in that preceding year.

This language clearly confirms the Service's view that whether the taxpayer actually includes the Section 956 amounts in income in the year a loan initially is made is not relevant to subsequent year Section 956 computations.

Additional case law illustrates the related, important point that if a Section 956 inclusion should have been made in a previous closed year, but such amounts were never included by the taxpayer or Respondent, these amounts cannot be taxed in a later year when they are actually received. For example, the Court of Appeals for the First Circuit has held that "[i]f a taxpayer actually receives income that was constructively received in a prior year and the statute of limitations precludes its assessment and collection in respect of the prior year, the income is still not includable in the taxpayer's income in the year it is actually received." Ross v. Commissioner, 169 F.2d 483, 492 (1st Cir. 1948). The Tax Court also has acknowledged and agreed with this very basic principle, citing. See Lewis v. Commissioner, T.C. Memo 1992-391.

Based on Ross and Lewis, if Respondent is not able to reach closed years under Section 956 (i.e., 2000-2003) to argue for inclusion of the annual increases in intercompany debt balances, Respondent is prohibited from assessing such amounts now under its alternative theory. These are the same amounts that already Petitioners constructively received in 2000 through 2003, and permitting the alternative theory to prevail would allow Respondent to blatantly circumvent the statute of limitations.

The cases Respondent cites to in his Motion for Partial Summary Judgment are confined solely to the domestic context, where this common law approach is the only tool available to tax amounts which would otherwise go untaxed. See Hash v. Commissioner, 273 F.2d 248 (4th Cir. 1959), Paramount-Richard Theatres v. Commissioner, 153 F.2d 602 (5th Cir. 1946). There is no statute of limitations concern in such cases, as there was only one year in which it was possible to argue for inclusion, and that is the later year of write-off. Those cases clearly are not controlling here.

In this case, which deals with cross-border tax issues, Section 956 was the appropriate basis for inclusion, and that statutory basis was available to Respondent as long as the statute of limitations continued to run. Respondent missed that window, and now has no valid means of reaching those amounts, notwithstanding his creative attempts to do so. See Lewis, T.C. Memo 1992-391; Ross, 169 F.2d 483 (1st Cir. 1948).

Based on the above, there is no basis for arguing that in 2009 the Petitioners realized a constructive dividend as a result of the write-off of the remaining balance of an intercompany receivable between Memcorp HK and Memcorp US. This is an improper attempt to circumvent the statute of limitations and in substance reopen a closed year that Respondent has already had the benefit of auditing.

IV. CONCLUSION

By filing his own motion for partial summary judgment with respect to the issues presented in this Motion, Respondent has conceded that there is no genuine dispute as to any material fact, and a decision may be rendered as a matter of law. There being no issue of material fact concerning the matters raised in this Motion, Petitioners are entitled to summary judgment declaring that: (1) the taxable portion of the 2008 distributions of earnings and profits were qualified dividends to Petitioners for U.S. tax purposes; and, (2) there was no constructive dividend to Hopper US in 2009.

Dated: August 16, 2016

Respectfully submitted,

BILZIN SUMBERG BAENA PRICE & AXELROD LLP
Attorneys for Petitioners
1450 Brickell Avenue, Suite 2300
Miami, Florida 33131
Telephone: 305-374-7580
Facsimile: 305-351-2234

By:
JEFFREY L. RUBINGER
T.C. Bar No. RJ1089
JOSE M. FERRER
T.C. Bar No. FJ0935
SUMMER A. LEPREE
T.C. Bar No. LS0474
SAMUEL C. ULLMAN
T.C. Bar No. US0016
DESIREE E. FERNANDEZ
T.C. Bar No. FD0367