SECTION 3. BACKGROUND

.01 The 2003 Act

In general, section 1(h)(1) of the Code provides that an individual taxpayer’s net capital gain for any taxable year is subject to a maximum tax rate of 15 percent (or 5 percent in the case of certain taxpayers). Section 1(h)(11) provides that, for purposes of section 1(h), the term “net capital gain” means net capital gain increased by qualified dividend income.

“Qualified dividend income” is defined as dividends received during the taxable year from domestic corporations and qualified foreign corporations. Section 1(h)(11)(B)(i) of the Code. The term “qualified foreign corporation” does not include any foreign corporation that, for the taxable year of the corporation in which the dividend is paid, or the preceding taxable year, is an FPHC, a FIC, or a PFIC. Section 1(h)(11)(C)(iii). Subject to this limitation, the term “qualified foreign corporation” means any foreign corporation that is incorporated in a possession of the United States or that is eligible for the benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory for purposes of this provision and which includes an exchange of information program. ¹ Section 1(h)(11)(C)(i). In addition, a foreign corporation is treated as a qualified foreign corporation with respect to any dividend paid by such corporation if the stock with respect to which such dividend is paid is readily tradable on an established securities market in the United States. ² Section 1(h)(11)(C)(ii).

.02 Anti-deferral Regimes under the Code

Income earned by a foreign corporation from its foreign operations generally is subject to U.S. tax when such income

1 See Notice 2003–69, 2003–42 I.R.B. 851 (providing the current list of U.S. tax treaties meeting these requirements).

2 See Notice 2003–71, 2003–43 I.R.B. 922 (defining “readily tradable” on an established securities market in the United States with respect to dividends received on or after January 1, 2003); Notice 2003–79, 2003–50 I.R.B. 1206 (defining “readily tradable” for securities other than ordinary or common stock).

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(3) FICs . A foreign corporation is a FIC if (1) it is registered under the Investment Company Act of 1940, either as a management company or as a unit investment trust; or (2) it is engaged primarily in the business of investing, reinvesting, or trading in securities or commodities, or in any interest in securities or commodities, at a time when 50 percent or more of the total combined voting power of all classes of stock entitled to vote, or the value of all classes of stock, is held by U.S. persons. Section 1246(b) of the Code. Under the FIC rules, in general, gain on the sale or exchange (or a distribution that is treated as an exchange) of stock in a FIC is treated as ordinary income to the extent of the taxpayer’s ratable share of the post–1962 undistributed earnings and profits of the FIC. Section 1246(a). Any amount previously included in the gross income of the shareholder under section 951 is excluded from the shareholder’s ratable share of the post–1962 undistributed earnings and profits of the FIC (but only to the extent the inclusion of such amount did not result in the exclusion of any other amount from gross income under section 959). A FIC that elected before 1963 to distribute annually 90 percent of its taxable income (other than capital gains) is not subject to the general rules of section 1246(a) with respect to any year in which the election applies. Section 1247(a)(1); Section 1.1247–1(c)(1) of the Income Tax Regulations. Qualified shareholders (as defined in section 1247(c)) who invest in FICs that elected this treatment under section 1247 and for which the election is currently in effect are required to include in income currently their share of the net long term capital gains of the FIC whether or not actually distributed.

(4) PFICs . In general, a foreign corporation is a PFIC if (1) 75 percent or more of its gross income for the taxable year consists of passive income; or (2) the average percentage of assets held by the corporation during the taxable year that produce, or are held for the production of, passive income is 50 percent or more. Section 1297(a) of the Code. Subject to certain exceptions, passive income generally means income of a kind that would be foreign personal holding company income under section 954(c). Section 1297(b).

In general, gain recognized by a U.S. person on the disposition of stock of a

is distributed to a U.S. person that holds stock in such foreign corporation. Accordingly, a U.S. person that is a shareholder of a foreign corporation generally is not subject to U.S. tax on the income earned by the foreign corporation until that income is distributed to the shareholder as a dividend. However, a variety of anti-deferral regimes apply to subject the U.S. shareholder to U.S. tax on that income even if the income is not actually distributed to the shareholder.

A brief summary of the rules applicable to foreign corporations subject to each of the anti-deferral regimes addressed in this notice is provided below.

(1) CFCs . In general, a CFC is any foreign corporation with respect to which U.S. shareholders own more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote or the total value of such corporation. Under section 951(b) of the Code, a “United States shareholder” is a U.S. person (as defined in section 957(c)) that owns ten percent or more of the total combined voting power of all classes of stock entitled to vote.

United States shareholders of CFCs are required to include in gross income currently their pro rata share of certain income of the CFC (referred to as “subpart F income”), without regard to whether the income is distributed by the CFC to its shareholders in the year the income is earned. Section 951(a)(1)(A) of the Code. Subpart F income includes foreign base company income, including foreign personal holding company income ( e.g., dividends, interest, annuities and other specified passive income), and certain insurance income. Sections 952, 953, and 954. United States shareholders of a CFC also are required to include currently in income their pro rata share of the CFC’s earnings to the extent invested by the CFC in U.S. property. Section 951(a)(1)(B). The amounts so included in income under section 951(a)(1) are limited to the shareholder’s pro rata share of the current earnings and profits of the CFC. Section 951(a)(2) and (c)(1)(A). Income of a CFC that has been included in the gross income of its United States shareholders as an inclusion under section 951(a)(1) of the Code is not included in gross income again when it actually is distributed to the United States shareholders.

Section 959(a)(1). Any income of a CFC that is not included in the gross income of its United States shareholders under section 951(a)(1) is not subject to U.S. tax as income of the United States shareholders until actually distributed as a dividend. A United States shareholder of a CFC that sells its stock in the CFC generally is required to report any recognized gain from the sale of the stock as a dividend to the extent of the untaxed undistributed earnings and profits of the CFC and certain subsidiaries that are attributable to the United States shareholder. Section 1248(a) and (c)(2).

(2) FPHCs . A foreign corporation is an FPHC if (1) at any time during the taxable year more than 50 percent of the stock of the corporation, determined by vote or value, is owned by five or fewer individuals who are U.S. citizens or residents; and (2) at least 60 percent of the corporation’s gross income for the taxable year is foreign personal holding company income ( e.g., dividends, interest, annuities and other specified passive income). Once a foreign corporation qualifies as an FPHC, however, the gross income threshold for each subsequent year is only 50 percent, until the expiration of either one taxable year during which the stock ownership requirement is not satisfied or three consecutive taxable years in each of which the gross income requirement is not satisfied at the 50 percent threshold. Section 552(a) of the Code.

All individual shareholders of an FPHC who are U.S. persons must include in gross income their distributive shares of undistributed foreign personal holding company income (as defined in section 556(a) of the Code) without regard to whether the income is distributed by the FPHC to its shareholders in the taxable year the income is earned. The undistributed foreign personal holding company income of an FPHC is the taxable income of the FPHC with adjustments minus the amount of the dividends paid deduction determined under section 561. Section 556(a). The undistributed foreign personal holding company income of an FPHC is treated as a dividend under section 551(b). Amounts that are deemed distributed as a dividend are treated as recontributed by the U.S. individual shareholders to the FPHC as a contribution to capital.

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dend). In addition, amounts treated as dividends under section 1.367(b)–2(e)(2) of the regulations ( i.e., section 1248 amounts and all earnings and profits amounts) are qualified dividend income provided that the CFC is otherwise a qualified foreign corporation under section 1(h)(11)(C) and the other requirements of section 1(h)(11) are met. ⁵

.02 Section 951(a)(1) Inclusions

Neither section 951(a)(1) nor the corresponding regulations characterize a section 951(a)(1) inclusion as a dividend. In contrast, deemed inclusions under the FPHC and PFIC regimes are characterized as dividends throughout the statutory provisions governing these regimes. See, e.g., section 551(b) (stating that undistributed foreign personal holding company income is included in a foreign personal holding company shareholder’s gross income as a dividend). Moreover, while section 1248 requires inclusions in gross income as a dividend, section 951 simply requires inclusions in gross income. ⁶ Accordingly, for purposes of section 1(h)(11), section 951(a)(1) inclusions are not dividends and therefore cannot constitute qualified dividend income.

.03 Distributions of Previously Taxed Income

Distributions of previously taxed income excluded from gross income under section 959(a) of the Code are not qualified dividend income because they are not subject to U.S. tax and are not dividends. See section 959(a) and (d).