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Fall 2005-07 Section 965 dividends received deduction

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Number 61
Fall 2005
Last call for all U.S. bound earnings:

Section 965 dividends received deduction

Last year Congress enacted the American Job Creations Act of 2004, which made significant changes to the Internal Revenue Code, in an attempt to boost the severed U.S. economy.

One of the new provisions added to the IRC was section 965, that affects the way the Internal Revenue Service taxes repatriated income from "controlled foreign corporations." This term encompasses corporations organized under the laws of the Commonwealth of Puerto Rico, if more than 50% of their shares are owned by United States holders.

Previous treatment

Earnings from foreign corporations (including certain Puerto Rico corporations) have been normally taxed as ordinary income to the stateside corporate shareholder, at the time they are repatriated to the U.S. as dividends. Foreign corporations would often reinvest their earnings outside the U.S. in order to avoid or postpone taxation at ordinary income rates. Section 965 serves as a special one-time incentive to repatriate and reinvest those foreign earnings in the United States.

Taxation under § 965

New § 965 grants corporations that are U.S. shareholders a one-time election to receive an 85% dividend received deduction for qualified dividends received by a controlled foreign corporation during the year for which the election is made. An 85% dividend received deduction provides corporations with an effective tax rate of 5.25% on those earnings. Compare that to the ordinary income rate of 35% that most corporations would normally be subjected to.

Qualifying dividends

Section 965 imposes certain limitation in order for dividends to qualify for the dividend received deduction. The provision limits the amount to the excess of the "base period amount." The "base period amount" is the average dividends received by the U.S. corporation over the preceding five years. Furthermore, this excess eligible for dividend received deduction treatment may not exceed the higher of: $500 million, or the specific amount shown to have been permanently reinvested outside the U.S. Various other limitations may apply, depending on the nature of the dividend.

Reinvestment plan limitation

A dividend will not qualify for dividend received deduction treatment unless it is subject to a "domestic reinvestment plan ." This plan must be approved by the corporation before the dividend is paid, and must comply with the rules set out in the § 965 regulations. This requirement seeks to guarantee that the extra capital that will result from an election under this section is actually reinvested in the United States. The regulation is flexible in the application of the reinvestment requirement by giving corporations a number of options regarding the manner in which to reinvest these earnings, among these: research, infrastructure, capital investment, worker hiring and training. The regulation also specifies certain reporting requirements relating to the reinvestment plan, for the years subsequent to the election year.

Timing of the election

Section 965 provides a one time, one taxable year election for the dividend received deduction treatment. The U.S. corporation may elect such treatment for the last taxable year that begins prior to October 22, 2004, or for the first taxable year starting within a year of the date of enactment of the law (October 22, 2004). Only distributions made in the elected taxable year are eligible for the 85% dividend received deduction.

Application to Puerto Rico

Section 965 applies to any corporation incorporated under the laws of Puerto Rico if more than 50% of its shares is owned by U.S. shareholders (i.e. controlled foreign corporations). In these cases § 965 serves as a vehicle by which a Puerto Rico corporation may repatriate accumulated earnings to the United States without the burden of substantial taxation.


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