Illinois court rejects dividends-received deduction.
In Kraft Inc. v. Illinois Department of Revenue, the Illinois Appellate Court considered the characterization of Subpart F income for state law purposes. Subpart F income is income of a foreign corporation required to be included in income by some shareholders.
In 1982 and 1983, Kraft owned and controlled a controlled foreign corporation and was required to include Subpart F income in its taxable income for federal income tax purposes. When the company filed its Illinois income tax returns, however, it took a deduction for the amount of Subpart F income it was required to include on its federal return. The deduction was claimed under a provision of the Illinois Income Tax Act which permitted a deduction from federal taxable income in calculating Illinois taxable income for dividends received from a corporation organized outside the United States. Thus, if these amounts were considered dividends, federal taxable income could be reduced as the base for calculating Illinois taxable income.
Essentially, the court held that the provisions of the Illinois statute in 1982 and 1983 were not intended to treat Subpart F income as a dividend. Furthermore, the Internal Revenue Code does not expressly provide or indicate that Subpart F income is to be considered tantamount to a dividend.
Although the case clearly deals with an issue of state law, the issue of whether Subpart F income is to be treated as a dividend is important for tax-exempt organizations owned by captives.
In a letter ruling, the Internal Revenue Service dealt with a tax-exempt organization that maintained a teaching hospital formed a wholly-owned captive which reinsured an admitted carrier which had provided medical malpractice insurance to the exempt organization, full-time faculty members, several other hospitals and full-time resident physicians employed by the hospitals. The captive reinsured 95 percent of the risk insured by the admitted carrier.
The issue was whether the Subpart F income generated by the captive constituted "unrelated business taxable income" which would be taxable to the tax-exempt organization notwithstanding its exemption. The letter ruling refers to Section 512 (b) (1) of the Internal Revenue Code, which excludes from unrelated business taxable income dividend and interest, among other items. The ruling then concludes that the income from the captive's operations falls within the exclusions from unrelated business taxable income. Thus, the rationale behind the ruling is not clear. Tax-exempt organizations sometimes relied on this ruling to use captives formed in foreign domiciles to avoid the imposition of an income tax either at the captive or parent level.
Authorities like those in the Kraft case raise questions regarding the basis for this ruling because there has been no clear position enunciated by any federal authority on the issue of whether Subpart F income is tantamount to a dividend.
P. Bruce Wright is a member of the law firm LeBoeuf, Lamb, Leiby and MacRae in New York.
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|Title Annotation:||Legal Considerations|
|Author:||Wright, P. Bruce|
|Date:||Oct 1, 1991|
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