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New Dividend Tax Provision Adds New Complexity and New Questions

June 2003
Reprinted with Permission, Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

The Jobs and Growth Tax Relief Reconciliation Act of 2003, which was signed into law on May 28, 2003, contains the President's long sought-after dividend tax relief, although in a somewhat different form than he originally proposed. The final bill treats certain "qualified dividend income" as "net capital gain" when received by an individual during the years 2003 through 2008. With the reduction in capital gains rates for this same period, the tax rate on dividends has been set at a flat 15% for most individuals, a decrease of approximately 61% from the top marginal rate of 38.6%. (The rate for individuals in the lowest bracket is reduced from 10% to 5% in 2003 through 2007 and to zero in 2008.)

Dividends paid by domestic corporations and "qualified foreign corporations" are eligible for the new rates. "Qualified foreign corporations" are generally defined as (i) U.S. possessions corporations; (ii) foreign corporations eligible for treaty benefits under a comprehensive U.S. income tax treaty that is approved by the Treasury as "satisfactory" for this purpose and that contains an exchange of information provision; and (iii) foreign corporations with stock (to which the dividend is attributable) that is readily traded on an established U.S. securities market. (Footnote 41 of the Managers' Statement and Explanation of the Final Conference Agreement to H.R. 2 ("Managers' Statement") states that a share of stock will be treated as traded on a U.S. securities market if an American Depository Receipt ("ADR") backed by such share is so traded.)

Dividends paid to U.S. shareholders by a foreign corporation that qualifies as a foreign personal holding company (FPHC), a foreign investment company (FIC), or a passive foreign investment company (PFIC) are expressly made ineligible for the new benefits regardless of the payer's treaty status.

Foreign publicly-traded companies that are not resident in a treaty country and that do not have stock traded on a U.S. stock exchange do not qualify for the new benefits. In a quest for U.S. portfolio investment, this could well disadvantage public companies in such regions as South America (other than Venezuela) and Asia (particularly Hong Kong and Singapore) vis-à-vis their counterparts. However, the stock of a number of companies from those regions is traded on the U.S. ADR market. For example, the stock of approximately 32 Brazilian companies and 14 Hong Kong companies is traded on the ADR market, permitting those companies to enjoy the benefit of the dividend rate reductions and thereby remain competitive in seeking U.S. investment capital.

The new legislation allows an "inverted" U.S. corporation, i.e., a U.S. corporation that has opted to become a subsidiary of a foreign holding company based in a non-treaty country through a corporate inversion transaction, to effectively qualify its dividends for the reduced rates by having the stock of the foreign parent traded on a U.S. stock exchange and flowing its dividends up through the parent. (The stock of most, if not all, of the foreign parent companies of U.S. corporations that have undergone inversion transactions is traded on the New York Stock Exchange, using the same trading symbol that was used prior to the inversion transaction.) The tax relief for such dividends may be short-lived, however, because Senate Finance Committee Chairman Grassley has warned that he will continue to work toward enactment of corporate inversion legislation that could well exclude dividends paid by such inverted companies from qualifying for dividend rate relief.

The use of treaty status to define one type of "qualified foreign corporation" is a novel approach that clearly disadvantages foreign companies not located in a treaty country. Potentially, this approach could place additional pressure on non-treaty countries to negotiate income tax treaties with the United States. Although the inclusion of U.S. publicly-traded foreign corporations as another type of "qualified foreign corporation" alleviates the non-treaty disadvantage somewhat, the bulk of such corporations currently reside in treaty countries. (Of the top 43 countries with companies trading on the U.S. ADR market, 35 are treaty countries and only eight are non-treaty countries.)

It is already apparent that not every U.S. treaty will be considered "satisfactory" for purposes of the dividend rate reduction. The Managers' Statement makes it clear that Congress intends the Treasury Department to issue "guidance" regarding which treaties will be considered satisfactory and which will not. Until such guidance is issued, a foreign corporation will evidently be treated as a "qualified foreign corporation" if it is eligible for the benefits of a comprehensive income tax treaty (other than the current U.S.-Barbados income tax treaty) that contains an exchange of information provision. The Managers' Statement expressly singles out the Barbados treaty as one not considered satisfactory, on the ground that it may provide benefits designed to eliminate double taxation to corporations not at risk of double taxation. Although the Barbados treaty is the only treaty currently earmarked as being unsatisfactory, it is possible that other countries may be added to the list by the Treasury.

Another restriction on the use of treaty status to qualify for the new dividend rate reductions is also contained in the Managers' Statement, where it is indicated that the conferees intend that a company will be eligible for the benefits of a comprehensive income tax treaty "if it would qualify for the benefits of the treaty with respect to substantially all of its income in the taxable year in which the dividend is paid." Presumably, this statement means that the foreign corporation must run the gauntlet of the Limitation on Benefits Article contained in the U.S. treaty with the country where it is a resident, in order to establish that it "would qualify" for treaty benefits with respect to substantially all (and not merely certain portions) of its income in the year it chooses to pay a dividend. However, the statement is certainly capable of different readings. Further clarification is definitely needed on this point.

Assuming the foreign corporation qualifies for the new rules under either the treaty eligibility or publicly-traded stock provision, any dividends it pays may, of course, be subject to foreign withholding tax. In such a case, H.R. 2 provides that the allowable foreign tax credit will be determined under rules similar to those of §904(b)(2)(B), which adjusts the foreign tax credit limitation to reflect capital gain differential tax rates. The Managers' Statement does not elaborate on how the credit limitation will take the new "dividend rate differential" into account.

As can be seen, the new relief provisions raise a number of interesting questions regarding the treatment of cross-border dividend payments. Hopefully, the Treasury will rather quickly provide at least some of the guidance required.

This commentary also will appear in the July 11, 2003, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see 764 T.M.,Dividends--Cash and Property, and 904 T.M.,The Foreign Tax Credit Limitation--Section 904, and in Tax Practice Series, see ¶7130, U.S. Persons--Foreign Activities.
 
© 2003 Tax Management Inc. A subsidiary of The Bureau of National Affairs, Inc 

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