Reproduced with the permission of the Canadian Tax Foundation from, Marla Waiss, "US Reduced Dividend Rate" (2003) vol. 11, no. 12 Canadian Tax Highlights.

Canadian Tax Highlights
December, 2003

by Marla Waiss

The US Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the US federal income tax rate on qualified dividend income received by individuals to 15 percent, effective for tax years beginning after 2002 and ending for tax years beginning after 2008. (See "US Tax Bill: Dividends" and "US Dividend/Capital Gain Rates," Canadian Tax Highlights, June 2003 and November 2003.) Under the Act, qualified dividend income is derived only from a qualified foreign corporation, which includes a corporation (1) incorporated in a US possession, (2) eligible for the benefits of a comprehensive income tax treaty with the United States, or (3) whose stock is "readily tradable on an established securities market in the United States." A foreign personal holding company (FPHC), a foreign investment company (FIC), and a passive foreign investment company (PFIC) are expressly excluded. The IRS recently issued guidance on the definition of a qualified foreign corporation. IRS Notice 2003-69, issued September 30, 2003, identifies the treaties that qualify as comprehensive US income tax treaties for this purpose--all such treaties that include exchange-of-information programs (except the Barbados treaty, which may provide benefits that are intended to mitigate or eliminate double taxation in cases where there is no risk of double taxation). The US-USSR income tax treaty was excluded because it does not include an information-exchange program; treaties with Bermuda and the Netherlands Antilles are also excluded. The IRS also indicated that it would continue to study the operation of each US income tax treaty, including the implications of any changes in the domestic laws of the treaty partner, to ensure that the treaty accomplishes its intended objectives. The IRS further indicated that a foreign corporation must be considered a resident under the relevant treaty and must satisfy any other treaty requirements, such as those under a limitation-on-benefits provision. The notice stated that Treasury and the IRS continue to work on guidance as to whether foreign corporations are qualified foreign corporations under the comprehensive income tax treaty test.

IRS Notice 2003-71, issued October 3, 2003, offers guidance on the application of the reduced tax rate for dividends paid by a foreign corporation whose stock is readily tradable on an established US securities market. For tax years beginning after 2002, common or ordinary stock or an American depository receipt in respect thereof meets that "readily tradable" test if it is listed on NASDAQ or on a national securities exchange that is registered with the Securities and Exchange Commission (SEC), including, as of September 30, 2002, the New York Stock Exchange, the American Stock Exchange, the Boston Stock Exchange, the Cincinnati Stock Exchange, the Chicago Stock Exchange, the Philadelphia Stock Exchange, and the Pacific Exchange, Inc. The IRS will continue to consider the treatment of dividends with respect to stock listed otherwise, such as on the OTC bulletin board or on the electronic pink sheets, and specifically whether and to what extent a stock's meeting the "readily tradable" test should be predicated on the satisfaction of parameters regarding minimum trading volume, minimum number of market makers, maintenance and publication of historical trade or quotation data, issuer reporting requirements under SEC or exchange rules, and issuer disclosure or determinations regarding PFIC, FIC, or FPHC status.

The IRS also issued guidance on simplified 2003 reporting procedures for dividends paid by a qualified foreign corporation (Notice 2003-79). For the 2003 tax year, recipients of a form 1099-DIV indicating that a dividend is a qualifying dividend may treat it as such unless they know or have reason to know otherwise.

The new administrative guidance leaves many issues open. For instance, how should qualified foreign corporation status and the reduced rate for dividends affect the foreign tax credit (FTC) available to a dividend recipient? The non-US tax available for FTC purposes is reduced in a manner similar to the existing law's reduction applicable to a capital gain. Generally, a taxpayer must reduce the numerator in the FTC limitation by the "rate differential portion" of any foreign-source capital gain net income (section 904(b)(2)). A foreign-source capital gain in the hands of a US person includes a gain from the sale of non-US real property or from the sale of personal property in an office or fixed place of business in a foreign country; such items must be taken into account for purposes of computing the FTC limitation (section 904(b)(2)(A)). A taxpayer cannot cross-credit foreign tax on foreign-source capital gain against US tax on US-source ordinary income and reduce the effective rate of tax thereon (section 904(b)(2)(B)).

The new law's application to controlled foreign corporations (CFCs) raises some interesting issues. Unlike an FPHC, FIC, or PFIC, a CFC is not disqualified from qualified foreign corporation status, and thus its distributions can qualify for the 15 percent reduced rate if it meets one of the three tests above. However, it appears that a CFC's subpart F inclusions generally do not qualify for the reduced rate because technically they are not treated as actual dividends; in contrast, section 1248 inclusions represent non-subpart F earnings and profits and are treated as dividends.

On a related note, proposals before Congress repeal the FPHC rules, which may be welcome news to many US shareholders of Canadian corporations who are unfairly caught up in the FPHC regime by its broad attribution rules.