International / Cross-Border

IRS on Qualified Dividends

Reprinted with permission, Canadian Tax Highlights, Volume 12, Number 11, November 2004

by Marla Waiss

IRS Notice 2004-70, October 8, 2004, provides guidance on the extent to which amounts received on or included in income after that date by US individual shareholders of foreign corporations may be treated as qualified dividend income eligible for the reduced (15 percent) dividend rate. (The US Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the rate, effective for tax years beginning after 2002 and before 2009. See "US Tax Bill: Dividends," Canadian Tax Highlights, June 2003; "US Dividend/Capital Gain Rates," Canadian Tax Highlights, November 2003; and "US Reduced Dividend Rate," Canadian Tax Highlights, December 2003.) Before regulations are issued, taxpayers may rely on the notice, which provides more definitive rules for US shareholders of Cancos subject to US anti-deferral rules.

Dividends received from domestic corporations and qualified foreign corporations qualify for the reduced rate; the latter includes any foreign corporation (1) that is incorporated in a US possession, (2) that is eligible for the benefits of a comprehensive US income tax treaty, and (3) whose stock is "readily tradeable on an established securities market in the United States." Excluded is a foreign corporation that, for its taxable year in which the dividend is paid or the preceding year, is a foreign personal holding company (FPHC), a foreign investment company (FIC), or a passive foreign investment company (PFIC); controlled foreign corporations (CFCs) are not excluded.

Generally, income earned by a foreign corporation, such as a Canco, from its foreign operations is not subject to US tax in the US shareholder's hands until it is actually distributed as a dividend, although the CFC, FPHC, and PFIC anti-deferral regimes may tax a US shareholder on undistributed earnings.

A CFC generally is a foreign corporation in which US shareholders own more than 50 percent of the total vote or value. A US shareholder is a US person who owns at least 10 percent of the combined voting power of all stock entitled to vote. A CFC's US shareholders must generally include their pro rata share of subpart F income (dividends, interest, rents, and royalties) in their gross income, whether or not it is actually distributed. If a US shareholder sells its CFC stock, any gain from the sale is generally reported as a section 1248(a) dividend to the extent of the CFC's untaxed undistributed earnings and profits. Because the Code does not exclude CFCs from the definition of "qualified foreign corporations," actual CFC dividends are treated as qualified dividend income if the CFC is otherwise a qualified foreign corporation and other requirements are met (section 1(h)(11)). Subpart F inclusions are not, however, treated as qualified dividends. Distributions from a CFC of previously taxed income are excluded from gross income and are thus not treated as a dividend and not subject to US tax.

A foreign corporation is an FPHC if (1) at any time during the tax year, more than 50 percent of the total combined vote or value is owned by five or fewer US persons, and (2) at least 60 percent (50 percent after the first year as an FPHC) of the corporation's gross income is FPHC income (dividends, interest, and royalties). US shareholders are taxed currently on their pro rata share of the FPHC's undistributed taxable income for the year. FPHCs are specifically excluded from the definition of "qualified foreign corporations"; thus, dividends therefrom do not enjoy the reduced dividend rate, nor do deemed distributions of FPHC income. Dividends from a CFC that is also an FPHC are tainted by the FPHC status and do not enjoy the reduced dividend rate. The American Jobs Creation Act of 2004, signed into law on October 22, 2004, repeals the FPHC rules, effective for taxable years after December 31, 2004; this is a welcome change for many caught by the broad FPHC attribution rules. Under the Code, a foreign corporation cannot be a qualified foreign corporation if it was an FPHC in the year preceding that in which the dividend is paid; thus, dividends from a Canco that was an FPHC in 2004 may not qualify in 2005 for the reduced rate even if all other requirements are met.

A foreign corporation is generally a PFIC if (1) 75 percent or more of its gross income for the taxable year consists of passive income (dividends, interest, rents, and royalties), or (2) 50 percent or more of its assets produce, or are held for the production of, passive income. In contrast to the CFC and FPHC regimes, US PFIC shareholders are taxed on excess distributions determined under section 1291. Amounts allocated to the current tax year and the pre-PFIC holding period (if any) are included as ordinary income in the current year. Amounts allocated to other years in the PFIC period are taxed at the highest US ordinary income tax rate (currently, 35 percent) plus an interest charge to reflect the benefit of deferral. US shareholders may elect qualified electing fund (QEF) treatment to generally avoid the excess distribution regime and be taxed currently on their pro rata share of the corporation's ordinary earnings and net capital gain, distributed or not; a mark-to-market election also generally avoids the excess distribution regime.

Like FPHCs, PFICs are specifically excluded from the definition of "qualified foreign corporation"; dividends therefrom do not qualify for the reduced rate, nor do amounts included in gross income under the QEF or the mark-to-market regime. PFIC status is determined vis-à-vis a particular shareholder; dividends from such a corporation may be qualified dividend income for some shareholders and not for others. A CFC that is also a PFIC is generally not treated as a PFIC vis-à-vis a US shareholder for tax years after 1997; actual distributions of its non-previously-taxed earnings and profits are treated as qualified dividend income if it is otherwise a qualified foreign corporation and other requirements are met.