The IRS recently announced (IRS Notice 2006-101, October 30, 2006) that Barbados has been formally added to the list of foreign countries that qualify for the 15 percent preferential US federal tax rate on dividends paid by a foreign corporation to US non-corporate shareholders. In 2003, the US federal tax rate was reduced to 15 percent on certain dividends paid by a US corporation and a qualified foreign corporation to US non-corporate shareholders. A qualified foreign corporation must, inter alia, have been formed in a foreign country that has a comprehensive tax treaty with the United States that includes an adequate exchange-of-information program. Notice 2006-101 formally acknowledges that the US-Barbados treaty now meets these requirements because the second protocol to the treaty became effective in December 2004.

Canada is also on the list of qualified foreign countries, but two additional tests must be met before dividends paid by a Canco qualify for the 15 percent tax rate: (1) the Canco must qualify for benefits under the Canada-US treaty's limitation-on-benefits article; and (2) the Canco must not be a passive foreign investment company (PFIC) in the year in which the dividend is paid or in the preceding year. In general, a PFIC is a foreign corporation that (1) is not a controlled foreign corporation (CFC) and (2) has excessive passive income or passive assets. If a Canco is a CFC (more than 50 percent owned by US citizens or residents), dividends paid by it generally qualify for the 15 percent rate, as does a gain from a sale or disposition of its stock recharacterized as a dividend under Code section 1248. However, a CFC's subpart F inclusions do not generally qualify for the low rate; this impediment, coupled with an inability to claim foreign tax credits for Canadian taxes paid on subpart F income of a CFC (with respect to shares held by US non-corporate shareholders), continues in some cases to encourage US non-corporate shareholders to use an Alberta or Nova Scotia unlimited liability company in lieu of a Canco to hold passive assets so as to be able to claim such foreign tax credits.

For dividends paid by a non-PFIC Canco to US shareholders, the 15 percent US tax rate combined with the availability of foreign tax credits for Canadian withholding taxes imposed on dividends (at 5 or 15 percent) normally results in little or no net US federal tax on the dividends. The fear that the Democrats might increase the 15 percent rate after they took control of the US Congress in the November 2006 elections has not been realized, and the new Democratic leadership has expressed no such intention.

Many a Canadian parent corporation uses a Barbados subsidiary to hold intellectual property rights or to facilitate the sale of goods to the United States, including sales to ultimate US customers and to its US subsidiaries. A Barbados sub is often formed as an SRL that elects to be treated as a disregarded entity or partnership for US federal tax purposes: the sub thereby opens the door to attempts at accessing certain benefits under the Canada-US treaty, most notably the PE protection for business profits. However, treaty protection for passive income such as royalties or interest payments received by an SRL is generally denied under section 894 because of the SRL's hybrid nature. Where possible, tax planning for the use of SRLs to sell goods into the United States normally includes an attempt to structure the sales to qualify as foreign-source income under the Code, a protective measure against any IRS attempt to extend the reach of section 894 to include active sales income or to otherwise deny benefits therefor under the Canada-US treaty.

Attempting to qualify for benefits under the US-Barbados treaty with respect to royalties or interest payments from US payers to Barbados IBCs or SRLs can be extremely difficult and often impossible if the Barbados entity is owned by non-Barbados residents and qualifies for preferential tax rates in Barbados. However, the addition of Barbados as a qualified foreign country for the purposes of the 15 percent US federal tax rate on dividends is welcomed for its impact on dividends paid to US shareholders by Barbados corporations that also meet the other requirements for qualified foreign corporation status.