Dividends received from foreign corporations--recent developments change the landscape.

AuthorRubinger, Jeffrey L.

The American Jobs Creation Act of 2004 (the "2004 Act") (1) has been called "the most significant tax law reform since 1986." (2) One of the provisions of the 2004 Act that has received a significant amount of attention is new [section] 965 of the Code. (3) Under [section] 965, a U.S. corporate shareholder (4) of a controlled foreign corporation (CFC) (5) can elect to deduct 85 percent of the cash dividends received from such CFC during the taxable year, (6) resulting in an effective corporate income tax rate of just 5.25 percent. (7)

The benefits available under [section] 965, however, appear to be limited to C corporations. (8) Therefore, individual U.S. shareholders that own CFCs directly, or through flow-through entities, will not be able to take advantage of the favorable one-time tax benefit. Other recent developments, however, while they may not be receiving as much attention as [section] 965, are significant in the context of repatriating foreign earnings to the U.S. at the reduced 15-percent rate applicable to individual shareholders, which was enacted as part of the Jobs and Growth Tax Reconciliation Relief Act of 2003 (the "2003 Act"). Specifically, under the 2004 Act, the foreign personal holding company (FPHC) rules and the foreign investment company (FIC) rules are eliminated from the Code, effective for tax years beginning after December 31, 2004. In Notice 200470, (9) the IRS clarified that deemed income inclusions under [section] 951(a)(1) are not treated as "dividends" under the Code and therefore cannot be taxed as "qualified dividend income" under [section] 1(h)(11). Finally, under the 2004 Act, the foreign base company shipping rules, a category of subpart F income, will be eliminated from the Code beginning after December 31, 2004. This article will explore these recent developments and examine how they affect the ability of U.S. taxpayers to convert nonqualified dividend income into qualified dividend income.

The 2003 Act in General

The 2003 Act was enacted on May 28, 2003. One of the most significant aspects of the 2003 Act is the addition of [section] 1(h)(11) to the Code, which provides for a 15-percent maximum tax rate on "qualified dividend income" received by individuals and other taxpayers subject to tax under [section] 1. (10) Section 1(h)(11) accomplishes this result by taxing qualified dividend income at the same rate as long-term capital gains.

To be eligible for this reduced rate, the dividends must be received from either a domestic corporation or a qualified foreign corporation (QFC). A QFC is defined as any foreign corporation that is 1) incorporated in a possession of the U.S., or 2) eligible for benefits of a comprehensive income tax treaty with the U.S. which the Secretary of Treasury determines is satisfactory for this purpose and which contains an exchange of information provision (the "treaty test"). Also, if a foreign corporation's stock is readily tradable on an established securities market in the U.S. (for example, as American Depositary Receipts or ADRs), the foreign corporation will be treated as a QFC with respect to dividends on that stock.

In Notice 2003-69, (11) the IRS published a list of jurisdictions that have concluded with the U.S. "satisfactory comprehensive" income tax treaties which contain an exchange of information provision. Excluded from this list are the classic tax haven jurisdictions, such as the Cayman Islands, the British Virgin Islands, the Bahamas, and so forth, given that these countries do not have comprehensive income tax treaties with the U.S. Also, four jurisdictions that have concluded income tax treaties with the U.S. but that specifically do not satisfy these requirements are Bermuda, the Netherlands Antilles, the former Soviet Union, and Barbados. Accordingly, any dividends received by a company organized in one of these jurisdictions will be ineligible for the 15-percent tax rate. (12)

Before the 2004 Act, even if a foreign corporation was organized in a qualified foreign jurisdiction, any dividend received from that corporation would not be treated as qualified dividend income if the corporation was a FPHC, (13) a FIC, (14) or a passive foreign investment company (PFIC), for the current year or the preceding tax year. As noted above, the 2004 Act eliminated FPHCs and FICs from the Code, effective for tax years beginning after December 31, 2004. Accordingly, beginning in 2005, if a foreign corporation is organized in a qualified foreign jurisdiction any dividends paid by such corporation to a U.S. shareholder will be eligible for the 15-percent tax rate, so long as the corporation is not characterized as a PFIC, either for the current year or the prior taxable year. It no longer will be necessary to determine whether the foreign corporation is also a FPHC or a FIC.

A foreign corporation will be classified as a PFIC if it satisfies an income test or an asset test. Under the income test, a foreign corporation will be characterized as a PFIC if 75 percent or more of its gross income for the tax year consists of "passive income." Under the asset test, a foreign corporation will be characterized as a PFIC if the average percentage of its assets during the tax year that produce passive income or that are held for the production of passive income is at least 50 percent.

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