Equating U.S. Tax Treatment of Dividends and Capital Gains for Foreign Portfolio Investors

Date01 June 2019
DOIhttp://doi.org/10.1111/ablj.12140
Published date01 June 2019
American Business Law Journal
Volume 56, Issue 2, 345–390, Summer 2019
Equating U.S. Tax Treatment of
Dividends and Capital Gains for
Foreign Portfolio Investors
Stanley Veliotis*
The U.S. tax law equates the tax rate on dividends and long-term capital gains on stock
owned by U.S. citizens and residents. However, the taxation of these two types of rewards
in the hands of foreign portfolio investors remains dramatically different from each other,
with the capital gain being fully exempt. Several reasons support this article’s proposal to
no longer exempt these gains. Extending finance theory and prior normative tax research,
this article argues that foreigners’ portfolio dividends and capital gains should be taxed
in the same manner because they are economically equivalent and emanate from the same
source. Three recent empirical developments also support repeal of the foreigner’s exemp-
tion. First, there is now extensive use by U.S. corporations of stock repurchases—which
are taxed to selling shareholders as capital gain—as a form of corporate payout that was
in the past primarily accomplished through dividends. Second, foreign ownership of
U.S. stocks has continued to increase, with an estimated one-third of these stocks owned
by foreigners. Third, the modern tax compliance environment—including aspects of the
Foreign Account Tax Compliance Act that apply to foreigners—reduces past congressio-
nal and academic concerns about enforcing the taxation of foreigners’ portfolio gains.
INTRODUCTION
In 2003, the U.S. tax law equated the tax rate on dividends and long-term cap-
ital gains for U.S. citizens’ and resident aliens’ portfolio investments in publicly
traded stocks of U.S. corporations.
1
However, the taxation of dividends and
capital gains in the hands of foreign investors remains dramatically different
*Associate Professor, Fordham University Gabelli School of Business. I thank Chelsea Cro-
nin, John Cox, John Shon, and Mauro Viskovic, along with referees from the American Busi-
ness Law Journal, for very helpful suggestions.
1
See infra notes 37–38 and accompanying text.
©2019 The Author
American Business Law Journal ©2019 Academy of Legal Studies in Business
345
from each other.The dividends are generallytaxedataflat30%taxrateunless
the foreigner claims a reduced rate (e.g., 15%) under the investor’s home
countrytreatywiththeUnitedStates.
2
On the other hand, with very rare
exceptions, the United States does not tax a foreigner’s capital gain on the sale
of these stocks.
3
This article proposes the United States no longer exempt foreign investors’
portfolio capital gains.
4
This article argues that, instead, foreigners’ portfolio
dividends and capital gains should be taxed in the same manner because they
are economically equivalent and emanate from the same source. This article
is not the first law review article to identify the economic equivalence of divi-
dends and capital gains. A half century ago, renowned tax scholar Marvin
Chirelstein was the first to identify this, although in the context of share
repurchases (which generate capital gain): “[A]ssumptions which underlie
the view that share repurchases are not equivalent to ordinary taxable divi-
dends seem less than completely satisfactory.”
5
In the international context,
several authors have also cited the economic equivalency of dividends and
capital gains in their analysis of the gain exemption, especially in Cynthia
Blum’s 1988 article arguing for a limited repeal of the gain exemption.
6
2
See infra notes 41–44 and accompanying text.
3
See infra notes 45–59 and accompanying text.
4
This article addresses foreign portfolio investment (FPI) in U.S. common stocks and
related indices (e.g., exchange-traded funds (ETF)), not foreign direct investment (FDI) in
U.S. businesses (e.g., over 10% investment). For discussion of FPI vs. FDI, see William
B. Barker, Optimal International Taxation and Tax Competition: Overcoming the Contradictions,
22 NW.J.INTLL. & BUS. 161, 163 (2002).
5
Marvin A. Chirelstein, Optional Redemptions and Optional Dividends: Taxing the Repurchase of
Common Shares,78Y
ALE L.J. 739, 755 (1969). Chirelstein “was the first legal academic to rec-
ognize the economic equivalence of such repurchases and dividend distributions and to
appreciate the significance of that equivalence for the taxation of corporate-shareholder
income.” Stephen B. Cohen, Marvin the Magician, 116 COLUM.L.REV. 293, 295 (2016).
6
Cynthia Blum, How the United States Should Tax Foreign Shareholders,7VA.TAX REV.
583, 622–25 (1988). Two other older articles also identify the economic equivalence in the
international context. See Stephen E. Shay et al., The David R. Tillinghast Lecture: “What’s
Source Got to Do with It?”—Source Rules and U.S. International Taxation,56T
AX L. REV. 81, 122
(2002); Reuven S. Avi-Yonah, The Structure of International Taxation: A Proposal for Simplifica-
tion,74T
EX.L.REV. 1301, 1320 (1996). There appears to be only one article since 2002 that
also identifies the economic equivalence and that argues for repeal of the gain exemption,
especially motivated by the foreign policies of President Trumpproviding a politically e xpe-
dient opportunity. See Henry Ordower, Taxing Others in the Age of Trump: Foreigners (and the
Politically Weak)as Tax Subjects,62S
T.LOUIS U. L.J. 157, 165 (2017).
346 Vol. 56 / American Business Law Journal
Three recent developments led to this article’s extension of Chirelstein’s
and Blum’s prior academic research and their arguments that the time has
comeforrepealoftheforeignersgainexemption.First,U.S.corporations
now extensively use stock repurchases—which are taxed as capital gain—as a
form of corporate payout that was, in the past, primarily accomplished
through dividends.
7
Second, foreign ownership of U.S. stocks has continued
to increase, resulting in an estimated one-third of these stocks owned by for-
eigners.
8
With the proliferation of low cost, ready trading and packaged stock
investments, such as exchange-traded funds (ETFs),
9
foreigners are able to
easily and inexpensively trade U.S. equities.
10
Third, the modern tax compli-
ance environment—including aspects of the Foreign Account Tax Compliance
Act (FATCA) that apply to foreigners—reduces past congressional and aca-
demic concerns about enforcing the taxation of foreigners’ portfolio gains.
11
This article proceeds as follows: Part I discusses the U.S. federal income
tax treatment of income from U.S. stocks received by U.S. citizens/residents
and foreigners. Part II details the legislative history of the exemption of for-
eigners’ portfolio gains, focusing on those congressional concerns I antici-
pate as resistance to the proposal to repeal the gain exemption. These
concerns interfered with targeted attempts—in Congress
12
and through the
7
See infra Part III.B.
8
See infra Part IV.A.
9
The ETF market has grown immensely in the last two decades, especially with low-cost commis-
sions. See, e.g.,AsjylynLoder,Investors Win from ETF Price War; U.S. ETF Market Could Top $10 Tril-
lion in Assets Within the Decade,W
ALL ST. J. (July 12, 2018, 8:00AM), https://www.wsj.com/articles/etf-
fees-tumble-as-price-war-heats-up-among-big-fund-firms-1531396800.
10
See, e.g., Gillian Rich, Charles Schwab Slashes Stock, ETF Trading Fees; TD Ameritrade, E-Trade
Hit,I
NVS.BUS.DAILY (Feb. 2, 2017), https://www.investors.com/news/charles-schwab-slashes-
stock-etf-trading-fees-td-ameritrade-e-trade-hit/; Bina Brown, Invest Overseas or You’ll Lose
Out,F
IN.REV. (June 28, 2014, 2:45AM), https://www.afr.com/markets/equity-markets/invest-
overseas-or-youll-lose-out-20140627-j05qw (noting that this article was written for an
Australian audience) (citing an online broker’s increase in direct international share transac-
tions, with 70% of its international-traded shares in the United States, followed by
London’s 11%).
11
Pub. L. No. 111-147, 124 Stat. 71 (2010), https://www.govinfo.gov/content/pkg/PLAW-
111publ147/pdf/PLAW-111publ147.pdf. See infra Part IV.B.
12
See, e.g., David Benson & William F. Leary, Senate Measure Would Tax Foreigners’ Stock Sales
and Limit Treaty Benefits,11T
AX NOTES INTL1278 (1995) (citing failed attempts in 1989,
1990, and 1995).
2019 / Taxing Foreigners’ Stock Gains 347

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