December 01, 2004

Dividends that US shareholders receive from foreign corporations sometimes qualify for tax at a reduced rate of 15%.

The IRS answered questions about when the lower rate applies in mid-October.

The lower tax rate can only be claimed by individuals – not corporations. It will remain in effect only through 2008 unless extended by Congress. Dividends from a foreign corporation qualify only in three circumstances. They qualify if the foreign corporation is incorporated in a US possession, like Puerto Rico or the US Virgin Islands. They qualify if the dividend is paid on shares of a foreign corporation that are “readily tradable on an established securities market in the United States.” An example is dividends paid on American depository receipts, or “ADRs,” that are traded on a US stock exchange.

Dividends paid by a foreign corporation also qualify if the foreign corporation is entitled to benefits under a “comprehensive” tax treaty between its country of residence and the United States, but only if the treaty has provisions requiring the sharing of information between tax authorities in the two countries.

Certain types of foreign corporations are ineligible. An example is any foreign corporation that the US tax laws label a PFIC – or “passive foreign investment company.”  This is a foreign corporation that earns a large amount of dividends, interest or other “passive” income or a sizable percentage of whose assets are the kinds of assets that generate such income. Foreign corporations are not PFICs if a majority of the shares are owned by US persons each of whom owns at least 10% of the shares.

With that background, the IRS said in October that the 15% rate cannot be claimed on “subpart F income”— or corporate earnings that are taxed to US shareholders under lookthrough rules without waiting for the foreign corporation actually to pay a dividend.

However, it does apply to “section 1248 inclusions.” A foreign corporation might accumulate earnings without distributing them as dividends to shareholders. Later, when a shareholder sells his shares, he will receive a higher price that reflects the undistributed earnings still parked in the offshore corporation. In the distant past, shareholders might have tried to do this to get capital gains rates on the earnings. However, section 1248 of the US tax code recharacterizes part of the sales proceeds – up to the amount of undistributed earnings – as a “dividend.” The IRS said any such recharacterized income qualifies for the 15% rate.

The IRS also said that whether dividends from a foreign corporation that is a PFIC qualify must be made on a shareholder-by-shareholder basis. Thus, dividends paid to one shareholder might be taxed at the 15% rate while dividends paid to other shareholders are not. In general, since January 1, 1998, a corporation cannot be a PFIC if a majority of its shareholders are US persons each of whom owns at least 10% of the shares. The agency cautioned that if the foreign corporation was a PFIC before this date, then it remains a PFIC and its dividends will not qualify for the lower tax rate.

The IRS guidance is in Notice 2004-70.

The 15% tax rate has complicated foreign tax planning for outbound investments by US private equity funds. To the extent the funds raise capital from individuals, they have had to pay attention in structuring offshore investments to take advantage of the 15% rate. 

Keith Martin