Foreign Qualified Dividend Income

In U.S. tax law, classification of income plays a very important role in determining your tax liability. One of the most important classifications is whether you have qualified dividend income eligible reduced tax rates applicable to certain capital gains – in most case, this means 15% tax rate.

As with almost every issue in U.S. law, the qualified dividend classification is complicated if you receive foreign dividends. In this article, I will discuss the IRS rules on determining whether your foreign dividends may be considered “qualified dividend income”.

Qualified Dividend Income

The concept of “qualified dividend income” comes from the Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27, 117 Stat. 752), which was enacted on May 28, 2003.

Prior to the Act, section 1(h)(1) of the Internal Revenue Code (the “IRC”) generally provided that a taxpayer’s “net capital gain” for any taxable year will be subject to a maximum tax rate of 15 percent (or 5 percent in the case of certain taxpayers). The new 2003 Act added section 1(h)(11), which provides that net capital gain for purposes of section 1(h) means net capital gain (determined without regard to section 1(h)(11)) increased by “qualified dividend income.”

The law clearly defines this concept of qualified dividend income in Section 1(h)(11)(B)(I). Qualified dividend income means dividends received during the taxable year from domestic corporations and “qualified foreign corporations.”.

Qualified Foreign Corporation

IRC Section 1(h)(11)(C)(i) defines the concept of qualified foreign corporation as (subject to certain exceptions) any foreign corporation that is either (i) incorporated in a possession of the United States, or (ii) eligible for benefits of a comprehensive income tax treaty with the United States that the Secretary determines is satisfactory for purposes of this provision and that includes an exchange of information program (the so-called “treaty test”).

A foreign corporation that does not satisfy either of these two tests is treated as a qualified foreign corporation with respect to any dividend paid by such corporation if the stock with respect to which such dividend is paid is readily tradable on an established securities market in the United States. Section 1(h)(11)(C)(ii) (see Notice 2003-71, 2003-2 C.B. 922, for the definition, for taxable years beginning on or after January 1, 2003, of “readily tradable on an established securities market in the United States”).

It is important to remember that a dividend from a qualified foreign corporation is also subject to the various limitations in section 1(h)(11). For example, a shareholder receiving a dividend from a qualified foreign corporation must satisfy the holding period requirements of section 1(h)(11)(B)(iii).

Interaction Between PFICs and Section 1(h)(11)

The current law is clear that a qualified foreign corporation does not include any foreign corporation that for the taxable year of the corporation in which the dividend was paid, or the preceding taxable year, is a passive foreign investment company (“PFIC”) as defined in section 1297. See IRC section 1(h)(11)(C)(iii).

Thus, PFIC dividends are not eligible for IRC Section 1(h)(11) favorable treatment. Rather, they will be treated according to the complex PFIC rules described elsewhere in the IRC.

The Treaty Test – Key Threshold

As stated above, subject to certain limitations and exceptions, foreign dividends are likely to be treated as qualified dividend income if a foreign corporation is eligible under the “treaty test”.

A treaty test is passed if the treaty is on the list of the U.S. income tax treaties that met the IRC requirements. The IRS published the first list of such treaties on October 20, 2003 (IRS Notice 2003-69, 2003-2 C.B. 851). Since then, the list has been periodically.

The most recent notice is IRS Notice 2011-64. The new additions since 2006 have been the treaty with Bulgaria (which entered into force on December 15, 2008) and the treaty with Malta (which entered into force on November 23, 2010).

Three U.S. income tax treaties do not meet the requirements of section 1(h)(11)(C)(i)(II). They are the U.S.-U.S.S.R. income tax treaty (which was signed on June 20, 1973, and currently applies to certain former Soviet Republics), and the tax treaties with Bermuda and the Netherlands Antilles.

There are also other requirements under the treaty test. As stated above, in order to be treated as a qualified foreign corporation under the treaty test, a foreign corporation must be eligible for benefits of one of the approved U.S. income tax treaties. Accordingly, the foreign corporation must be a resident within the meaning of such term under the relevant treaty and must satisfy any other requirements of that treaty, including the requirements under any applicable limitation on benefits provision. For purposes of determining whether it satisfies these requirements, a foreign corporation is treated as though it were claiming treaty benefits, even if it does not derive income from sources within the United States. See H.R. Conf. Rep. No. 108-126, at 42 (2003) (stating that a company will be treated as eligible for treaty benefits if it “would qualify” for benefits under the treaty).

Effective Date

It is always important to check the effective dates for each of the treaty for determining when the eligibility for the preferential IRC Section 1(h)(11) arises.

As of the time of this article, IRS Notice 2011-64 is effective with respect to Bulgaria for dividends paid on or after December 15, 2008; Malta – on or after November 23, 2010; Bangladesh – August 7, 2006; Barbados – December 20, 2004; Sri Lanka – July 12, 2004; all other US income tax treaties listed in the Notice – after December 31, 2002.

List of Eligible Treaties

For the reader’s convenience, I listed below all of the U.S. Income Tax Treaties that satisfied the requirements of the IRC Section 1(h)(11)(C)(i)(II) as described in the Appendix to the IRS Notice 2011-64.

Czech Republic
New Zealand
Russian Federation
Slovak Republic
South Africa
Sri Lanka
Trinidad and Tobago
United Kingdom

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