Dividends Recieved From Foreign CorporationsâRecent Developments Change the Landscape
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 §965 of the Code.3 Under §965, a U.S. corporate shareholder4 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 §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 §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 2004-70,9 the IRS clarified that deemed income inclusions under §951(a)(1) are not treated as “dividends” under the Code and therefore cannot be taxed as “qualified dividend income” under §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 §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 §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.
Noticeably absent from the list of QFCs that are ineligible to pay qualified dividends are controlled foreign corporations (CFC). Briefly, a CFC is a foreign corporation that is more than 50 percent owned by 10 percent U.S. shareholders.15 If a foreign corporation is classified as a CFC, any subpart F income it earns will be subject to current U.S. federal income tax by the corporation’s direct or indirect U.S. shareholders, regardless of whether the income actually is distributed.16
The significance of a CFC being eligible to pay qualified dividend income, but not a PFIC, is that if a foreign corporation is characterized as both a CFC and a PFIC for the current tax year, it will not be treated as a PFIC for those U.S. shareholders who own 10 percent or more of the voting stock of the foreign corporation.17 Accordingly, any dividends received from such as corporation will be eligible for the 15-percent tax rate, at least for those U.S. shareholders who own 10 percent or more of the QFC’s voting stock.
Notably, the coordination provisions between the CFC and FPHC rules did not similarly cause a FPHC that was also a CFC to be characterized only as a CFC. Thus, prior to the 2004 Act, a CFC that was also a FPHC could not pay qualifying dividends, whereas a CFC that was also a PFIC, but not a FPHC could do so. This was confirmed by the IRS in Notice 2004-70. Therefore, the repeal of the FPHC provisions by the 2004 Act may be significant if at least 60 percent (which was the amount that would cause a corporation to be considered a FPHC, if other requirements were satisfied), but less than 100 percent, of the foreign corporation’s income is passive income, because now, the foreign corporation’s active income will be eligible for the 15-percent tax rate, whereas before none of the foreign corporation’s income was eligible for the 15-percent tax rate, even if only 60 percent of its income was considered passive income.
Furthermore, a foreign corporation that was a FPHC in 2003 or 2004 could not distribute as a qualifying dividend its earnings and profits that were previously accumulated in years in which it was not a FPHC. For tax years beginning after 2004, however, this will no longer be an impediment to the distribution of such accumulated earnings and profits as qualifying dividends.
Ability to Use Holding Companies Under 2003 Act
As previously noted, if a foreign corporation earns income in a low or zero-tax jurisdiction, it generally will not be possible to repatriate such income to the U.S. in the form of qualified dividend income. If, however, a favorable holding company organized in a qualified foreign jurisdiction is interposed between the foreign operating company and the U.S. shareholder(s), it may be possible to convert the offshore income, which would otherwise be taxed at ordinary income rates when repatriated, into qualifying dividend income.
There are four main features that make an offshore holding company attractive from a tax perspective: 1) little or no withholding tax on incoming dividends paid from the subsidiary, 2) low or zero corporate income tax imposed by the holding company on dividends received from the subsidiary, 3) any gain realized on the sale of the shares of the subsidiary should either be exempt from capital gains tax or subject to tax at a low rate in the holding company’s jurisdiction, and 4) low or zero withholding taxes on outgoing dividends remitted by the holding company to the ultimate shareholders of the holding company.
Currently, there are a number of qualified foreign jurisdictions that have favorable holding company regimes, which can be used to repatriate low-taxed active income from nonqualified foreign jurisdictions to the U.S. in the form of qualified dividend income in a tax-efficient manner. These jurisdictions include: Denmark, Australia, Austria, Switzerland, and Cyprus.
Denmark. Denmark’s holding company regime is ideal for the repatriation of active income. Specifically, Denmark will not impose corporate income tax on inbound dividends if 1) the holding company owns at least 20 percent of the shares in the foreign subsidiary for at least one year, and 2) the foreign subsidiary must not be a “low-taxed finance company.” In addition, Denmark also will not impose withholding taxes on outbound dividends paid by the holding company provided a) the U.S. shareholder owns at least 20 percent of the shares in the Danish holding company, b) the shares of the Danish holding company have been owned for a continuous period of at least one year, during which time the dividend is declared, c) a treaty exists between the U.S. and Denmark that reduces the withholding tax rate on dividends, and d) the U.S. shareholder is a “company or similar entity.”
Australia. As of July 1, 2004, Australia’s holding company regime is ideal for the repatriation of active income in the form of qualified dividend income. Under this new regime, dividends received by an Australian holding company will be fully exempt from Australian corporate income tax so long as the holding company owns at least 10 percent of the voting shares in the lower-tier subsidiary. There is no holding period requirement necessary to get this tax free treatment. In addition, outbound dividends remitted by the Australian holding company to the U.S. will not be subject to withholding tax so long as the Australian holding company is capitalized 100 percent by equity.
Austria. Austria also has a favorable holding company regime for the repatriation of active income as dividends received by an Austrian holding company will be fully exempt from Austrian corporate income tax, regardless of the type of income earned by the subsidiary and whether the subsidiary is subject to an income tax in its jurisdiction. The only requirements are that 1) the subsidiary company must be comparable to an Austrian corporation, 2) the Austrian holding company must own at least 10 percent of the shares in the foreign subsidiary for a minimum period of 12 months, and 3) the Austrian holding company must affirmatively elect to have the participation exemption apply. In addition, outbound dividends remitted to the U.S. will be subject to a 15-percent withholding tax under the Austria-U.S. income tax treaty but the U.S. shareholders should be eligible to claim these taxes as a foreign tax credit, subject to the foreign tax credit limitation provisions.
Switzerland. Switzerland has a favorable holding company regime for the repatriation of active and passive income. Dividends received by a Swiss holding company will be fully exempt from Swiss corporate income tax, irrespective of the holding period of the shares, the type of income earned by the subsidiary, and whether the subsidiary is subject to corporate income tax in its jurisdiction. The only requirement is that the Swiss holding company must own at least 20 percent of the shares in the foreign subsidiary or the fair market value of the shares of the foreign subsidiary must be equal to at least CH f62 million. The main drawback of the Swiss holding company is that there will be a 35-percent withholding tax on outbound dividends. However, for U.S. taxpayers other than C corporations, the 35-percent withholding rate initially will apply but the taxpayer is then eligible to request a refund of 20 percent of that amount, resulting in a total tax liability of 15 percent under the U.S.-Switzerland income tax treaty. The U.S. shareholders should be eligible to claim these withholding taxes under the foreign tax credit provisions, subject to the foreign tax credit limitations imposed under §904.
Cyprus. Finally, Cyprus has a very favorable holding company regime for the repatriation of active income as dividends received by a Cyprus holding company will be fully exempt from corporate income tax so long as the holding company owns at least one percent of the shares of the foreign subsidiary, irrespective of the holding period of the shares. For the exemption to apply, Cyprus requires the foreign subsidiary to be subject to an income tax at a rate of at least five percent, but this rule applies only if more than 50 percent of the foreign subsidiary’s income is made up of passive income. Accordingly, as long as at least 50 percent of the foreign subsidiary’s income is active income, any dividends received by the Cyprus holding company should not be subject to corporate income tax in Cyprus, regardless of the tax rate in the subsidiary jurisdiction. Also, Cyprus does not impose withholding tax on outbound dividends paid to non-Cyprus shareholders, whether those shareholders are individuals or corporations.
Is Subpart F Income a “Dividend”?
As noted above, U.S. shareholders who directly or indirectly own at least 10 percent of the voting stock of a CFC must include in their incomes their pro rata share of the CFC’s subpart F income, irrespective of whether it is distributed. When §1(h)(11) was enacted, the question was whether subpart F income could be characterized as “qualified dividend income” and thus taxed at the 15-percent rate under §1(h)(11). To clarify the issue, the IRS issued Notice 2004-70 in October 2004. In this notice, the IRS confirmed that CFCs are eligible to pay qualified dividends but also specifically stated that deemed income inclusions under §951(a)(1) (i.e., subpart F inclusions and §956 inclusions) are not characterized as “dividends” under the Code and therefore cannot be taxed at the 15-percent rate. Accordingly, any subpart F income earned by the foreign holding company cannot qualify for the 15-percent tax rate.
This is where the third recent development becomes important. As previously indicated, foreign base company shipping income will no longer be a category of subpart F income starting in January of 2005. Thus, notwithstanding the fact that subpart F income cannot be treated as qualified dividend income, CFCs that are engaged in shipping related activities will be able to repatriate their earnings to the U.S. at a 15-percent tax rate, assuming the dividend is otherwise being paid from a qualified foreign jurisdiction.
Anti-Treaty Shopping Concerns
It should be noted that there are a number of potential arguments available to the IRS to challenge the legitimacy of the holding company structures discussed above, the most likely one being that the holding company is merely a “conduit” for the passage of dividend payments to the U.S. and therefore should be disregarded. In Aiken Industries v. Commissioner, 56 T.C. 925 (1971), the IRS successfully argued that interest payments made by a U.S. corporation to a Honduran corporation to collect such interest on behalf of a Bahamian corporation was not exempt from U.S. withholding tax under the U.S.-Honduras income tax treaty then in effect. The Tax Court, in agreeing with the IRS, reasoned that the Honduran corporation, while a valid resident under the U.S.-Honduras treaty, was a mere collection agent or “conduit for the passage of interest payments” from the U.S. entity to the Bahamian entity.
In the context of the holding company structures discussed above, however, a check-the-box election would be filed on behalf of the operating company, and therefore, the operating company would be treated as a branch of the holding company. Therefore, for U.S. federal income tax purposes, there would be no “back-to-back” payments between the operating company and the holding company, and the holding company and the U.S.. Accordingly, the IRS would have a more difficult time contending that the holding company is acting as a “conduit” for the passage of payments between the operating company and the U.S.
In addition, the limitation on benefits provisions contained in the particular treaties concluded between the U.S. and the holding company jurisdictions discussed above would all appear to be satisfied, which is a requirement under Notice 2003-69 for the foreign corporation to be considered a “qualified foreign corporation.” In particular, in the Australian, Austrian, and Danish income tax treaties that have been concluded with the U.S., the limitations on benefits provisions will be satisfied so long as 1) the foreign holding company is at least 50 percent owned by U.S. residents and 2) not more than 50 percent of the gross income of the foreign holding company is paid or accrued, in the form of deductible payments, to persons who are not residents of the U.S. or the jurisdiction where the holding company is formed.
Similarly, in the case of Switzerland, the limitations on benefits provision contained in the U.S.-Switzerland income tax treaty will be satisfied if 1) the ultimate beneficial owners of 95 percent or more of the shares of the Swiss holding company are seven or fewer residents of a member state that is a party to NAFTA (which includes U.S. residents),18 and 2) the amount of expenses that are paid out to persons that are neither U.S. citizens nor residents of a member state of the EU is less than 50 percent. Under the proposed structures discussed above, given that the foreign holding company would be 100 percent owned by U.S. residents and all or substantially all of the holding company’s income would be paid out to U.S. residents in the form of nondeductible dividends, these provisions should be satisfied.
On the other hand, in the case of a Cyprus holding company, it is not entirely clear whether the limitation on benefits provision would be satisfied when such a holding company is 100 percent owned by U.S. residents. Under the U.S.-Cyprus income tax treaty, the limitation on benefits provision generally will be satisfied if more than 75 percent of the shares of a Cyprus holding company are owned by residents of Cyprus, and the gross income of the Cyprus holding company is not used in substantial part to meet liabilities of persons who are residents of a state other than the U.S. or Cyprus. There is an exception, however, from this general rule, if it is determined that the establishment, acquisition, and maintenance of the Cyprus holding company and the conduct of its operations “did not have as a principal purpose obtaining benefits under the Convention.”
Clearly, in the proposed holding company structures discussed above, the general rule contained in the limitation on benefits provision of the U.S.-Cyprus treaty would not be satisfied because the Cyprus holding company would not be more than 75 percent owned by Cyprus residents. Accordingly, the question is whether the formation of the Cyprus holding company had as a principal purpose obtaining benefits under the U.S-Cyprus income tax treaty. Arguably, no treaty benefits are being obtained in the proposed structures as the qualified dividend income provisions and Cyprus’ participation exemption regime are both local law benefits. Equally persuasive, however, is the argument that the treaty benefit that is being obtained is the ability to use the treaty in the first place, which is a requirement under Notice 2003-69 in order for a foreign corporation to be considered a “qualified foreign corporation.” Until further guidance is issued, in the context of repatriating low-taxed foreign earnings it would be prudent to utilize a jurisdiction other than Cyprus, such as Australia, especially given the fact that the both Australia and Cyprus have similar requirements that need to be satisfied in order to take advantage of their participation exemption regimes (i.e., no holding period, no withholding tax on outbound dividends, etc.).
The tax planning opportunities for U.S. individuals to repatriate dividend income at the preferential 15-percent tax rate have been enhanced significantly by several provisions of the 2004 Act. In particular, the repeal of the FPHC provisions of the Code will allow a foreign corporation that otherwise was precluded from qualifying as a QFC because it was an FPHC to now qualify. As a result, U.S. individuals may be able to restructure their offshore holdings in order to repatriate foreign earnings that were not previously taxed under subpart F as qualifying dividends.
1 P.L. 108-357 (H.R. 4250).
2 Ernst & Young, “The Guide to the American Jobs Creation Act of 2004,” 2004 TNT 213-14 (Nov. 3, 2004).
3 All references to the term “section” refer to sections of the Internal Revenue of 1986, as amended, and to the regulations promulgated thereunder (the “Regulations”).
4 A “U.S. shareholder” is defined as a U.S. person that owns, directly, indirectly or constructively, 10 percent or more of the voting stock of a foreign corporation. Section 951(b).
5 A controlled foreign corporation is defined as a foreign corporation that is more than 50 percent owned, directly, indirectly, or constructively, by vote or value, by U.S. shareholders on any day during the taxable year. Section 957(a).
6 For purposes of this provision, dividends do not include amounts includible in gross income under §78, 367, or 1248. In addition, amounts included in gross income under §951(a)(1) (i.e., subpart F inclusions and §956 inclusions) are not treated as dividends for this purpose. Conf. Rept. No. 108-755.
7 35 percent tax rate x 15 percent of dividend that continues to be taxed.
8 While the statute does not specifically state that it is limited to C corporations, it is doubtful that S corporations would be eligible for the 85 percent dividend-received deduction. This follows from the fact that §1373(a)(1) provides that S corporations are to be treated as partnerships for purposes of subpart F of the Code, which now includes §965.
9 2004-44 IRB 724.
10 This benefit is scheduled to sunset after December 31, 2008.
11 2003-42 IRB 851.
12 Notice 2003-69 also indicates that in order to satisfy the “treaty test,” the foreign corporation must be a resident of the specified treaty and must also satisfy any other requirements in the treaty, including the limitation on benefits provision.
13 A FPHC was a foreign corporation that satisfied 1) an income test and 2) a stock ownership test. The foreign corporation satisfied the income test if at least 60 percent of its income consisted of FPHC income, which included, among other items, dividends, interest, rents, royalties, annuities, and gains from the sale or exchange of stocks or securities. The foreign corporation satisfied the stock ownership test if at any time during the tax year more than 50 percent of the corporation’s stock was owned by five or fewer individuals who were citizens or residents of the U.S. Section 552(a).
14 A foreign corporation was characterized as a FIC if two tests were satisfied 1) an activity test and 2) a stock ownership test. The activity test was satisfied if the foreign corporation was either 1) registered under the Investment Company Act of 1940 as a management company or as a unit investment trust, or 2) engaged primarily in the business of investing, reinvesting, or trading in securities, commodities, or any interest in securities or commodities. The stock ownership test was satisfied if 50 percent or more of the foreign corporation’s stock was owned by U.S. persons.
15 Section 957(a).
16 Section 951(a)(1).
17 Section 1297(e)(1). If, however, the foreign corporation was a PFIC prior to December 31, 1997, then it generally will continue to be characterized as a PFIC. Section 1298(b)(1).
18 See Announcement 2003-59, 2003-40 I.R.B. 746, which confirms that a U.S. resident will qualify as a party to NAFTA.
Jeffrey L. Rubinger is an associate in Holland & Knight’s Ft. Lauderdale office. He received his J.D. from the University of Florida and an LL.M. from New York University School of Law. Mr. Rubinger is admitted to the Florida and New York bars and is a certified public accountant.
William B. Sherman is a partner in Holland & Knight’s Ft. Lauderdale office. He received his J.D. from Brooklyn Law School and an LL.M. in taxation from New York University School of Law. Mr. Sherman is admitted to the Florida and New York bars.
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, Benjamin A. Jablow, and Normarie Segurola, editors.