Qualified Dividend Income Under the 2003 Tax Act
The 2003 Tax Act1 reduces federal income tax on Qualified Dividend Income (QDI) by throwing it into the net capital gain calculation for capital gains and losses. A taxpayer’s net capital gain will now be taxed at five percent if the taxpayer is in the 10 or 15 percent income tax bracket, and at 15 percent for taxpayers in the higher income tax brackets.2 Importantly, the new law saves these capital gains rate reductions from the dreaded alternative minimum tax (AMT) by imposing the same tax rates on adjusted net capital gain under the AMT as under the regular tax.3
The 2003 Act exacts a price, however, when taxpayers take advantage of the act’s reduced tax rates on dividends. Leveraged taxpayers claiming the reduced rates on QDI cannot count the dividend as investment income,4 which will in turn reduce the amount of interest expense the taxpayer may deduct. The investment interest rules generally limit a taxpayer’s deduction for such interest to the income from the taxpayer’s investments.5 As investment income other than QDI is the higher ordinary income rates, taking advantage of the lower rates on QDI may mean foregoing valuable investment interest expense deductions.
For example, consider a taxpayer in the highest marginal rate of 35 percent. The taxpayer pays $1,500,000 in interest used to purchase investment property yielding $1,000,000 in income and another $500,000 in QDI. Before the 2003 Act, the taxpayer could deduct all the interest because the taxpayer had as much interest income as interest expense. After the 2003 Act, the taxpayer loses $500,000 of interest expense deductions worth $175,000 after tax (.35 x $500,000 = $175,000). The taxpayer reduces tax on the dividends from $175,000 (.35 x $500,000 = $175,000) to $75,000 (.15 x $500,000 = $75,000), saving $100,000 in tax. But this costs the taxpayer deductions with an after-tax value of $175,000. So the taxpayer is $100,000 in the hole.
Fortunately, Congress foresaw this possibility. The 2003 Act amended the investment interest rules to allow taxpayers to elect to forego the reduced rates on QDI if they want to include the dividends in investment income and free up investment interest expense deductions they would otherwise lose.6 The Internal Revenue Service recently issued temporary and proposed regulations on making this election.7 Deciding whether to elect treating QDI as investment income and forego the reduced tax rates on QDI will be quite complicated. First, taxpayers make this election, and thus must perform the required analysis, on a year-by-year basis. Second, taxpayers will have to consider the effect of any investment interest expense carryovers they may have which they might not otherwise be able to use for several years. Third, taxpayers will have to include the AMT in their calculations. The AMT picks up some investment income not included in the regular tax,8 but correspondingly increases the AMT version of the investment interest expense deduction.9 Taxpayers can pay regular tax in one year and AMT the next. Taxpayers may also have minimum tax credit carryovers available10 but whose use may be problematical. In calculating whether to elect to treat QDI as investment income, all these factors will have to be considered.11
“Dividend” is a term of art. “Dividend” is not synonymous with “distribution.” The Internal Revenue Code does not define distribution, but does define “dividend.”12 A dividend is a distribution of property (including cash) out of the earnings and profits (E&P) of the distributing corporation.13 E&P is not the same as taxable income; the IRC has complicated rules spelling out the differences,14 which are beyond the scope of this article.15 E&P, like the AMT, more closely approximates the true earnings a corporation has available to distribute to its shareholders.
The 2003 Act makes all dividends paid by domestic corporations (see below for dividends from foreign corporations) eligible for QDI treatment except those specifically excluded: 1) dividends paid by corporations exempt from tax under IRC §501 or 521; 2) dividends which mutual savings bank deducts under IRC §591; and 2) dividends deducted under IRC §404(k) as paid to an employee stock ownership plan (ESOP).16
Dividends from pass-through entities such as a regulation investment company (RIC), real estate investment trust (REIT) or S corporation can be QDI. Individual shareholders of RICs and REITs will report as QDI that part of the dividend from the RIC or REIT which was QDI in the hands of the RIC or REIT. Capital gain distributions thus cannot count as QDI. As REITs must invest primarily in real estate, they will most likely have little QDI to pass on to their shareholders.17 The Service has issued guidance allowing qualifying partners under IRC §775 to use the simplified flow-through method of IRC §772 to take into account partner’s share of partnership’s QDI.18
Payments in lieu of dividends cannot be QDI. The statute does not specify this, but the legislative history is clear.19 Shareholders receive “in-lieu of” payments when they (or rather, their broker) lend their shares to another party. Brokerage agreements require the broker to return identical shares to the investor and reimburse him or her for all dividends paid on the stock while lent out. The investor’s position at the end of transaction thus does not change. But the tax law does not treat these in-lieu-of payments as dividends. Even the securities lending rules of IRC §1058, which may protect the investor from recognizing gain or loss, do not turn in-lieu-of payments into dividends.20
While the investor suffers no change in economic position, that legal position has changed greatly. The investor will receive in-lieu-of payments taxed not at the reduced rates for QDI, but at the full marginal rate for ordinary income. Most brokerage agreements allow the broker to borrow the investor’s shares, and the investor may not even know until the Form 1099 arrives in mail the next year. The new QDI rules make it imperative for investors to renegotiate the terms of their brokerage contracts to prohibit the broker from borrowing the shares.
Before the 2003 Act, only corporate investors needed to distinguish dividends from in-lieu of payments, because only corporations could claim a dividends-received deduction (DRD). The information reporting regulations presently require brokers report in-lieu-of payments separately from dividends only for corporate customers.21 Individual taxpayers now similarly need to distinguish dividends from in-lieu-of payments. The legislative history prods the Service to allow individual taxpayers to rely on the Forms 1099-DIV they receive from their brokers unless the taxpayer knew or had reason to know the payments were not dividends.22 Following this legislative mandate, the Service recently published guidance allowing taxpayers to rely on Forms 1099-DIV to treat as dividends any in-lieu-of payments erroneously characterized as dividends unless the taxpayer knew or had reason to know the payment was an in-lieu-of payment and not a dividend.23
Finally, while the new law allows extraordinary dividends as defined in IRC §1059 to count as QDI, it exacts a price: any loss on selling the shares is long-term capital loss to the extent of the QDI. An extraordinary dividend is one which exceeds five percent of the taxpayer’s adjusted basis in preferred stock, and 10 percent for common stock.24 A taxpayer receiving an extraordinary dividend must reduce the basis of the stock by the amount of the extraordinary dividend.25 Thus, a taxpayer receiving QDI as an extraordinary dividend will not only lose basis, but also recharacterize any later loss on selling the stock as long-term capital loss.
Dividends From Foreign Corporations
The 2003 Act gives the benefits of QDI to dividends from foreign corporations, but to a lesser extent than to dividends from domestic corporations. Dividends from qualified foreign corporations (QFC) are entitled to the reduced tax rates for QDI.26 Dividends from any other corporation are not.
A QFC includes corporations 1) incorporated in a U.S. possession (e.g., Puerto Rico);27 2) eligible for the benefits of a comprehensive income tax treaty with the U.S. that includes an exchange of information program;28 and 3) whose stock is readily tradable on an established U.S. securities market.29 In addition, the statute excludes from the definition of QFC any foreign corporation which, in either the year it pays the dividend or the preceding year, is 1) a foreign personal holding company (FPHC) under IRC §552; 2) a foreign investment company (FIC) under IRC §1246(b); or 3) passive foreign investment company (PFIC) under IRC §1297.30 These are generally foreign corporations either controlled by U.S. citizens or residents or whose assets consist mostly of investment assets such as stock, bonds, and other securities.
The Service recently issued guidance on QFCs. First, Notice 2003-7131 defines stock “readily tradable on an established securities market” as stock listed on national securities exchanges registered under §6 of the Securities Exchange Act of 193432 and the NASDAQ. Stocks listed on the OTC Bulletin Board or the pink sheets do not qualify.
Second, Notice 2003-6933 lists the income tax treaties the Service has concluded satisfy the requirements for comprehensive income tax treaties with an exchange of information program. Most of the U.S.’s current treaties qualify. Four treaties, however, do not. The Bermuda and Netherlands Antilles treaties are not comprehensive income tax treaties. The U.S.S.R. treaty, which applies to several of the former republics of the Soviet Union, has no exchange of information program. And the legislative history singles out the Barbados treaty for possibly giving benefits meant to avoid double taxation where none exists.34
Third, Notice 2003-7935 states the Service plans to develop a program under which foreign corporations could annually certify they meet these requirements. Simplified procedures would determine whether 1) the instrument on which the dividend is paid is debt or equity; and 2) the foreign corporation is not a FPHC, FIC, or PFIC. The notice also says the Service will develop simplified information reporting procedures for other purposes.
The PFIC rules may provide a loophole allowing a shareholder in a PFIC to treat PFIC dividends as QDI. As stated above, a PFIC cannot be a QFC and its dividends cannot count as QDI. The statute does not say a CFC (controlled foreign corporation) cannot be a qualified foreign corporation, so dividends from a CFC can be QDI. A foreign corporation can be both a CFC and a PFIC, however. A PFIC is any foreign corporation with passive income accounting for at least 75 percent of its gross income, or one with at least 50 percent of its assets producing passive income.36 A CFC is any foreign corporation where U.S. citizens or residents own more than 50 percent of its stock, measured by vote or value.37 Thus, a PFIC in which U.S. citizens or residents own more than 50 percent of its stock is also a CFC. In this case, the PFIC rules defer to the CFC rules. A U.S. shareholder of the PFIC/CFC will not treat it as a PFIC.38 The U.S. shareholder seemingly could treat the PFIC/CFC as a QFC and its dividends as QDI.
The 2003 Act requires the taxpayer to have owned the stock for a minimum period of time before its dividends are eligible to be QDI. The act imports and lengthens the holding-period rules of the corporate DRD. The taxpayer must hold the stock a minimum number of days during a window period straddling the ex-dividend date (the date on which the shareholder becomes entitled to the dividend). For common and most preferred stock, the 120-day window period starts 60 days before the ex-dividend date.39 The taxpayer must hold the stock for 61 days during this 120-day window.40 This requires the taxpayer to hold the stock on the ex-dividend date. For preferred stock dividends “attributable a period or periods aggregating more than 366 days,” the holding period increases to 91 days and the window increases to 180 days.41 The act also imports the day-counting conventions of the corporate DRD. The day of disposition counts, but not the day of acquisition.42 Most importantly, taxpayers cannot count days during which they hedged their risk of loss in a manner IRC §246(c) prohibits, especially by holding a position in substantially similar or related property (SSRP).
The SSRP test is far more than merely counting days. Unlike the legalistic and ineffective “substantially identical stock or securities” test of the wash sale rules,43 IRC §246(c)(4)(C) tests the economics of a hedge to determine if a taxpayer has unacceptably reduced the risk of loss on stock. This requires understanding and analyzing the economics of the hedge. Property is substantially similar or related to stock if the fair market values of the two are reasonably expected to vary inversely and reflect primarily the performance of a) a single firm or enterprise, b) the same industries, or c) the same economic factors such as (but not limited to) interest rates, commodity prices, or foreign-currency exchange rates.44 The SSRP rules give a relatively looser test for portfolios. A hedge reflecting the value of 20 or more stocks (such as an futures position on a broad-based index like the S&P 500) must meet an overlap test requiring possibly multiple iterations.45 Using index positions to effectively hedge stock portfolios without tolling the holding thus is relatively easier than doing so with single stocks. Finally, the regulations require deconstructing notional principle contracts to determine if any of its components meet the SSRP test.46 Taxpayers cannot hide behind the netting provisions of the standard International Swaps Dealers Association form agreements.
A pending technical corrections bill47 would slightly change the holding period requirements for both the corporate DRD and individual QDI rules to allow taxpayers to purchase stock the day before the ex-dividend date and still claim QDI or the DRD.48 Taxpayers would add a day to the window period, increasing it from 120 days to 121 days. Taxpayers would have to hold the stock for 61 days during the 121-day window beginning 60 days before the ex-dividend date. Similarly, taxpayers holding preferred stock with dividends “attributable a period or periods aggregating more than 366 days” would have to hold the stock for 91 days during the 181-day window beginning 90 days before the ex-dividend date.
The Service recently announced it will allow taxpayers to use the extended windows in the pending technical corrections bill.49 Curiously, the Service will allow the unusual reliance on a yet-to-be-enacted bill only for the QDI rules. The bill would make the same changes to the corporate DRD rules and the foreign tax credit rules, yet the Service will not allow taxpayers affected by those provisions to rely on the pending bill.50
The new law reducing tax rates on QDI presents those earning substantial dividend income the opportunity to greatly reduce their taxes. Most dividends paid by domestic corporations clearly will get the benefits of QDI. Some dividends from foreign corporations may not because the new law limits which foreign corporations can pay QDI. But the new law charges a price for the reduced tax rates. Taxpayers must hold the stock for a sufficiently long period of time and bear some real market risk. Clients actively and rapidly trading stocks—and not just day traders—must carefully monitor holding periods to avoid losing the benefits of QDI. Hedge funds structured as pass-through entities in particular should avoid inappropriately hedging risk of loss with their trading strategies unless they think the returns on their trading strategies outweigh the lost tax benefits. If not, their investors stand to lose substantial tax benefits. Evaluating a client’s potential investment in a hedge fund thus will require a complex analysis of not only trading frequency but also hedging strategies.
1 Section 302 of the Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. No. 108-27. All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986, as amended.
2 I.R.C. §1(h)(11)(A) includes QDI in adjusted net capital gain. I.R.C. §§1(h)(1)(B) and (C) tax net capital gains at five percent and 15 percent, respectively, based on the taxpayer’s income tax rate bracket.
3 I.R.C. §55(b)(3). The regular tax essentially is the income tax without the AMT. See I.R.C. §55(c).
4 I.R.C. §1(h)(11)(D)(i).
5 I.R.C. §163(d)(1).
6 I.R.C. §163(d)(4)(B), flush language at end.
7 T.D. 9147, 69 Fed. Reg. 47364 (August 5, 2004) (temporary); REG-171386-03, 69 Fed. Reg. 47395 (August 5, 2004) (proposed). Taxpayers make the election on Form 4952, “Investment Interest Expense Deduction” and must file the Form 4952 by the due date of the return (including any extension the taxpayer has obtained).
8 For example, the preference for interest on private activity bonds in I.R.C. §57(a)(5).
9 I.R.C. §56(b)(1)(C)(v).
10 See I.R.C. §53.
11 Perhaps recognizing this complexity, the temporary and proposed regulations on making the election take the rare and unusual step of allowing taxpayers to revoke this election. Most elections are irrevocable once made.
12 I.R.C. §316.
13 I.R.C. §316(a).
14 I.R.C. §312.
15 See generally Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations and Shareholders ¶8.01-8.04 (7th ed. 2002).
16 I.R.C. §1(h)(11)(B)(ii).
17 This may not be true with taxable REIT subsidiaries. I.R.C. §856(l) allows REITs to own taxable subsidiaries, and I.R.C. §856(c)(4) limits this to 20 percent of the REIT’s assets. The taxable REIT subsidiary thus may produce dividends which are QDI in the hands of the REIT’s individual shareholders.
18 Notice 2004-5, 2004-7 I.R.B. 489.
19 H. Conf. Rep. No. 108-126, 108th Cong., 1st Sess. 42-43 (2003).
20 Proposed Treas. Reg. §1.1058-1(d) would specifically deny such payments the status as dividends. LR-182-78, 1983-2 C.B. 644, 646.
21 Section 1.6045-2.
22 H. Conf. Rep. No. 108-126, supra note 19, at 42-43.
23 Notice 2003-67, 2003-40 I.R.B. 752.
24 I.R.C. §1059(c).
25 I.R.C. §1059(a).
26 I.R.C. §1(h)(11)(B)(i)(II).
27 I.R.C. §1(h)(11)(C)(i)(I).
28 I.R.C. §1(h)(11)(C)(i)(II).
29 I.R.C. §1(h)(11)(C)(ii).
30 I.R.C. §1(h)(11)(C)(iii)
31 2003-43 I.R.B. 922.
32 15 U.S.C. §78f.
33 2003-42 I.R.B. 851.
34 H. Conf. Rep. 108-126, supra note 19, at 42.
35 2003-50 I.R.B. 1206.
36 I.R.C. §1297(a).
37 I.R.C. §957(a).
38 I.R.C. §1297(e).
39 I.R.C. §1(h)(11)(B)(iii)(I), incorporating the holding-period requirements of I.R.C. §246(c).
40 Id. The statute phrases this in the negative by denying a DRD for stocks held for 45 days or less during the window period. Thus, a corporate taxpayer must hold the stock for at least 46 days to get the DRD. Correspondingly, an individual taxpayer must hold the stock for at least 61 days to treat a dividend as QDI.
41 I.R.C. §246(c)(2). Neither the code nor the regulations explain how a dividend is “attributable” to a time period. The legislative history also is silent, essentially parroting the statute. S. Rep. No. 1983 (1958), reprinted in 3 U.S.C.C.A.N. 4791, 4929 (1958). This may refer to preferred dividends paid after being in arrears for more than 366 days.
42 I.R.C. §246(c)(3).
43 I.R.C. §1091(a), (c) and (d). See H. Rep. 98-432, 98th Cong., 2d Sess. 1185-1186 (1984).
44 Treas. Reg. §1.246-5(b)(1).
45 Treas. Reg. §§1.246-5(c)(1)(i) and 1.246-5(d), Example 3.
46 Treas. Reg. §1.246-5(c)(7).
47 Tax Technical Corrections Act of 2003, H.R. 3654 and S. 1984, 108th Cong., 1st Sess. (introduced December 8, 2003, in the House by Chairman Thomas of the Ways and Means Committee and the following day in the Senate by Chairman Grassley of the Finance Committee). The two bills are identical. They have not made their way out of the Ways and Means and Finance Committees as of the publication date of this article.
48 Section 7(d) of H.R. 3654 and S. 1984, supra note 47, would add a day to the 90-day window of I.R.C. §246(c)(1)(A) and the 180-day window of I.R.C. §246(c)(2)(B), increasing them to 91 and 181 days, respectively. See William M. Paul, Qualified Dividend Income: Issues, Problems and Opportunities, 21 J. Tax. of Investments 139, 141 (2004).
49 Announcement 2004-11, 2004-10 I.R.B. 581.
50 Announcement 2004-11, supra note 49, lets taxpayers rely only on §2 of the bill. The changes to the DRD and foreign tax credit rules are in §7 of the bill.
Author’s note—On October 4, 2004, the President signed into law H.R. 1308, the Working Families Tax Relief Act of 2004. This codified the relevant parts of the Tax Technical Corrections Act of 2003 cited in this article in note 47. The Federal Register has not yet assigned a Public Law number as of October 5, 2004.
Nicholas Bogos is a member of The Florida Bar Tax Section and consults with equity and fixed-income derivative dealers on tax and structuring issues. He formerly was with the IRS Office of Chief Counsel in Washington, D.C., drafting financial product guidance such as the DRD regulations of Treas. Reg. §1.246-5.
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, BenjaminA. Jablow, and Normarie Segurola, editors.