Dividends Paid by Foreign Corporations – Are they “Qualified” & Eligible for Capital Gain Rates?

In IRS Notice 2024-11, the Internal Revenue Service (IRS) updated the list of treaties that can provide a foreign corporation with the special status of being a “qualified foreign corporation” (QFC).  The list was updated to include the treaty with Chile, which entered into force on December 19, 2023, and to remove the treaty with Hungary and the treaty with Russia.

A dividend paid to an individual shareholder from a QFC is “qualified dividend income” (QDI) and generally eligible to be taxed at the reduced capital gains rate (e.g., 20% maximum).  This is a huge benefit since “ordinary dividends” can be taxed at the maximum 37% ordinary income rate.

Dividends paid by a domestic (US) corporation are generally treated as QDI and taxed at the lower capital gain rates, but this is not the case with dividends paid by foreign corporations.  In order to pay QDI, a foreign corporation must meet the rigorous test of being a QFC.   (By now, readers of my blog will not be surprised to know that many US owners of corporations that are foreign, that is, not incorporated in the USA,  get the short end of the stick when it comes to US tax.).

Today’ post will explain the interplay between foreign corporations and eligibility for lower tax rates available only for “qualified dividends”.  It’s a more complicated topic than meets the eye.

Qualified Dividends

So, what is a “qualified dividend,” eligible for favorable tax rates?

As a general matter, the typical dividend paid by a US corporation is “qualified” and thus taxed at the favorable rates, discussed above. In comparison, dividends paid by foreign corporations are not as easily treated as “qualified”.  The tax rate for non-qualified, or ordinary dividends, is at a taxpayer’s ordinary income tax rates, which can be as high as 37%. (Don’t forget to add on the 3.8% NIIT, if applicable!). Since the qualified rates are lower than the typical income tax rate that applies to non-qualified, or ordinary dividends, a taxpayer can pay significantly higher taxes on a non-qualified dividend.

Qualified Dividend Paid by a Foreign Corporation

A dividend paid by a foreign corporation can be a “qualified” dividend provided certain requirements are met, including the shareholder meeting a minimum holding period for the stock. The tax law clearly defines what is meant by QDI at IRC Section 1(h)(11)(B)(i)(II)).  Under the rules, “qualified dividend income” means dividends received during the taxable year from domestic corporations and from “qualified foreign corporations.”

A QFC is defined by IRC Section 1(h)(11)(C)(i) as “any foreign corporation (subject to certain exceptions, for example, a PFIC) 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…..” This latter provision is generally referred to as the so-called “Treaty Test”.

A foreign corporation that does not satisfy either of these two tests can still possibly pay a qualified dividend if the dividend paid by that corporation is with respect to stock that is “readily tradable on an established securities market in the United States”. Section 1(h)(11)(C)(ii). Notice 2003-71, 2003-2 C.B. 922 defines the meaning of “readily tradable on an established securities market in the United States”.  Generally, this means the exchange is listed on a national securities exchange that is registered under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f) or on the Nasdaq Stock Market. According to the Notice as at Sept. 30, 2002, registered national exchanges, include the American Stock Exchange, the Boston Stock Exchange, the Cincinnati Stock Exchange, the Chicago Stock Exchange, the NYSE, the Philadelphia Stock Exchange, and the Pacific Exchange, Inc.

Treaty Test: Which Countries Have “Satisfactory” Treaties? 

The IRS has listed the countries determined to be “satisfactory” under the Treaty Test for purposes of paying “qualified dividends”. The countries are listed in the Appendix to Notice 2024-11, referenced above.

Merely because a country is listed, however, does not mean that dividends paid by a corporation established in that country will automatically qualify for the favorable “qualified dividend” treatment.  This may come as a surprise to many tax return preparers. In my experience, many do not understand the concept and simply believe if a treaty exists, the dividend paid by a foreign corporation qualifies! Not so. Other requirements must be satisfied before a foreign corporation can be treated as a QFC for purposes of paying “qualified dividends” to its shareholders.

Dig Deeper – Limitation on Benefits Clause

If  a corporation is formed in a country on the list, is mere incorporation in such a country sufficient to provide the benefits of  paying qualified dividends?  In a word, “no”!  The corporation itself must be “eligible” to receive the benefits bestowed by the relevant treaty.   Generally, this means that the foreign corporation must be a “resident” of the treaty country as required under the terms of the treaty.  Legislative history indicates that in determining if the foreign corporation is “eligible” for the benefits of the treaty, one must make the determination by examining whether the corporation itself would qualify if it were itself claiming treaty benefits.

One important aspect would be whether the treaty’s “Limitations on Benefits” (LoB) clause would apply to deny treaty benefits.  The IRS explains this concept as follows – “Limitations on benefits provisions generally prohibit third country residents from obtaining treaty benefits. For example, a foreign corporation may not be entitled to a reduced rate of withholding unless a minimum percentage of its owners are citizens or residents of the United States or the treaty country.”  A certain percentage of the foreign corporation’s shares must be owned by residents of either or both of the treaty countries. (Depending on the precise treaty terms, a corporation not meeting these tests may still qualify for example, if it is engaged in a trade or business in the treaty jurisdiction).

The LoB clause serves as a mechanism to limit application of the treaty and its benefits only to taxpayers actually entitled to receive them. Since the treaty is a type of contract entered into between two sovereign nations, the LoB clause is aimed at preventing members of third-party countries, not a party to the treaty, from exploiting its benefits. The LoB terms must be carefully examined as they may differ from treaty to treaty.

Dividends from “Controlled Foreign Corporations” (CFC)

What about dividends from CFCs?  This issue gets tricky because US shareholders in a CFC must currently include in income certain amounts even if no actual distribution  is made by the corporation. These are “Subpart F” income and so-called GILTI income.  Can such deemed inclusions be taxable as dividends and be treated as “qualified dividends” to US shareholders? These rules will be detailed in a later blog posting.

Posted January 4, 2024

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