Nonresident aliens and foreign corporations are subject to a U.S. gross basis withholding tax on U.S. source dividend income. Code Secs. 871(a)(1)(A) and 881(a)(1). The gross basis withholding tax is 30 percent (or lower treaty) rate. Code Secs. 1441 and 1442. Generally the place of incorporation of the payor of the dividend, will determine the source of the income. Code Secs. 861(a)(2)(A) and 862(a)(2). Dividend income will be U.S. source if it is paid by a U.S. domestic corporation. Code Sec. 861(a)(2). The source of dividend income from a foreign corporation is dependent upon whether more or less than 25 percent of its gross income is income effectively connected with its U.S. trade or business. If less than 25 percent of its income is effectively connected with a U.S. trade or business, then none of the dividend from the foreign corporation will be treated as U.S. source. Where more than 25 percent of its income is effectively connected with a U.S. trade or business, then the same portion of the foreign corporations total dividend will be U.S. source dividend income. Code Sec. 861(a)(2)(B).
305: United States Corporation
(A) In General
A corporation is deemed to be a U.S. corporation if it is incorporated under the laws of one of the fifty states of the United States of America or the District of Columbia. Code Sec. 7701(a)(4). A dividend paid by any other corporation, including a company organized in a U.S. possession, is a foreign source dividend.
Example 1: U.S.A. Corp. organized in the State of Florida paid a distribution, to a nonresident alien, which is classified as a dividend under U.S. tax law. That dividend payment to the nonresident alien is a U.S. source dividend subject to the 30% (or lower treaty) gross basis withholding tax.
Example 2: F Co. organized in Spain paid a distribution, to a nonresident alien, which is classified as a dividend under U.S. tax law. That payment is a foreign source dividend, which is not subject to the U.S. gross basis withholding tax.
(B) U.S. Corporations With 80 Percent Foreign Business Income
Generally, dividends paid by a U.S. corporation are U.S. source dividends subject to U.S. gross basis withholding tax. However where a U.S. corporation qualifies for the 80 percent foreign business exception, only a portion of its dividends will be U.S. source. Code Secs. 871(i)(2)(B) and 881(d). The 80 percent foreign business exception is met where during the preceding three years, at least 80 percent of the U.S. corporation’s gross income from all sources, was derived from the active conduct of a foreign trade or business. If the corporation has no gross income for such three-year period, the testing period shall be the tax year in which the payment is made. Code Sec. 861(c). Where the U.S. corporation meets the 80 percent foreign business exception, its dividend distributions will only be U.S. source to the extent of the company’s percentage of U.S. source gross income for the three preceding years.
Example 3: USCO organized in New York, earned 87% of its gross income from its foreign business during years Y1-Y3. In Y4 USCO paid a $1,000 dividend to Mr. NRA. Mr. NRA has $870 of foreign source income as a result of this dividend from USCO.
Example 4: New USCO was organized in Y1. During Y1 New USCO distributes a $100 dividend to Ms. NRA. During Y1, 95% of New USCO’S gross income was from its foreign business. Therefore, $95, which was received by Ms. NRA is foreign source and $5 is U.S. source dividend income.
(C) Multiple Tier Dividend
Determining the source of income where there are multiple distributions through tiers of corporations becomes more difficult, since the general rule looks to the country of incorporation of the company paying the dividend to determine the source of the dividend income.
Example 5: USCO pays a $100 distribution, which is characterized as a U.S. source dividend and subject to the 30% gross basis withholding tax. F Co. distributes the $70 which it earned as a net dividend distribution to its NRA shareholder. The distribution from USCO to F Co. is a U.S. source dividend. The general rule would provide that the $70 dividend from F Co., which is not incorporated in any country within the 50 states or the District of Columbia, is a foreign source dividend to its NRA shareholder.
Over the years, tax planners have used intermediate foreign companies to recharacterize U.S. source income as foreign source income. One tax planning strategy was to have an intermediate foreign company organized in a country which had a U.S. tax treaty exempting dividends from U.S. taxation. The U.S. company would pay a dividend to the intermediate foreign company which was not subject to U.S. gross basis withholding tax pursuant to a tax treaty. This foreign company would then repatriate the dividend to the ultimate beneficial NRA or foreign corporation without any withholding tax. The benefit of this structure was to allow an NRA or foreign corporation to obtain the benefits of a U.S. tax treaty with a country where they are not a resident.
Example 6: Same facts as Example 5 except that F Co. is organized in a country which has a U.S. treaty that reduces U.S. withholding tax on dividends to 5%. USCO pays a $100 dividend to F Co., which qualifies for a treaty reduced 5% U.S. gross basis withholding tax. F Co. receives $95 net of reduced U.S. withholding tax, which it can then distribute as a foreign source dividend to its NRA shareholder. The general sourcing rule resources the $95 dividend from F Co. as a foreign source dividend when received by its NRA shareholder.
Most U.S. tax treaties now have anti treaty shopping provisions, which prohibit nonresidents of a particular country from obtaining the benefits of a U.S. tax treaty with that country. This would prohibit a NRA or foreign corporation from forming an intermediate F Co. in a country which has a U.S. tax treaty, as described in Example 6 above, unless they were also residents of that country or another country which provides similar U.S. tax treaty benefits.
Furthermore, regulations have been adopted to deal with conduit financing arrangements (see ¶245 (B) above). They mandate that any intermediate foreign companies will be ignored for purposes of characterization of the type of income and for purposes of sourcing dividend income. Where a financing arrangement is characterized as a conduit financing arrangement, the U.S. withholding agent is required to withhold on payments to any conduit entity as though the conduit entity is disregarded and they should withhold the amount of tax as though the payment was made directly from the U.S. payor to the ultimate recipient of the income. Code Sec. 1441 and Reg. § 1.881-3(d). Furthermore, the U.S. withholding agent is to ignore any tax treaty benefits which maybe available to the intermediate conduit entity.
Example 7: U.S. brokerage pays U.S. source dividends from F Co.’s U.S. stock portfolio. F Co. is organized in a country whose U.S. tax treaty permits treaty shopping (very few still remain in existence). Mr. NRA a resident of a South American country, which doesn’t have a tax treaty with the U.S., is the ultimate beneficial owner of F Co. Where there is no substantial economic reason for F Co.’s existence, the conduit entity regulations will re-characterize the distribution from the U.S. brokerage as U.S. source dividends paid from the various U.S. corporations directly to Mr. NRA and all of these U.S. source dividends will be subject to U.S. gross basis withholding tax. Reg. § 1.881-3.
315: Foreign Corporations
(A) In General
Dividends from a foreign corporation (one not organized under the laws of one of the fifty states or District of Columbia) or a U.S. possession are foreign dividends. Code Sec. 862(a)(2). This is in conformity with the general rule that dividends are sourced based upon the place of incorporation of the payor. With the exception of the conduit financing principles discussed herein, where a foreign corporation has a De minimis amount of U.S. business income, a dividend payment from a foreign corporation will be treated as foreign source.
(B) Foreign Corporation with 25 Percent or Greater U.S. Income
Foreign corporations which derive 25 percent or more of their gross income from sources which are effectively connected with a U.S. trade or business, shall have a portion of their dividends re-sourced as U.S. source dividends. Code Sec. 861(a)(2)(B). Where the foreign corporation, during the three period preceding the year in which the dividend is declared, has 25 percent or more of its gross income from a U.S. trade or business, the same portion of its dividend will be U.S. source. The portion of the foreign corporation’s dividend which is re-sourced as U.S. source dividend is determined as follows:
Gross income effectively
connected with a trade or business Dividend income
within the U.S. for the three-year period x Dividend = from sources
Total gross income for the three-year within the U.S.
period from all sources
Example 1: F Co. had during Y1 - Y3 $390,000 of U.S. source effectively connected gross income and $1,000,000 of worldwide gross income. In Y4, F Co. makes a dividend of $100,000; $39,000 of this dividend will be U.S. source and any NRA or foreign corporation receiving a dividend from F Co. in Y4 will have 39% of their dividend treated as U.S. source subject to U.S. gross basis withholding tax on that portion of F Co.’s dividend.
(C) Foreign Corporation Subject to Branch Profit Tax
The applicability of resourcing a portion of a foreign corporation’s dividends as U.S. source, as mentioned above, has been greatly reduced as a result of the enactment of the branch profits tax for tax year beginning after 1986. Where a foreign corporation is subject to branch profit tax on its U.S. source earnings, then there is no resourcing of its dividend payments. Code Sec. 884(e)(3)(A). The branch profit tax already provides for a 30% withholding tax on the deemed dividend equivalent amount available for distribution, but not actually distributed, by the U.S. branch of the foreign corporation. Code Sec. 884.
Therefore the resourcing of dividends for foreign corporation with 25% or greater U.S. source income, should only occur where the foreign corporation is a qualified resident of a country which has a tax treaty with the United States which prohibits the branch profit tax.
(D) Foreign Corporate Distributions with U.S. Domestic Corporate Earnings and Profits
Where a foreign corporation acquires the earnings and profits of a domestic corporation in a reorganization, merger or other combination, then dividends paid by a foreign corporation will be treated as U.S. source if:
(1) The foreign corporation has succeeded to the earnings and profits accumulated by the domestic corporation during the period with respect to such corporation was subject to tax as a U.S. corporation and
(2) The foreign corporation paid the dividend out of such earnings and profits (see e.g. Georday Enterprises, Ltd. v. Comm., 126 F. 2d. 384 (4th CIR 1942).
Example 2: USCO was organized in the State of Delaware and had earnings and profits during its first 10 years of business of $1,000,000. USCO was merged into F Co. in year 11. At the end of year 11, F. Co. distributed all of its current and accumulated earnings of $1,200,000. $1,000,000 of this distribution would be re-characterized as U.S. source dividend income subject to U.S. gross basis withholding tax. Code Sec. 243(a).
325: Domestic International Sales Corporation (DISC) and Foreign Sales Corporation (FSC)
(A) In General
Both of these types of corporations focus on non U.S. sales and have special source of income rules relating dividend distributions from these types of entities. Basically, a portion of the dividends equal to a portion of the total revenue produced from certain sales would be treated as foreign source or U.S. effectively connected income pursuant to each entity’s special sourcing rules; regardless of where the entity making the distribution was organized.
The pre 1985 system of tax deferral for DISCs has generally been replaced by the system of FSCs. However, DISCs have not been entirely abolished. A shareholder of a DISC may defer income up to $10,000,000 or less for qualified U.S. export receipts. However the shareholder must pay an interest charge every year on the deferred tax liability.
For more details regarding DISCs, see Stand. Fed. Tax Rep. (CCH) ¶ ____.
As mentioned above DISCs generally have been replaced by the FSC system. Under this system a portion of the foreign trade income of the FSC will be exempt from tax at the corporate level, provided it is derived from the foreign presence and foreign economic activity of the FSC.
In order to qualify as an FSC, a corporation must meet certain requirements. Reg. § 1.921-2. Where the requirements are met, the corporation will be treated as an FSC, provided it makes an election in accordance with the procedural requirements for electing FSC status. Code Sec. 927(f). The requirements for an FSC are designed to insure that the corporation actually derives its economic activity from a foreign presence.
For more details regarding FSCs, see Stand. Fed. Tax Report (CCH) ¶.
(D) Special Dividend Sourcing Rules for DISC and FSC
The dividends from these two types of entities are not sourced according to the general rule which is based upon where the corporation is incorporated. They are sourced based upon special rules, which look at the type of income which these entities generate.
(1) DISC Dividend Sourcing Rule
Dividends received from a DISC or a former DISC are treated as U.S. source income, except for that portion which may be attributable to “qualified export receipts.” Code Sec. 861(a)(2)(D). The definition of “qualified export receipts” is set forth in Code Sec.993(a)(1). It generally includes gross receipts from the sale or other disposition of property for export outside of the United States. Certain income from interest and gains, described in Code Sec.995(b)(1), are excluded from the definition of qualified export receipts: 1. interest from producer’s loans, 2. gain realized from the disposition of property other than a qualified export asset, and 3. gain realized from the disposition of certain non-inventory property, provided the gain would have been ordinary income to the transferor.
Actual and deemed DISC dividends are sourced as follows:
(a) Deemed distributions that are taxable dividends pursuant to Code Secs. 995(b)(1)(A), (b)(1)(B) and (b)(1)(C) are treated as completely U.S. source income.
(b) Deemed distributions that are taxable dividends pursuant to Code Secs. 995(b)(1)(D), 995(b)(1)(E) and 995(b)(1)(F) are treated as completely foreign source, provided the DISC had no “nonqualified export taxable income” which is defined in Reg. §1.861-3(a)(5).
(c) If there was “nonqualified export taxable income” during the preceding year, a portion of the dividend deemed taxable under Code Secs. 995(b)(1)(D), 995(b)(1)(E) and 995(b)(1)(F) is treated as U.S. sourced and the remainder is treated as foreign source. The U.S. source portion is computed by dividing the sum of the Code Secs. 995(b)(1)(D), 995(b)(1)(E) and 995(b)(1)(F) distributions by the difference between the DISC’s taxable income for that year and the Code Secs. 995(b)(1)(A), (b)(1)(B) and (b)(1)(C) distributions.
(d) If there is no “nonqualified export taxable income” that may be attributable to the “accumulated DISC income”, for the preceding tax year, then any dividend that reduces the “accumulated DISC income” may be treated as completely foreign source.
(e) If there is “nonqualified export taxable income” that may be attributable to the “accumulated DISC income” for the preceding tax year, then a portion of any dividend that reduces the “accumulated DISC income” is U.S. source and the remainder may be treated as foreign source. The U.S. source portion is computed by dividing the “accumulated DISC income” attributable to “nonqualified export taxable income” by the total accumulated disc income. Reg. § 1.861-3(a)(5).
Any dividend, or portion thereof, that is treated as foreign sourced under the above-mentioned rules is treated by Code Sec.901(d) as a dividend from a foreign corporation. Therefore, domestic corporate shareholders holding 10% or more of a DISC’s voting stock can benefit from the Code Sec.902 deemed paid foreign tax credit for foreign taxes paid by the DISC.
(2) FSC Dividend Sourcing Rule
Dividend distributions to an NRA or foreign corporate shareholders made by an FSC out of earnings and profits attributable to “Foreign Trade Income” shall be treated as U.S. source income. Code Sec. 926(b). Dividends from an FSC shall be treated as first made out of earning and profits attributable to “Foreign Trade Income” and then out of other earnings and profits. Code Sec. 926(a). FSC distributions made out of other earnings and profits are considered to be foreign source income under the general rule that dividends are sourced where the company is incorporated. Reg. § 1.926(a)-1.
Furthermore, the regulations treat any distribution made to any foreign entity that would be treated as a pass-through entity under U.S. law as having been made directly to the beneficiaries or partners of such entity in proportion to their respective interests. Temp. Reg.§1.926(a)-1T(a). Distributions from a FSC to a foreign trust, estate, or partnership, that are made out of other earnings and profits are foreign source to the ultimate beneficiaries or partners.
For more detail regarding sourcing FSC distributions see Stand. Fed. Tax Rep. ¶ _________.
335: Possessions Corporations
The possession tax credit is terminated for tax years beginning after December 31, 1995. However, there is a special phase-out rule which allows existing credit claimants, a portion of credit attributable to their active business income from a U.S. possession. In determining the amount of the credit there must first be a determination of the U.S. possession source income.
Dividends paid by a qualified domestic corporation, which has made a valid Puerto Rico and Possession Tax Credit election pursuant to Code Sec. 936, are foreign source dividend income. Code Secs. 861 (a)(2)(A) and 862 (a)(2). To qualify for the Code Sec. 936 election, 80% or more of the corporation’s gross income must come from sources within a possession of the United States for the preceding three years or the period of corporate existence, whichever is shorter. Code Sec. 936(a)(2)(A). Additionally, at least 75% of the corporation’s gross income must be derived from the active conduct of a trade or business within a possession of the United States. Code Sec. 936(a)(2)(B).
345: Distributions Qualifying as a Dividend
(A) In General
U.S. law measures a corporation’s ability to make distributions which will be classified as a dividend based upon that corporation’s earnings and profits. A distribution by a corporation is treated as a dividend to the extent the corporation has either accumulated earnings and profits (Post February 28, 1913 year’s earnings) or has current earnings and profits. Code Sec. 316. Current earnings and profits include earnings and profits for the entire tax year in which the dividend is paid. Current year earnings and profits are not reduced by any deficit in earnings and profits from prior years.
Example 1: USCO had earnings and profits in Y1 of $200,000 and distributed to its shareholders $350,000. Only $200,000 is classified as a dividend distribution. The other $150,000 is a tax-free return of capital or a capital gain where this amount is in excess of the shareholders cost of its USCO stock. Either way the $150,000 would not be subject to U.S. tax by a NRA or foreign corporation.
Example 2: USCO started a new business in Y1 and lost money until Y3. In Y4 USCO had earnings and profits of $50,000. In Y4 USCO distributed $50,000 to its shareholders. USCO’s shareholders will have U.S. source dividend income of $50,000, since the distribution is deemed to come all out of Y4 earnings and Y4 earnings are not reduced at all by Y1-Y3 deficits in earnings and profits.
Earnings and profits are calculated according to prescribed rules within Code Sec. 312. Earnings and profits are not equal to U.S. taxable income, nor are they exactly equal to financial earnings. A computation of earnings and profits require either adjustments to taxable income or book income to arrive at earnings and profits for U.S. tax purposes. To determining whether you have an issue as to whether your distribution from a U.S. corporation is going to be taxable as a dividend, a rough rule of thumb would be that where that corporation has financial accounting current income or accumulated retained earnings, then that corporation may very well have earnings and profits for U.S. tax purposes. While book financial current income and retained earnings are not equivalent to earnings and profits for U.S. tax purposes, there is a good chance that where current book income or accumulated earnings exist, that the corporation will have earnings and profits for U.S. tax purposes.
(B) Substitute Dividend Payments
A substitute dividend payment is a payment, made to the transferor of a security in a securities lending transaction or a sale/repurchase transaction, of an amount equivalent to a dividend payment, which the owner of the transferred security is entitled to receive during the term of the transaction. Where securities are loaned to a borrower in return for payments characterized as other than a dividend, then the IRS will re-characterize the substitute payments on the debt instruments as a dividend on these loaned securities. Reg. § 1.861-3(a)(6).
A securities lending transaction is a transfer of one or more securities described in Code Sec. 1058(a) or a substantially similar transaction. A Code Sec. 1058 transaction provides for nonrecognition of gain or loss upon the transfer of security where pursuant to an agreement:
1. the borrower must return to lender securities identical to the securities transferred;
2. the borrower must make payments to the transferor of an amount equivalent to all amounts received on the borrowed securities; and
3. the transferor does not reduce it’s risk of loss or it’s opportunity for gain on the securities transferred to the borrower. Code Sec. 1058(b).
A sale and repurchased transaction is an agreement under which a person transfers a security in exchange for cash and simultaneously agrees to receive substantial identical securities from the transferee in the future in exchange for cash.
A substitute dividend payment shall be sourced in the same manner as the distributions with respect to the transferred security, for purposes of the gross basis withholding tax.
Example 3: U.S. Brokerage Company transfers to U.K. Brokerage Company stocks of U.S. corporations, which distribute more than $1,000,000 a year in U.S. source dividends. There is an agreement that the U.K. Brokerage Company will transfer identical securities to the U.S. Brokerage Company in the future, make payments of substantially equivalent amounts (e.g. $1,000,000 per year) and the U.S. Brokerage Company maintains the risk of loss should the U.S. corporations go bankrupt or otherwise while the U.K. Brokerage Company hold their shares. The substitute payments from the U.K. brokerage firm, which would be foreign source dividends to the U.S. brokerage firm or to U.S. brokerage firm’s NRA clients, is resourced as U.S. source dividend income. Therefore, the $1,000,000 which is paid from the U.K. Brokerage Company to the U.S. which is then repaid to NRAs or foreign corporations will not retain its foreign source character, but will be converted to U.S. source dividend income pursuant to the substitute dividend payment provisions. Reg. § 1.861-3(a)(6).
(C) Stock Dividend
Generally a distribution of additional shares of stock from a U.S. corporation is nontaxable. Code Sec.305. Stock dividends are taxable where they are used as some form of disguised dividend. A stock dividend would be a disguised dividend where the shareholder can receive a dividend instead of money or where some shareholders receive stock while other shareholders receive money or other property or where there is distribution of common and preferred stock with different types of stocks being distributed to different shareholders. For further discussion see Stand Fed.Tax Rep. (CCH) ¶____________.
(D) Constructive Dividend
Where a U.S. company makes a distribution which is characterized as other than a dividend (e.g. interest payment, compensation for services, etc.) which is later re-characterized as a constructive dividend, this will be treated as a dividend for U.S. gross basis withholding tax. The essential item to remember is that the U.S. gross basis tax is imposed on payment of a U.S. dividend. Therefore where a U.S. company accrues an interest expense, which is later determined to be a dividend since the instrument is lacking all the indicia of valid indebtedness and is from the shareholder, then there can be no U.S. gross basis tax until there is actual payment of the amount accrued for book financial accounting purposes.
Example 4: USCO is owned by brother NRA. Sister NRA makes a loan to USCO. The loan from sister NRA to USCO lacks all the indicia of bona fide indebtedness (e.g. no note evidencing the indebtedness, USCO does not have collateral, the market rate of interest is higher than customary, etc.). Sister NRA’s loan qualifies as valid portfolio indebtedness, the interest upon which is exempt from U.S. taxation. During Y4 USCO pays sister NRA all the interest from Y1 through Y4. The IRS later determines and re-characterizes the interest payment to sister NRA as a constructive dividend from USCO. There would be no U.S. gross basis withholding tax on Y1 through Y3 as a constructive dividend would have been accrued but not paid. In Y4 the constructive dividend would be subject to U.S. gross basis withholding tax on full amount of the payment.
(E) Consent Dividend
A consent dividend is a dividend distribution to the corporations qualifying shareholders on the last day of the tax year provided the shareholder files an election to treat the distribution as an actual distribution. Reg. § 1.565-1(a).
The corporations which qualify to have their shareholder elect a consent dividend are U.S. Personal Holding Companies, Foreign Personal Holding Companies, Regulated Investment Companies (RIC), Real Estate Investment Trust (REIT) or a company that is subject to accumulated earnings tax. For more information see Stand Fed. Tax Rep. (CCH) ¶____________.
Even where there is no payment made to the foreign shareholders, a consent dividend is taxable to a foreign shareholders during each year which the corporation has earnings, after they have consented to treat the earnings of a particular corporation as though they were an actual dividend distribution. Reg. § 1.565-1(c)(4).
(F) Capital Gain Dividends
Capital gain dividends paid by a Regulated Investment Company (RIC) or a Real Estate Investment Trust (REIT) are generally not subject to gross basis withholding tax. However, capital gains dividends paid by a REIT may subject a foreign shareholder to U.S. net basis FIRPTA tax where the gain is attributable to gain from the sale of a “U.S. Real Property interest” by the REIT. Code Sec. 897 (h)(1).
(G) Redemptions and Liquidating Distributions
A redemption, which is a payment from a U.S. company in exchange for redeeming and canceling its shares may be treated as a dividend. Generally a distribution by a corporation in redemption of its own stock is treated as a distribution as part or full payment in exchange for the shareholder’s stock. Code Sec.302(a). However, where the redemption is really essentially equivalent to a disguised dividend or is disproportionate with some shareholders being redeemed while others remain, then the redemption will be re-characterized as a dividend which is subject to U.S. gross basis withholding tax. Code Sec. 302(b). Further discussion of redemption’s being treated as dividends see Stand Fed.Tax Rep. (CCH) ¶____________.
Where a company completely liquidates and distributes cash and property to the NRA or foreign corporation shareholders in liquidation and cessation of their business, this should be treated as a distribution in full payment in exchange for the shareholders’ stock and not as a dividend. Generally, any gain which a foreign shareholder recognizes on a the liquidation of a U.S. corporation will be nontaxable.
355: Investments Producing U.S. Dividend Income
(A) Stock in the Domestic Corporation
Dividends paid by U.S. corporations (which do not qualify for the 80 percent foreign business exclusion) are subject to the gross basis withholding tax. Dividends can be paid on common stock or on preferred stock.
The use of preferred stock is one of the most common methods for giving one class of investors a priority in earnings. Preferred shares can have various characteristics. They can be preferred as to current earnings or they can be preferred as to receiving distribution of current and accumulated earnings prior to any distribution on common shares.
Preferred stock usually has a preferred rate of return which yields dividends comparable with similar debt instruments and which get paid prior to any payment on common stock. For U.S. tax purposes, the fact that the dividend has a promised annual return and is paid prior to common shareholders does not impact its classification as dividend income subject to U.S. gross basis withholding tax.
Caution: Any distribution on any type of stock in excess of earnings and profits, will be re-characterized first as a return of capital and then as capital gain to the extent it exceeds the original investment in the stock.
(B) Money Market Mutual Fund
A money market mutual fund is a domestic corporation which invests in money market debt instruments thereby diversifying the risk from any one particular investment and obtaining a higher rate of return as a result of its mix of debt instruments. Distributions from these domestic corporations are still classified as dividends from U.S. domestic corporations to the extent of their earnings and profits. Code Sec 861(a)(2). This is true even where the money market mutual fund invests in short term OID indebtedness or state municipal bonds which would have been exempt from tax where the nonresident alien or foreign corporation invested in these type of investments directly.
Planning Note: The use of a U.S. partnership, a U.S. LLP, a U.S LLC or a U.S. trust to invest in otherwise exempt debts such as short term OID obligations or state tax exempt bonds would be a more profitable vehicle, since the income from these passthrough type investment vehicles maintain its tax exempt character in the hands of the ultimate foreign partner or foreign beneficiary.
A money market mutual fund may passthrough the tax exempt character of its income to its foreign shareholders where it qualifies and elects to be treated as a RIC (see ¶ 345 (D) below).
(C) Stock Mutual Funds
Over the past several years, investments in U.S. mutual funds have become a preferred vehicle for investors, since a mutual fund invests in diversified stock investments which reduces the impact of any one particular stock’s performance on the performance of the total mutual fund portfolio. Dividends paid by the U.S. corporation mutual fund, which invests in U.S. corporation stock, should be treated as dividend income to the extent of the funds earnings and profits. Code Sec. 861(a)(2).
A stock mutual fund may passthrough the tax exempt character of its income to its foreign shareholders where it qualifies and elects to be treated as a RIC (see ¶ 345 (D) below).
(D) Regulated Investment Companies (RIC)
A U.S. corporation that derives at least 90 percent of its gross income from dividends, interest, payments with respect to stock and securities loans, and gains from sale or other dispositions of stock, securities, or foreign currencies and meets certain other requirements may elect to be taxed as a RIC. Code Sec. 851. Where a RIC currently distributes 90 percent of its dividend and interest income and meets certain other conditions, it is not taxed on amounts distributed to its shareholders. Where a RIC satisfies the distribution requirements, it will generally be taxed as a passthrough entity. This results from allowing the RIC to deduct the amounts distributed to its shareholders and thereby passthrough to the shareholders the income and the character of the income earned by the RIC. A RIC can passthrough the character of its capital gain income as well as its exempt interest income.
Most U.S. mutual funds today elect to be taxed as a RIC, because of the above-mentioned benefit of being treated as a passthrough entity and the benefit of being able to passthrough capital gain and exempt income to its shareholders.
The taxation of the RIC shareholders depends upon the distribution which they receive. A RIC can distribute ordinary dividends, return of capital distributions, capital gain dividends and exempt interest dividends. Reg. § 1.852-4. For foreign shareholders, the only distribution from a RIC which will be subject to U.S. gross basis withholding tax is a distribution of its U.S. source dividend income. Therefore, foreigners will not be subject to U.S. gross basis withholding tax on return of capital distributions, capital gain dividends, and exempt interest dividends passed through to them from a RIC. For further discussion of RICs see Stand Fed.Tax Rep. (CCH) ____________.
(E) Real Estate Investment Trusts (REIT)
A Real Estate Investment Trust (REIT) is a corporation, trust or other association that specializes in investments in U.S. real estate and real estate mortgages. A foreign corporation cannot be a REIT. Rev Rul.89-130, 1989-2 C.B. 117. Like a mutual fund, a REIT brings together a pool of capital to invest in mortgages, real property, or both. The income from the Real Estate or from the mortgages is divided among the shareholders after the manager has paid the associated expenses.
The shares of a REIT are traded on two major stock exchanges as well as on the NASDAQ market. REITS have enjoyed numerous gains in popularity in recent years and there are many to chose from. Certainly, they provide a far more liquid approach to invest in Real Estate than owning a house or an office building. They also offer the investor the opportunity to diversify amongst several real estate properties in different geographical areas.
A REIT which distributes at least 95% of its taxable income for the tax year and complies with certain record keeping requirements is taxable like any other U.S. corporation, with the major difference that a REIT is entitled to a deduction for the dividends it pays its shareholders. Code Sec. 857(b)(2)(B). Like a RIC, a REIT will have only one level of taxation where it distributes all its income to its shareholders.
REIT shareholders are taxed on distributions of ordinary income in the same manner as any other corporate distribution, except where the REIT has a net capital gain and designates part of its distributions as a capital gain dividend, then that portion is taxable to the REIT shareholders as long term capital gain. As a result, the REIT’s income and capital gains generally are taxed only at the owner’s level, either as ordinary income or capital gains, depending on whether or not the distribution is a capital gain dividend. Code Secs. 856 & 857(a)(1).
NRA and foreign corporation REIT shareholders will be subject to the 30% U.S. gross basis withholding tax to the extent that the REIT distributes ordinary income. Where the REIT distributes dividends or capital gains that are attributable to a sale or exchange by the REIT of a “United States Real Property Interest”; foreign shareholders will be taxed on a net basis as though these gains were realized in connection with a U.S. trade or business and will be subject to normal U.S. tax rules. Code Sec. 897(a)(1). It is not entirely clear whether all REIT dividends are to be treated as effectively connected with a U.S. trade or business are only those dividends characterized as capital gain dividends under Code Sec. 857(b)(3)(B). We will have to wait for Treasury Regulations and case law to clarify this ambiguity. For further discussion of REITs see Stand Fed.Tax Rep. (CCH) ____________.
365: Resourcing Dividends
(A) Conduit Intermediaries
Dividends that are paid by a foreign corporation can be reclassified as U.S. source dividends subject to the gross basis withholding tax, where the foreign payor is part of a conduit financing arrangement. Where the foreign corporation is deemed to be a intermediary between the U.S. payor and the ultimate foreign beneficiary, then the IRS may disregard the intermediary foreign corporation and treat the distribution as directly from the U.S. corporate payor directly to the ultimate beneficial owner. This will usually involve a foreign intermediary, that can claim the benefits as a resident of a country which has a reduced gross basis withholding tax on U.S. source dividends pursuant to a tax treaty with the U.S.
(B) Resourcing Dividends upon Subsequent Payment to Beneficial Owner
Where dividends are received by an entity and then re-distributed to the ultimate beneficiary, the source rules that are applied to the beneficiary depend on the type of entity that originally received the dividend.
Dividend income received by a C corporation is taxable to it as either U.S. or foreign source income. When the foreign corporation distributes the after-tax dividend income to its shareholders, the income loses its U.S. source character. The source of dividend income is then determined according to the general sourcing rules for dividend income. Accordingly, a foreign corporation which is not engaged in a U.S. trade or business and which receives U.S. source dividend income, acts as a converter for such income because the dividends paid by it are generally considered foreign source.
A partnership is not a taxable entity and the items of gross income are treated as belonging to the partners in accordance with their respective “distributive shares.” Code Sec. 702(a). When a partnership receives dividend income, each partner must report its distributive share of such income and the source of such income carries over to each individual partner. Code Sec. 702(b). Accordingly, a partner’s distributive share of the partnership’s U.S. source dividend income, is U.S. source dividend income to that partner.
(3) Trusts and Estates
Trusts are divided into the two categories: of grantor trusts and ordinary trusts. Grantor trusts are ignored for federal income tax purposes and the trust income is taxed directly to the grantor. Code Sec. 671. Where a grantor trust receives dividend income, the grantor is deemed to have received that income directly from the source from which the trust received it. Rev. Rul. 59-245, 1959-2 C.B. 172.
Ordinary trusts may be simple or complex. A simple trust is one that must currently distribute all of its income to the beneficiaries. Code Secs. 651-652. With a complex trust, the trustee has discretion, or may be required, to accumulate income that is taxed to the trust and not the beneficiaries. Code Sec. 661. Distributions from simple trusts have the same character in the hands of the beneficiary as in the hands of the trust. Code Sec. 652(b). Dividends from a U.S. corporation received by the trust and then distributed to its beneficiaries are U.S. source income in the hands of the beneficiaries.
The same rule applies to current distributions from complex trusts. Code Sec. 661(b). Distributions of accumulated income retain their character in the hands of an NRA or foreign corporate beneficiary only when taxed to the beneficiary under the throwback rule. Code Secs. 662(b), 667(e) and 665-668.
The rules relating to complex trusts apply equally to estates except that beneficiaries of estates are not taxed upon the distribution of accumulated income. Code Secs. 641, 661 and 667.
(C) Foreign Tax Credit
There are special rules for sourcing of dividends for purposes of determining a U.S. foreign tax credit. Solely for purposes of computing the U.S. foreign tax credit limitation, certain kinds of income derived from U.S. owned foreign corporations are treated as U.S. source income. Code Sec. 904(g). Where a foreign corporation is U.S. owned, then both deemed dividends pursuant to Subpart F, personal holding company and passive foreign investment company rules, as well as, actual dividends are resourced as U.S. source dividends. For more information on U.S. foreign tax credits see Stand Fed.Tax Rep. (CCH) ____________.
(D) Accumulated Earnings Tax
U.S. law provides for a special secondary tax on corporations which do not distribute their income currently and accumulate their income in order to avoid the second level of tax on dividend distributions. Code Sec. 531. There is also a special sourcing rule in computing accumulated earnings tax where the foreign corporation has a certain portion of U.S. source income and is U.S. owned. In this case, solely for purposes of the accumulated earnings tax, the dividends from the foreign corporation will be resourced as U.S. source dividends. Code Sec. 535(d). For more information on accumulated earnings tax see Stand. Fed. Tax Rep. (CCH) ¶ _______.
375: Dividend Withholding Tax Issues
(A) In General
U.S. source dividends are subject to a 30 percent (or lower treaty) gross basis withholding tax. Code Secs. 871(a) and 881(a). Dividend distributions which are subject to withholding tax are only those distributions to the extent the corporation has either accumulated earnings and profits or current earnings or profits. Code Sec. 316. Distributions in excess of earnings and profits and capital gain distributions in excess of the shareholders cost basis in the stock are not subject to U.S. tax. However, the gross basis withholding rules require that withholding shall be applied to all distributions regardless of their taxability. Reg. § 1.1441-3(c)(1). This rule takes into consideration administrative convenience, since the corporation may or may not have earnings and profits on the day that it makes a distribution, in any event, earnings and profits will not be determined until the end of the year. Where the foreign shareholder in fact receives a nontaxable distribution from which the gross basis tax was withheld, the taxpayer can file for a refund of the taxes after the U.S. corporation’s year-end.
Example 1: USCO has a tax year ending June 30. On 12/31/Y1 USCO pays a $100,000 distribution to F Co. F Co. is organized in a country which does not have a treaty with the U.S. As of 6/30/Y2 USCO has E&P of $40,000. On 12/31/Y1 USCO is required to deduct and withhold U.S. tax of $30,000 and remit the remaining $70,000 distribution to F Co. F Co. may file a tax return for its tax year-end of 12/31/Y1 with the IRS claiming a refund of tax in the amount of $18,000. The refund is the difference between the correct withholding tax in the amount of $12,000 and the $30,000 of tax which was actually withheld from the total distribution made by USCO. F Co. would have to wait until after 6/30/Y2 to claim its refund for 12/31/Y1’s over withholding of tax, since USCO cannot determine its E&P until after 6/30/Y2. See Rev. Rul. 72-87,1972-1 C.B.274.
In order to remedy this withholding requirement on the full amount of all corporate distributions, the Treasury issued new withholding rules which were originally scheduled to take effect in 1999, but the effective date of these rules have been postponed until 1/1/2001. Notice 99-25, 1999-20 I.R.B. The new regulations provide that USCO may withhold that portion of a distribution, which it considers to be a dividend, based on its reasonable estimation of earnings and profits on the payment date. Any amount under withheld will then be the obligation of USCO. Reg. § 1.1441-3(c)(3)(ii).
Example 2: USCO is a publicly traded corporation with both U.S. and foreign shareholders, which has a tax year ending 12/31. In 2001 USCO’s books and records indicate that it had $10,000,000 in earnings and profits (E&P). On January 15, 2002 USCO announces that it will make a dividend to its shareholders of $8,000,000 on February 15, 2002. On February 1, 2002 USCO’s lawyers and accountants discover an accrued liability which reduces USCO’s E&P for December 31, 2001 to $5,000,000. Pursuant to Reg. § 1.1441-3(c)(2)(ii), USCO will not be required to subject the whole $8,000,000 distribution to 30% withholding tax, but rather can subject only $5,000,000 of the distribution to withholding tax based upon an estimate of the total distribution which will be taxable as a dividend to the NRA or foreign corporation shareholders.
(B) U.S. Address System
If the shareholders address is in the U.S., the withholding agent may assume that the shareholder is a citizen and resident of the U.S. or a domestic partnership or corporation in the case of a payment of a dividend. Unless the facts and circumstance indicate clearly that the shareholder is a nonresident alien, foreign partnership or foreign corporation, an address in care of another person in the U.S. does not in and of itself warrant treating the shareholder as a nonresident alien, foreign partnership, or foreign corporation. Reg. § 1.1441-3(b)(3). This address system is unique to dividends and it does not apply to U.S. gross basis withholding tax on any other type of investment income paid to NRAs or foreign corporations.
Example 3: U.S. Brokerage sends dividends to 123 Street, Philadelphia, PA 19083. The U.S. Brokerage can rely on the address and not subject dividend distributions going to that address to U.S. gross basis withholding tax.
Example 4: U.S. Brokerage mails dividends to John Doe c/o 456 Nowhere Street, Miami, FL. U.S. Brokerage can exempt dividend payments to this address from U.S. gross basis withholding, where the Broker does not have clear facts and circumstances which indicate that the shareholder is foreign.
(C) Joint Owned Stock
If stock is owned jointly by a nonresident alien individual and a U.S. citizen individual, the U.S. withholding agent must only withhold tax on the amount of dividends considered paid to the NRA. IRS Publication 515.
(D) Tax Treaties
The U.S. has many tax treaties to provide for reduced rates of the gross basis withholding tax on dividends from 30% to holding rates as low as 5%. Currently there is no tax treaty which the U.S. has with any other country, which completely eliminates or reduces the withholding tax on U.S. source dividends to zero. IRS Publication 515, Table 1. Many treaties further reduce U.S. withholding tax on dividends, where the foreign corporate shareholder owns a substantial interest in a U.S. corporation paying the U.S. source dividend.
(E) Dividends Exempt From Withholding
The following types of distribution are exempt from U.S. gross basis withholding tax:
(1) A distribution payable in stock or stock rights where it is not essentially equivalent to a dividend,
(2) A distribution in full or part payment in exchange for stock as in the case of a redemption or a complete liquidation,
(3) A distribution from a RIC which is attributable to tax exempt income or capital gain income passthrough pursuant to elections available to corporations which qualify as a RIC,
(4) A distribution from a REIT to the extent that the capital gain passes through pursuant to elections available to a REIT (may be subject to normal U.S. net basis tax if associated with FIRPTA investment by the REIT), and
(5) A distribution from a U.S. real property holding corporation to the extent the tax has already been paid pursuant to the FIRPTA tax provisions on investments in U.S. real estate. Reg. § 1.1441-3(c)(2).
385: Exceptions for Foreign Tax Credit Purposes for Dividends Eligible For Code Sec. 245 Deduction
Code Sec. 245 provides a deduction for dividends received by a corporation from a qualified 10 percent owned foreign corporation equal to the percentage of U.S. source portion of such dividends. Dividends received from a foreign corporation are also subject to a foreign tax credit. Therefore, certain dividends from a 10-percent owned foreign corporation may potentially qualify for both a U.S. foreign tax credit and a dividend received deduction. In order to avoid foreign tax credit on dividends which have already been excluded pursuant to Code Sec. 245, there is a foreign tax credit limit on dividends paid by foreign corporations. The limitation provides that a dividend paid by a foreign corporation shall be treated as income from sources without the United States only to the extent that it exceeds the following percentage: 100 divided by the percentage deduction allowable under Code Sec.245 in respect of such dividend. Code Sec. 861(a)(2)(B).
Chapter 1. Introduction - Source of Income Rules.
Chapter 2. Interest Income, excluding OID and OID Income.
Chapter 3. Dividend Income.
Chapter 4. Rents and Royalties.
Chapter 5. Sale of Personal Property Income.
Chapter 6. Services Income.
Chapter 7. U.S. Real Estate and Other Unique Income.
Chapter 8. U.S. Tax Rules.