As most investors know, the Tax Act of 2003 lowered the tax rate for most dividends to 15 percent. But what about non-U.S. dividends? Are they taxed at 15 percent? The answer depends on the interplay of several sets of rules. If your clients receive payments from overseas investments, you should first make sure that those payments are true dividends and not a return of capital. Once you determine that a payment really is a dividend, you must then follow holding period rules, just as with U.S. equities. There are traps in the rules--but there are also opportunities.
The 15 percent rate applies to dividends of qualifying foreign corporations. To qualify, an issuer must be one of the following:o Established in a country that has a comprehensive income tax treaty with the U.S. that the IRS approves for these purposes, (The IRS list of income tax treaty countries is available at http://www.irs.gov/
OR
o Incorporated in a U.S. possession, ORo An issuer of stock that is tradable on an established U.S. securities market (defined by IRS Notice 2003-71 as "readily tradable on an established securities market").
If a company is headquartered in a non-treaty foreign country such as Taiwan or Hong Kong (see box at right), its ordinary stock is ineligible for the reduced dividend rate. In this case, investors should purchase ADRs in the company rather than ordinary shares. The ADR format should make dividends on the investment eligible for the 15 percent dividend tax rate. In contrast, if an investor buys ordinary stock in the same company, the dividends would be taxed at 35 percent.
It is not clear whether the 15 percent dividend rate will be available to all ADRs traded in the United States. ADRs that trade only in the "pink sheets" may not qualify.
However, investors who are contemplating the use of ADRs to obtain the reduced tax should be made aware that Congress may end this approach. U.S. Senate bill 1363 aims to deny the 15 percent tax rate to dividends received from companies in tax havens. It would change the definition of "qualified foreign corporation" to require that if a corporation's shares are readily tradable on an established U.S. securities market, then that corporation must also be created under the laws of a country that has an IRS-approved comprehensive income tax treaty.
Global real estate investments--specifically, global REITs--also merit special tax treatment. If a REIT is based in the U.S., its dividends are taxed at 35 percent, but if it is domiciled in a foreign country with a U.S. tax treaty, its dividends are taxed at only 15 percent.
As of the end of 2005, there were 11 treaty countries in North America, Europe and the Asia-Pacific regions with REITs or REIT-like structures: Australia, Belgium, Canada, France, Greece, Japan, the Netherlands, New Zealand, Russia, South Korea and Turkey. Italy has a hybrid REIT structure. The following non-treaty countries also had REIT-like structures: Hong Kong, Malaysia, Singapore and Taiwan. In addition, several countries--including Germany and the United Kingdom--are considering REIT-like structures. (For more on international REITs, see "Passport to Profits," July/August 2006.)
Also take note of specific Canadian rules: If a Canadian royalty trust is treated as a corporation in the U.S.--as most are--the dividends from that trust are eligible for the 15 percent tax. In contrast, U.S. royalty trusts' dividends are taxed at 35 percent. This gives Canadian trusts a distinct tax advantage over their U.S. counterparts. Furthermore, Canadian trusts, unlike their U.S. counterparts, are permitted to replace reserves, enabling them, in theory, to continue forever.
If an American taxpayer invests in a Canadian oil and gas trust, Canada would impose a 15 percent withholding tax on the dividend. The investor could take a U.S. foreign tax credit on that withholding, so in effect, there is no additional tax to be paid. (Coincidentally, the foreign tax credit equals the U.S. dividend tax.) The foreign tax credit is only available if the shares are held unhedged more than 16 days, as opposed to 61 days for the reduced 15 percent tax rate.
Be aware, however, that the large distributions Canadian trusts pay are not all dividends; instead, much of the distributions is a return of capital. These distributions reduce the holder's cost basis and would increase any capital gain or decrease any capital loss upon sale. There is no withholding tax on return of capital distributions.
Complicated? Pay attention to the rules, and you can make sure your clients' dividends are taxed at only 15 percent.
Non-Treaty Countries with Companies Issuing ADRs
o Argentinao Boliviao Brazilo Chileo Columbiao Dominican Republico Equadoro Hong Kongo Jerseyo Jordano Malaysiao Panamao Papua New Guineao Peruo Singaporeo Taiwano Zambia
Robert N. Gordon is the president of Twenty-First Securities Corporation and the author (with Jan Rosen) of Wall Street Secrets for Tax-Efficient Investing.
