IRS updates list of treaties qualifying foreign dividends for preferential rates

Notice 2011-64, 2011-37 IRB

A new notice updates the list of U.S. tax treaties that meet requirements for dividends from foreign corporations to qualify for preferential rates. The notice also clarifies the requirements for treatment as a qualified foreign corporation.

Background. A noncorporate taxpayer's adjusted net capital gain is taxed at a maximum rate of 15% or, to the extent it would have been taxed at a rate below 25% if it had been ordinary income, at a maximum rate of 0%. (Code Sec. 1(h))

Adjusted net capital gain is net capital gain for the tax year (i.e., the excess of net long-term capital gains over net short-term capital losses for a tax year):

• less the sum of specified types of long-term capital gain that are taxed at a maximum rate of 28% (gain on the sale of most collectibles and gain on the unexcluded part of Code Sec. 1202 small business stock) or 25% (unrecaptured section 1250 gain, i.e., gain attributable to real estate depreciation),
• plus qualified dividend income.

Qualified dividend income—generally, dividends received during the tax year from domestic corporations and “qualified foreign corporations,” subject to holding period requirements and specified exceptions—is effectively treated as adjusted net capital gain, and therefore taxed at the same rates that apply to adjusted net capital gain. (Code Sec. 1(h)(11))

Subject to certain exceptions, a qualified foreign corporation is any foreign corporation that is either (i) incorporated in a U.S. possession (Code Sec. 1(h)(11)(C)(i)(I)), or (ii) eligible for benefits of a comprehensive income tax treaty with the U.S. that IRS determines is satisfactory for purposes of this provision and that includes an exchange of information program (the “treaty test”). (Code Sec. 1(h)(11)(C)(i)(II)) A foreign corporation that does not satisfy either of these two tests is treated as a qualified foreign corporation with respect to any dividend paid by it if the stock on which the dividend is paid is readily tradable on an established securities market in the U.S. (Code Sec. 1(h)(11)(C)(ii))

A qualified foreign corporation does not include any foreign corporation that for its tax year in which the dividend was paid, or the preceding tax year, is a Code Sec. 1297 passive foreign investment company. (Code Sec. 1(h)(11)(C)(iii)) A dividend from a qualified foreign corporation is also subject to the other limitations in Code Sec. 1(h)(11). For example, a shareholder receiving a dividend from a qualified foreign corporation must satisfy the Code Sec. 1(h)(11)(B)(iii) holding period requirements.

Updated list. Notice 2011-64 updates the list to add two U.S. income tax treaties that entered into force after the publication of Notice 2006-101: the U.S. income tax treaties with Bulgaria (which entered into force on Dec. 15, 2008) and Malta (which entered into force on Nov. 23, 2010). (Notice 2011-64, Sec. 2)

Other requirements. Notice 2011-64 also clarifies that a foreign corporation must be eligible for benefits of one of the U.S. income tax treaties listed in the Appendix in order to be treated as a qualified foreign corporation under Code Sec. 1(h)(11)(C)(i) 's treaty test. Accordingly, the foreign corporation must be a resident under the relevant treaty and satisfy any other requirements of that treaty, including the requirements under any applicable limitation on benefits provision. For purposes of determining whether it satisfies these requirements, a foreign corporation is treated as though it were claiming treaty benefits, even if it does not derive income from sources within the U.S. (Notice 2011-64, Sec. 3)

Effective date. Notice 2011-64 is effective with respect to: (1) Bulgaria for dividends paid on or after Dec. 15, 2008; (2) Malta for dividends paid on or after Nov. 23, 2010; (3) Bangladesh for dividends paid on or after Aug. 7, 2006; (4) Barbados for dividends paid after Dec. 19, 2004; (5) Sri Lanka for dividends paid on or after July 12, 2004; and (6) all other U.S. income tax treaties listed in the appendix for tax years beginning after Dec. 31, 2002. (Notice 2011-64, Sec. 4)