For individuals whose income tax rate is in the 10% or 15% brackets, then the dividend and long-term capital gains tax rate is zero. What this means is that there is no tax imposed on qualified dividends or long-term capital gains on a single person with taxable income up to $36,250, heads of households having taxable income of up to $48,600 or a married couple having taxable income up to $72,850.The 15% rate applies to long term capital gains and qualified dividends for individuals filing as single and having taxable income over $36,250 but below $400,000; for married persons with taxable income above $72,850 but below $450,000; and for head of households with taxable income above $48,600 but below $400,000.
High income earners will be taxed on their long-term capital gains and qualified dividends at a rate of 20%. This means, single individuals with taxable income over $400,000 or married couples over $450,000.
The capital gains tax should not be confused with the new 3.8% Medicare surcharge imposed on net investment income. These are two separate taxes; each with their own particular set of rules. Broadly speaking, the 3.8% net investment income tax (“NIIT”) applies to any unearned income, including capital gains, for certain high-income taxpayers. Generally, the NITT applies to single/head of household taxpayers with a modified adjusted gross income (“MAGI”) above $200,000 and married couples with MAGI above $250,000. Once the threshold limits are exceeded, only the income that is investment income will be subject to the NIIT (earned income such as wages or salary are not subject to the tax). You can learn more about the NIIT and all its nuances here.
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 39.6%. (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, you can pay significantly higher taxes on a non-qualified dividend.
Can a Dividend Paid by a Foreign Corporation be “Qualified”?
Yes, a dividend paid by a foreign corporation can be a “qualified” dividend provided certain requirements are met.
The tax law clearly defines what is meant by “qualified dividend income” (see IRC Section 1(h)(11)(B)(i))
Under the rules, “qualified dividend income” means dividends received during the taxable year from domestic corporations and from “qualified foreign corporations.” A qualified foreign corporation is defined by IRC Section 1(h)(11)(C)(i) as (subject to certain exceptions, for example, a PFIC) “any foreign corporation 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.
Which Countries Have “Satisfactory” Treaties and Is Incorporation in Such a Country Sufficient?
The IRS has listed the countries determined to be satisfactory for purposes of paying “qualified dividends”. The countries are listed in the table below, excerpted from IRS Publication 17.
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. Other requirements must be satisfied before a foreign corporation can be treated as a “qualified foreign corporation” for purposes of paying “qualified dividends” to its shareholders. 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.” “Claiming Tax Treaty Benefits”. Thus, 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.
Table 8-1. Income Tax Treaties
| Income tax treaties the United States has with the following countries satisfy requirement (2) under Qualified foreign corporation. | ||
| Australia | Indonesia | Romania |
| Austria | Ireland | Russian |
| Bangladesh | Israel | Federation |
| Barbados | Italy | Slovak |
| Belgium | Jamaica | Republic |
| Bulgaria | Japan | Slovenia |
| Canada | Kazakhstan | South Africa |
| China | Korea | Spain |
| Cyprus | Latvia | Sri Lanka |
| Czech | Lithuania | Sweden |
| Republic | Luxembourg | Switzerland |
| Denmark | Malta | Thailand |
| Egypt | Mexico | Trinidad and |
| Estonia | Morocco | Tobago |
| Finland | Netherlands | Tunisia |
| France | New Zealand | Turkey |
| Germany | Norway | Ukraine |
| Greece | Pakistan | United |
| Hungary | Philippines | Kingdom |
| Iceland | Poland | Venezuela |
| India | Portugal | |
Special rules apply to dividends paid by CFCs. These rules will be detailed in a later blog posting.
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