Dividends From Foreign Corporations – Understand Your Investment! Part 1

Not all dividends are treated the same and the nuances can make a big difference to your ultimate investment return.

“Regular Dividends” and “Qualified Dividends”

In general, there are two different types of dividends – “regular dividends” and “qualified dividends”. One is taxed far more favorably than the other.  A so-called “qualified” dividend is given beneficial tax treatment because it is taxed at a lower more beneficial long-term capital gains tax rate.  For most individuals this rate is currently at 15%, but the rate can be lower or higher for very low or very high income earners.

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. This means 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.  (Readers of my blog know by now that there is always a proviso, when it comes to US tax law)!

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  
Dividends from “Controlled Foreign Corporations” (CFC)

Special rules apply to dividends paid by CFCs. These rules will be detailed in a later blog posting.

In accordance with Circular 230 Disclosure

Virginia La Torre Jeker J.D., has been a member of the New York Bar since 1984 and is also admitted to practice before the United States Tax Court. She has 30 years of experience specializing in US and international tax planning as well as international commercial transactions. She has been based in Dubai since 2001; prior to that time she worked in Hong Kong for 15 years as a US tax consultant for international law firms, major banks (including HSBC) international accounting firms (Deloitte) and trust companies. Early in her career she worked in New York with the top-tier international law firm, Willkie Farr & Gallagher.

Virginia is regularly asked to speak at numerous conferences and seminars for various institutes and commercial organizations; publishes a vast array of scholarly works in her area of expertise, been interviewed by CNN and is regularly quoted (or has her articles featured) in local and international publications. She was recently appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland. She was a guest lecturer at the University of Hong Kong, LL.M Program (Law Department) and served as an adjunct Business Law professor at the American University of Dubai and at the American University of Sharjah where she also taught the legal / ethical aspects of internet law and internet based transactions.


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2 comments on “Dividends From Foreign Corporations – Understand Your Investment! Part 1

  • James Kronenberg EA CPA MBA


    Thanks for this pertinent summary regarding foreign corporations making cash distributions to US shareholders that meet “qualified dividends” tax rate treatment. Wondering if Asset Depository Receipt (ADR) securities are automatically considered to be “qualified dividends” when making distributions from accumulated Earnings & Profits (E&P) to US shareholders. Also, there is a special type of corporate distribution known as “extraordinary dividend” which I wonder if is “excluded” as “Qualifying Dividend”. Thanks for any feedback you have on these additional concerns !

  • Virginia La Torre Jeker J.D.

    Hi James – you raise some interesting questions. I would really need to research these issues as I don’t have ready answers. My concerns with ADR – is this an equity ownership similar to stock? As for extraordinary dividends – I suggest you research what the tax code defines as a “dividend” and go from there. I am not sure which IRC section contains that definition. Keep me posted. These are good Qs & I wish I had time to research them.

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