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- ICI Comment Letters
RIC Implementation of JGTRRA Qualified Foreign Corporation Rules
The “qualified dividend income” (“QDI”) rules of the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (“JGTRRA”) significantly affect international investments by US-domiciled investment companies that qualify for federal income taxation as regulated investment companies (“RICs”). This memorandum identifies a series of interpretive issues on which the Investment Company Institute1 seeks guidance that would enable RICs to effectively implement the new law and provide their shareholders with the full benefits of JGTRRA’s 15 percent maximum tax rate on dividends from “qualified foreign corporations” (“QFCs”).2 This memorandum also suggests solutions to these issues.
Table of Contents
JGTRRA provides various tests for determining whether a foreign corporation is a QFC. Under JGTRRA’s treaty-based test, a foreign corporation is a QFC if: (1) it is eligible for the benefits of a comprehensive income tax treaty with the United States for the year the dividend is paid, (2) the Secretary determines that the treaty is satisfactory for purposes of the statute, and (3) the treaty includes an exchange of information program. The Conference Committee’s Statement of Managers indicates that, until the Treasury Department issues guidance regarding which treaties are satisfactory, a foreign corporation shall be treated as a QFC under the treaty-based test if it is eligible for the benefits of a comprehensive income tax treaty (other than the Barbados treaty). The Statement of Managers also indicates that the foreign corporation must be eligible for treaty benefits with respect to “substantially all” its income in the taxable year for any dividend paid to be eligible for the 15 percent tax rate.
Under a second test, based on US trading, a foreign corporation is a QFC if the stock with respect to which the dividend is paid is readily tradable on an established securities market in the United States. The Statement of Managers includes a footnote that states that “a share shall be treated as so traded if an American Depository Receipt (“ADR”) backed by such share is so traded.”3
Finally, a foreign corporation shall not be treated as a QFC under either test if it is a foreign personal holding company (“FPHC”), a foreign investment company (“FIC”) or a passive foreign investment company (“PFIC”) for the taxable year in which the dividend is paid or for the proceeding year.
RICs with an investment objective of holding foreign equity securities (hereinafter foreign equity RICs)4 had total net assets, at the end of 2002, of $365 billion.5 Most of these assets ($358 billion) were held in RICs organized as open-end investment companies, or mutual funds;6 the remaining $7 billion of assets were held in RICs organized as closed-end investment companies, or closed-end funds.7 These foreign equity RICs may acquire foreign equities (1) on local markets, other foreign markets, or in the United States, (2) through an exchange trade, over the counter, or through private placement, and (3) in local share form or as an ADR. In many cases, a single foreign equity may be available for purchase in multiple local, foreign and/or US markets and either in local share form or as an ADR.
Federal tax and securities laws expressly or effectively require RICs to advise their shareholders of the portion of each RIC dividend that is eligible for the 15 percent tax rate. Federal tax reporting is required on IRS Forms 1099-DIV that must be sent by January 31 of the year following the year in which the RIC dividend is paid. Many RICs already are attempting to provide their shareholders with estimates of the portion of each year-to-date dividend that is eligible for 15-percent-rate treatment.8 Among other things, this information is useful to RIC shareholders seeking to determine estimated tax payment liability. The character of each RIC distribution also is relevant for compliance with securities law requirements that RICs calculate after-tax returns. These calculations must be included in prospectuses and, in certain cases, where total returns are reported (e.g., print advertisements and web pages).
Because of the large and constantly changing number of individual foreign equities held, the total volume and frequency of the dividends paid by these foreign equities, and the federal tax and securities law requirements for reporting the character of a RIC’s distributions, RICs and their shareholders have a strong need for rules that permit a RIC to quickly and accurately determine whether each foreign dividend received is eligible for 15-percent-rate treatment. A strong preference thus exists within the industry for rules that will permit the relevant determinations to be made on the basis of readily-available public information. It simply would not be feasible to implement JGTRRA’s QDI rules if RICs were required to obtain detailed non-public factual information and, in some cases, to have that information analyzed by tax lawyers and accountants knowledgeable about tax treaties.
III. Policies Underlying the Extension of the 15 Percent Rate to Dividends from Foreign Corporations
The policy rationale for lowering the tax rate on QDI is to mitigate distortions arising from the double taxation of corporate earnings. Prior to the passage of JGTRRA, the United States subjected corporate earnings to two full levels of taxation—once at the corporate level and again at the shareholder level when dividends were paid. Under this system, dividend income was taxed as ordinary income, the rate for which could be as high as 38.6 percent.9
The Statement of Managers does not state explicitly the policy reasons underlying the extension of the 15 percent tax rate to dividends from foreign corporations or the limitations imposed by the statute on when a foreign corporation may be a QFC. These reasons may be inferred, however, from the structure of the provision; they are different from the more focused purpose of treaty provisions designed to restrict erosion of the source country’s tax base.
Extending the 15 percent tax rate to dividends from certain foreign corporations mitigates distortions by removing the incentive that otherwise would exist for US investors to discriminate against ownership of stock in foreign corporations that pay tax. Distortions are further mitigated by treating equally (1) a foreign corporation eligible for treaty benefits under a comprehensive income tax treaty with an exchange of information program and (2) a foreign corporation the stock of which is readily tradable on a US exchange. Equal tax treatment is appropriate since, as discussed below, these foreign corporations are likely to be subject to a reasonable level of foreign corporate tax.
It may seem over-inclusive to extend the reduced rate to a non-treaty company publicly traded on a US exchange that does not suffer corporate-level tax in its residence country, which is possible under this rule. The extension of the 15 percent rate in such a case, however, presumably was based on the (generally correct) assumption that most of the corporation’s income is earned directly or indirectly through subsidiaries in countries that impose full corporate-level tax. Thus, the statute targets foreign corporations that are most likely to pay tax and that are potentially subject either to tax information exchange under a treaty or to regulation by the Securities and Exchange Commission (“SEC”).10
The Institute has identified interpretive issues under JGTRRA with respect to both the treaty-based test and the test based on US trading. The Institute also has observed that JGTRRA compounds existing (non-interpretive) difficulties with identifying PFICs. Until these issues are resolved, RICs will continue having difficulty ascertaining with complete accuracy the portion of each RIC dividend that is eligible for 15-percent-rate treatment. The policies underlying the extension of the 15 percent rate to foreign corporations strongly support adopting guidance that will overcome these difficulties in extending the benefit of the 15 percent rate to individual investors in RICs.
The industry has a number of questions regarding how it should implement the condition for QFC status that a foreign corporation be eligible for the benefits of a comprehensive income tax treaty with the United States (other than the Barbados treaty). Guidance also will be needed regarding those treaties that the Secretary determines are satisfactory for purposes of the statute and that include an exchange of information program.
This guidance should take into account the fact that US treaty provisions are neither intended nor designed to permit a portfolio shareholder to determine efficiently whether a corporation is eligible for treaty benefits. Indeed, no US treaty imposes any obligation on a shareholder of a corporation to determine whether the corporation is eligible for the benefits of an income tax treaty. Instead, the corporation itself makes that determination either to qualify for relief from source taxation by another country or to qualify for relief from double taxation in its country of residence.
The tax policy rationale for negotiating tax treaties that (on a reciprocal basis) provide treaty benefits to a corporation resident in another country is to reduce or mitigate potential double taxation of the same income. The underlying premise for the treaty is that the foreign corporation will be subject to tax in its country of residence (“the residence country”) as well as in the country in which income arises (“the source country”). Treaties thus contain a series of screens—that may require detailed information about an individual corporation’s facts and circumstances—that are intended to provide the source country with assurance that the foreign corporation is paying tax in the residence country.
The first “screen” is that the corporation must be a “resident” of the other country, as that term is defined in the treaty. Generally, a corporation organized in the treaty country is treated as resident. In many treaties, a corporation resident in both countries will not be eligible for treaty benefits at all. In addition, a few treaties use an “effective management” test for corporate residence.11 Although the residence provision generally should not be difficult to apply, a portfolio shareholder might not know whether a foreign corporation is dual resident or where it is effectively managed.
The far more difficult provision for a portfolio shareholder to implement is the limitation on benefits article, which acts as a second screen to limit treaty benefits. Even if a foreign corporation is resident in a treaty country, the limitation on benefits article denies treaty benefits unless the corporation meets one of a series of tests. Some of these tests, such as the publicly-traded test, the ownership and base erosion test, and the competent authority test, have (or may have) the effect of qualifying the corporation itself for all the benefits of the treaty. Other tests, such as the business relationship test, are highly factual and applied on an item-of-income basis. As a practical matter, it would be extremely difficult for a portfolio shareholder to apply any test but the publicly traded company test.
A standard publicly-traded test in a limitation of benefits article will be satisfied if the principal class of shares of the foreign corporation is regularly traded on a recognized stock exchange.12 For this purpose, a recognized stock exchange includes, in addition to the US securities exchanges, the principal exchange in the local country and any other exchange agreed to by the competent authorities.13 The publicly-traded test often is accompanied by standards to determine when stock is regularly traded. For example, Article 23(7)(e) of the recently ratified income tax treaty between the United States and the United Kingdom provides that a class of shares will be regularly traded in a taxable period if the aggregate number of shares in that class that is traded on one or more recognized exchanges during the 12 months ending on the day before the beginning of that taxable period is at least 6 percent of the average number of shares outstanding in that class during that period.
A treaty also may include an anti-abuse rule that supercedes the publicly-traded test. For example, Article 23(5) of the new US-UK income tax treaty specifies that if a company has shares that entitle its holders to a disproportionate amount of income from the other contracting state (i.e., the United States) and 50 percent or more of the voting power or value of the company is not owned by qualified persons under the article, then treaty relief is denied for the disproportionate income.14 This provision supercedes the other provisions of the article. These trading and anti-abuse provisions would be difficult if not impossible to implement by a portfolio shareholder.
The Institute submits that the JGTRRA reference to income tax treaty eligibility does not require observance of treaty rules intended to protect a source country’s tax base to the same degree as is necessary to protect the policies of the 15 percent tax rate on foreign dividends. We suggest that the Treasury Department issue guidance providing that a dividend paid by a foreign corporation should be treated as QDI if (1) the foreign corporation is resident in a treaty country, (2) shares on which the dividend is paid are publicly traded on a recognized stock exchange identified for the purposes of this provision, and (3) the shareholder does not otherwise have actual knowledge that the corporation is not eligible for the benefits of the treaty with respect to substantially all of its income.
The statute provides that a foreign corporation is treated as a QFC with respect to a dividend paid with respect to stock that is “readily tradable” on an established securities market in the United States. RICs presently do not have guidance from which they can determine whether a foreign stock meets this test. Consequently, we suggest that this standard should be treated as satisfied if stock of the same class is listed on a national securities exchange registered under the Securities Exchange Act of 1934 or is traded on the NASDAQ System. This standard would be easy for RICs to apply.
The footnote in the Statement of Managers regarding ADRs raises the question of whether QDI treatment is available to dividends paid on local shares of a corporation purchased on a stock exchange outside the United States where stock of the same class is in an ADR program. Neither the statute nor the Statement of Managers suggest that Congress intended that QDI treatment be available in this situation only with respect to the shares in the ADR program and there would appear to be no policy justification for such a result. Consequently, we suggest that guidance clarify that if stock is in the same class of stock as stock that is traded on an established securities market in the United States through an ADR program, dividends on any share in that class will constitute QDI irrespective of where the stock in question is acquired.
Portfolio investors such as RICs often have great difficulty ascertaining with confidence whether a foreign corporation is a PFIC. The Institute previously has discussed with Treasury the substantial difficulties that RICs have in applying the PFIC tests and has suggested modifications (such as elimination of the asset test) that would simplify greatly the process of identifying PFICs.15 That identification issue now also will burden application of the JGTRRA 15 percent rate on dividends from foreign corporations.
The apparent purpose of excluding PFICs (as well as FPHCs and FICs) from the 15 percent dividend rate is to limit the benefits of deferral, by taxing dividends paid by a PFIC at top marginal rates rather than at 15 percent, even if a foreign corporation satisfies the treaty-based or US-trading-based tests. Limiting the benefits of deferral should not be a concern for RIC investments in portfolio foreign corporations, particularly since RICs effectively are required to mark annually to market the shares of any foreign corporation that they identify as a PFIC.
1. A dividend paid by a foreign corporation should be treated as QDI if (a) the foreign corporation is resident in a treaty country, (b) shares on which the dividend is paid are publicly traded on a recognized stock exchange identified for the purposes of this provision, and (c) the shareholder does not otherwise have actual knowledge that the corporation is not eligible for the benefits of the treaty with respect to substantially all of its income.
2. Stock should be considered readily tradable on an established securities market in the United States if stock of the same class is listed on a national securities exchange registered under the Securities Exchange Act of 1934 or is traded on the NASDAQ System.
3. If stock on which a dividend is paid is in the same class of stock as stock that is traded on an established securities market in the United States through an ADR program, dividends on any share in that class will constitute QDI irrespective of where the stock in question is acquired.
1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,678 open-end investment companies ("mutual funds"), 555 closed-end investment companies, 106 exchange-traded funds, and six sponsors of unit investment trusts. Its mutual fund members have assets of about $6.697 trillion, accounting for approximately 95 percent of total industry assets, and 90.2 million individual shareholders.
2 Under Section 1(h) of the Internal Revenue Code, as amended by JGTRRA, distributions from a QFC are QDI taxable at the maximum long-term capital gains rate (generally 15 percent, but 5 percent or lower for certain taxpayers) beginning January 1, 2003 (and expiring, under JGTRRA, after December 31, 2008). Hereinafter, the tax rate on QDI generally is referred to as the 15 percent rate. If a foreign corporation is not a QFC, its dividend distributions will be taxed at ordinary income rates of up to 35 percent (under JGTRRA).
3 A third test, providing QFC status to any corporation organized in a US possession, has not generated any industry issues and is not discussed in this memorandum.
4 Foreign equity RICs may be either “global equity RICs” (with the investment objective of investing in both foreign and U.S. equities) or “international equity RICs” (with an investment objective of investing only in foreign equities).
5 See 2003 Mutual Fund Fact Book, pp. 68 and 102.
6 Foreign equity mutual fund assets were over 13 percent of total assets for all equity mutual funds.
7 Of the 1,006 foreign equity RICs in existence at the end of 2002, 947 were mutual funds and 59 were closed-end funds.
8 JGTRRA’s statutory language, as enacted, technically does not permit a RIC to pay a dividend to its shareholders that retains the character of QDI from a QFC. A proposed technical correction to remedy this unintended error has been drafted and circulated to various staffs.
9 This rate has been reduced to 35 percent by JGTRRA.
10 The statute appears to be under-inclusive by not providing for a reduced rate on dividends from companies that are subject to a full level of corporate taxation domestically and that are located in countries that are parties to a tax information exchange agreement with the United States (although the countries do not have a comprehensive tax treaty with the United States). Thus, under the statute, dividends from a company in Peru will not be eligible for the reduced 15 percent rate, even though it would be in accord with the policy underlying JGTRRA to extend the lower rate to such dividends.
11 See, e.g., the US treaties with Jamaica and Pakistan.
12 The principal class of shares normally is the class possessing more than 50 percent of the aggregate voting power, and sometimes value, of the corporation.
13 The US-UK income tax treaty provides that, in addition to US and UK exchanges, recognized stock exchanges include: the Irish Stock Exchange, the Swiss Stock Exchange and the stock exchanges of Amsterdam, Brussels, Frankfurt, Hamburg, Johannesburg, Madrid, Milan, Paris, Stockholm, Sydney, Tokyo, Toronto, and Vienna.
14 Although this is an admittedly narrow provision, it is worth noting that Article 16(4) of the recently ratified treaty between the United States and Australia includes a similar provision.
15 See, e.g., Institute letter to Robert P. Hanson and Barbara M. Angus, dated June 28, 2002.