Keeping up with a new act

By Nelson B. Brooks & Stephen Jackson
Illustration: Sara Tyson

Canadian companies wanting to attract and retain US investors must revisit its dividend-paying policies

The US Jobs and Growth Tax Relief Reconciliation Act of 2003, signed into law on May 28, 2003, will have significant implications to Canadian corporations in their effort to retain and attract US individual and mutual fund shareholders, thanks to the act's temporary reduction in the US federal income tax rate on the receipt of qualifying dividends. As stated by President George W. Bush in his remarks at the signing of the act, the lower dividend income tax rate will help US markets, increase the wealth effect around the US and will encourage companies to pay dividends, which will be good news for investors and will be a corporate reform measure. What he didn't mention was that for Canadian companies trying to attract US investors, this could be a potential significant disadvantage when, all else being equal, the investor will receive a reduced US federal income tax rate on dividends paid by US corporations but may not receive the lower rate on the dividends paid by Canadian companies. To be competitive in attracting and retaining US investors, a Canadian corporation will likely have to revisit its dividend-paying policy and ensure that what it is distributing in respect of its stock is a qualifying dividend.

The act effectively reduces the US federal income tax rate on qualified dividend income, received January 1, 2003 through December 31, 2008, by treating such dividends as net capital gains. As the act also reduced the maximum capitals gains rates to 15% from 20% for individuals, the result is a 15% US federal income tax rate on qualified dividend income. To be eligible for the lower tax rate, the shareholder must hold a share of stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date.

Qualified dividend income is defined as dividends received during the taxable year from domestic corporations and qualified foreign corporations. A qualified foreign corporation is defined as any foreign corporation either incorporated in a possession of the US or one that is eligible for the benefits of a comprehensive income tax treaty with the US that the Secretary of Treasury determines is satisfactory and that includes an exchange of information program. 

Any foreign corporation not otherwise treated as a qualified foreign corporation under the definition above shall be treated as a qualified foreign corporation regarding any dividend paid in respect of stock that is readily tradable on an established securities market in the US.

The term "qualified foreign corporation" specifically excludes any foreign corporation that is a foreign personal holding company, a foreign investment company or a passive foreign investment company in the corporation's taxable year in which the dividend was paid or in the preceding taxable year. A foreign personal holding company (FPHC) is any foreign corporation in which at least 60% of its gross income for the taxable year is foreign personal holding company income and at any time during the taxable year 50% or more of the vote or value of such foreign corporation is owned (directly or indirectly) by or for not more than five individuals who are citizens or residents of the US. A foreign investment company is any foreign corporation that is registered under the Investment Company Act of 1940, as amended, either as a management company or as a unit investment trust, or is engaged primarily in the business of investing, reinvesting or trading in securities or commodities at a time when 50% or more of the total combined voting power of all classes of stock entitled to vote, or the total value of all classes of stock, was held directly or indirectly by US persons. A passive foreign investment company (PFIC) is any foreign corporation in which 75% or more of its gross income for the taxable year is passive income or the average percentage of assets held by the corporation during the taxable year that produces passive income or that are held for the production of passive income is at least 50%.

A foreign corporation will be treated as a qualified foreign corporation when it is eligible for the benefits of a comprehensive income tax treaty with the US, which includes an exchange of information program. The Internal Revenue Service has issued guidance on which of its current income tax treaties meets the above requirements. Currently, only four income tax treaties do not meet the requirements. These are the treaties with Netherlands Antilles, Bermuda, USSR (which applies to certain former Soviet Republics) and Barbados. Although the Barbados treaty appears to meet the requirements, there was a concern that such a treaty could be used to provide unintended benefits and therefore was determined to be an unsatisfactory treaty. The Canadian income tax treaty with the US was listed as a satisfactory treaty.

To be eligible for the benefits of an income tax treaty, a foreign corporation must be resident in the relevant jurisdiction, as defined within the treaty, and meet all other requirements of the treaty, specifically any requirements of an applicable limitation on benefits provision. For Canadian corporations, this would mean meeting the residency requirements as provided under Article IV and the limitation on benefits requirements as provided under Article XXIX A of the current Canada-US income tax treaty.

A foreign corporation is considered a qualified foreign corporation if the stock in respect of the dividend is readily tradable on an established securities market in the US. The IRS has issued guidance on what the meaning of readily tradable on an established securities market in the US is. For qualified foreign corporation status purposes, common or ordinary stock or a US depositary receipt in respect of such stock is considered readily tradable on an established securities market in the US if

it is listed on a national securities exchange that is registered under Section 6 of the Securities Exchange Act of 1934 or on Nasdaq. The registered national exchanges, at press time, include the American Stock Exchange, Boston Stock Exchange, Cincinnati Stock Exchange, Chicago Stock Exchange, NYSE, Philadelphia Stock Exchange and Pacific Exchange Inc.

Both Treasury and the IRS have stated that they are considering the treatment of dividends with respect to stock listed on the OTC Bulletin Board or on the electronic pink sheets. Also under consideration are setting parameters such as a minimum number of market-makers and a minimum trading volume. Although the definition above serves to provide some basic guidance, the terms used to describe the shares, common or ordinary stock, leave questions concerning the treatment of preferred and other noncommon or ordinary stock. Rest assured, more guidance is forthcoming.

For US federal income tax purposes, a dividend means any distribution of property made by a corporation to its shareholders (1) out of accumulated earnings and profits or (2) out of the earnings and profits of the current taxable year without regard to the amount of earnings and profits at the time the distribution was made. The second point is what is referred to as the nimble dividend rule. A nimble dividend is a dividend paid out of current year earnings and profits, regardless of the fact that on an accumulated basis the corporation is in a deficit position. 

The earnings and profits of a corporation is a defined calculation that starts with US federal taxable income and adjusts such taxable income for statutorily defined items. Some of the more common adjustments for earnings and profits determination are slower depreciation allowances on fixed assets, deduction for disallowed meals and entertainment expenses, deduction for federal income taxes paid and the inclusion of tax-exempt income. To determine a Canadian corporation's earnings and profits, one must first determine the US federal taxable income of the corporation and then make the necessary adjustments to arrive at earnings and profits.

In order to be a dividend, the paying entity itself must have earnings and profits. This means for a Canadian corporation that is engaged in the trade or business of a holding company, such holding company will not include in its earnings and profits the earnings and profits retained by its subsidiaries, unless the subsidiaries actually distribute their earnings and profits (i.e., via a dividend) to the holding company.

The US capital markets are already feeling the impact of the reduced income tax rate on qualified dividends. Microsoft, a once long-time capital gain play company that became a dividend payer almost immediately after the signing of the act, has evidenced this change. For a Canadian company to remain competitive in attracting and retaining US individual and mutual fund investors, it must revisit its dividend-paying policies, determine its qualified foreign corporation status and make the public aware that its distributions are qualified dividends. For Canadian companies that are not qualified, serious consideration should be given to taking steps to qualify.

(This article was prepared October 17, 2003, based on the law and guidance as of that time.) 

Nelson Brooks, CPA, senior manager, US corporate tax services group, Ernst & Young. Stephen Jackson, CPA, MPA, practice leader, US corporate tax services group, Ernst & Young

Technical editor: Michel Lanteigne, FCA, managing partner, tax for Canada, Ernst & Young LLP.