Tip of the Month for November 2003

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The tax cuts announced in May lowered the top tax rate on dividends to 15 percent from
38.6 percent. It sounds pretty straightforward doesn’t it? However, when it comes to what constitutes a “qualified” dividend, complications abound. The Internal Revenue Service (IRS) continues to clarify “gray” areas to help investors better understand when dividends qualify for the new favorable tax rates.

Recently, the IRS provided more input on dividend income related to short sales and on “qualified” foreign corporations. Here’s an update:

Short Selling
Questions still remain, but in Notice 2003-67, the IRS addresses short sales. Because the lender (short seller) no longer owns the stock (as per Section 316 of the new tax legislation), the payments the short seller receives from the borrower in lieu of dividends should not be eligible for the reduced tax rate under the new law’s definition of dividends. However, because the law was passed mid-year, the IRS has recognized that brokers may not yet have had sufficient time to change the way they report these payments to clients. Because of this, the IRS does not intend to penalize those clients whose brokers have not yet updated their systems to correctly identify such payments “as in lieu of dividends”. This grace period extends only until the end of this year, and the temporary waiver of penalties applies only if a brokerage firm can show a good faith effort to comply.

Furthermore, the IRS will allow taxpayers to treat such payments received in lieu of dividends as if they were dividends, if they are reported by the broker on Form 1099-DIV to the customer as “dividend income” and—and this is a big “ and”—unless the broker’s client “knows, or has reason to know, that the payments are made in lieu of dividends”. If you find this IRS update somewhat confusing—and it is—we recommend that you ask your tax professional to keep you posted, and that you seek expert tax advice on this issue prior to the tax season onslaught.

Qualified Foreign Corporations
The IRS has provided more information on the issue of when, and under what circumstances, a company based outside the U.S. may be considered a “qualified foreign corporation” and the dividend payments it makes to U.S. taxpayers eligible for the new rates.

What does it take to be considered “qualified”? For the most part, a qualified foreign corporation may be defined as a foreign company located in a country that has a comprehensive tax treaty with the U.S. The U.S. Treasury Secretary determines what constitutes a satisfactory tax treaty –and it must include a program that permits exchange of information between treaty partners. IRS’ Notice 2003-69 lists the countries considered “qualified”. Note that Barbados, Bermuda, Russia and the Netherlands Antilles currently are excluded from this list.

If the foreign company stock yielding a dividend is readily tradable on an established U.S. securities exchange, the IRS also deems a foreign company “qualified”. At this time, the IRS considers the following to be established exchanges: the NYSE; Nasdaq; and Amex plus the regional exchanges in Chicago, Cincinnati, Boston, Philadelphia and the Pacific Exchange.

We expect the IRS will continue to provide more clarification on dividend taxation issues. Please contact us for further advice, if you have any questions or comments.


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