Where Qualified Dividend Treatment Is Important, Serious Consideration Should Be Given to Ensuring the Company Is Eligible for Treaty Benefits Before Taking It Public.
Dividends generally are taxed at ordinary income rates (up to 39.6 percent for individuals). Qualified dividends derived by individuals, however, are taxed at the preferential rate applicable to capital gains (usually 20 percent).1 Generally, all dividends paid by a domestic corporation are qualified dividends. Dividends paid by a foreign corporation, however, must meet certain requirements in order to be considered qualified and, thus, entitled to favorable tax rates in the hands of individual payees. This article discusses certain dividend planning opportunities and considerations to be taken into account in connection with the initial public offering of a foreign corporation, including the surprising position of the Internal Revenue Service (IRS) related to dividends on shares of a foreign public company that are not registered under the Securities Act of 1933 (the 33 Act).
Only Dividends Paid by "Qualified Foreign Corporations" Are Qualified Dividends
For dividends paid by a foreign corporation to be qualified dividends, the foreign corporation must be a "qualified foreign corporation." A qualified foreign corporation is a foreign corporation that meets one of the following criteria:
is incorporated in a possession of the United States
is eligible for the benefits of a comprehensive income tax treaty with the United States that includes an exchange of information program
pays dividends on its stock if the stock with respect to which the dividends are paid is readily tradable on a U.S. securities market.
Foreign Corporations Eligible for the Benefits of a Comprehensive Income Tax Treaty
The IRS has identified 57 treaties that are considered to be comprehensive and that include exchange of information programs.2 Corporations eligible for the benefits of such treaties are qualified foreign corporations.
To be eligible for the benefits of an income tax treaty, a foreign corporation must be tax resident in a country that has a tax treaty with the United States. In addition, that company must meet all eligibility requirements of the applicable treaty. Most U.S. tax treaties include a limitation on benefits (LOB) provision designed to preclude "treaty shopping" (i.e., forming a company in a country primarily to obtain treaty benefits). The LOB provisions of modern treaties are comprehensive. At the most basic level, they require that a certain percentage of the foreign corporation’s shares be owned by residents of either or both of the contracting countries. A corporation not meeting these tests may still qualify if, among other possibilities, it is engaged in a trade or business in the treaty jurisdiction. In addition, certain publicly traded corporations may satisfy the LOB clause even if its owners are not resident in either treaty jurisdiction and if its shares are traded on an exchange other than an exchange in the treaty jurisdiction.
For example, under the LOB clause of the Irish tax treaty, an Irish corporation will be eligible for the benefits of the treaty if a principal class of its shares is substantially and regularly traded on one or more recognized stock exchanges. For this purpose, a recognized stock exchange includes the NASDAQ system and any stock exchange registered with the U.S. Securities and Exchange Commission (SEC) (including the New York Stock Exchange and NASDAQ),3 the Irish Stock Exchange, and the stock exchanges of Amsterdam, Brussels, Frankfurt, Hamburg, London, Madrid, Milan, Paris, Stockholm, Sydney, Tokyo, Toronto, Vienna and Zurich. Thus, so long as the company to be taken public is tax resident in Ireland, it will be entitled to treaty benefits if its primary class of shares are substantially and regularly traded on one or more of these exchanges. Dividends it pays on its shares will be treated as qualified dividends in the hands of individual investors, taxable at a favorable tax rate.
If the company to be taken public would not otherwise be eligible for treaty benefits, planning likely will be available by moving the company to a jurisdiction with a favorable tax treaty with the United States, even if the plan is for the company’s shares to be treated on an exchange outside such jurisdiction. Planning for the corporation may involve (a) moving its tax residence to a jurisdiction with a favorable treaty, (b) merging it into a company tax resident in a jurisdiction with a favorable tax treaty or (c) contributing it to a new corporation tax resident in a jurisdiction with a favorable tax treaty. With proper planning, these transactions typically can be accomplished in a tax-free manner for U.S. tax purposes. Of course, applicable foreign tax planning will be required.
Dividends Payable on Readily Tradable Stock
A foreign corporation that is not otherwise treated as a qualified foreign corporation (as described in the first two bullets defining qualified foreign corporations above) is treated as a qualified foreign corporation with respect to any dividends paid by such corporation if the stock with respect to which the dividend is paid is readily tradable on an established securities market in the United States. The first thing to note is that, unlike the LOB provision in the Irish treaty (as well as certain other treaties), stock must be tradable on a U.S. securities market.
The IRS has stated in three notices4 that stock is considered "readily tradable" on an established U.S. securities market if it is listed on a national securities exchange that is registered under section 6 of the Securities Exchange Act of 1934.5 Despite the IRS’s three prior notices stating that the critical question is whether shares are listed on a national securities exchange, the IRS subsequently ruled in PLR 200606021 (Feb. 10, 2006) that unregistered shares are not readily tradable for the purposes of determining whether a corporation is a qualified foreign corporation. The ruling held that "shares that are not registered under the Securities Act of 1933 are not considered readily tradable" for the purposes of determining whether a foreign corporation will be treated as a qualified foreign corporation with respect to dividends paid on readily tradable shares. The ruling is based on the IRS’s understanding that "[s]ecurities [listed on a national securities exchange] must be registered under the Securities Act of 1933." This statement, however, is not universally correct. Additionally, the IRS’s revised position creates the potential for dividends paid on shares of the same class to have a different character, depending on whether the shares are qualified or not. This is inconsistent with the other requirements a foreign corporation can meet to be a qualified foreign corporation, which look to the nature of the foreign corporation itself, rather than requiring a share-by-share analysis to determine whether dividends are qualified. It also fails to take into account the proper operation of the securities laws and may be impossible to determine.
Listed Versus Registered Shares
Listing refers to the listing of shares on a national securities exchange, such as the New York Stock Exchange or NASDAQ. Each exchange has its own rules for the listing of shares. The fact that shares are registered (discussed below) does not mean that they necessarily will be listed on any exchange. Moreover, the fact that shares are listed does not mean that they can be sold without restriction.
Under the 33 Act, the sale of shares that are not registered with the SEC is subject to restriction. Shares are registered when they are identified in a prospectus filed with the SEC. It is common that a corporation will not register all of its shares for sale. Registration itself relates to a particular offer and sale. Thus, only those shares being offered and sold pursuant to a prospectus will be registered with the SEC. Thus, if the corporation’s existing shareholders do not intend to sell shares pursuant to the prospectus, the shares will not be registered. Registering all of a corporation’s shares could cause the public concern that founders and existing holders will rush to sell their shares and, thus, deflate the price of the shares after the IPO. This also may be inconsistent with lock-up agreements required by investment banks working on the IPO.
XYZ is a Cayman Islands corporation. It has 100,000,000 shares issued and outstanding. 85,000,000 shares are held by ABC, a private equity fund, and 15,000,000 are held by managers of XYZ. ABC and its owners decide that ABC should become a public company. It registers 50,000,000 new shares and 25,000,000 shares currently held by ABC and managers to be sold in connection with an IPO. It lists all of its outstanding shares on NASDAQ. After the IPO, XYZ has 150,000,000 shares outstanding, 75,000,000 of which are registered. ABC and managers continue to own the remaining 75,000,000 shares, which are listed, but not registered.
Shares of a corporation that have not been registered with the SEC may be sold in transactions exempt from registration, including under Rule 144 of the 33 Act. Rule 144 permits sales of shares of a publicly traded company to be sold, subject to certain limitations. The nature of these limitations differs depending on whether or not the holder is considered to be an affiliate of the issuer of the stock. Similarly, even if shares of a foreign corporation are registered, an affiliate cannot simply sell as many shares as he/ she/it wants. Such persons are subject to restrictions. In short, certain restrictions on the ability of a person to sell listed shares on a securities exchange are personal, and not attached to the shares. Finally, once the shares on sold on the market, it is impossible to determine which were previously sold in a registered transaction and which were not.
There is no clear policy rational for treating dividends paid with respect to listed but unregistered shares as ineligible for qualified dividend treatment, and no such distinction is made in the legislative history.6
The IRS’s latest position that dividends paid with respect to listed but unregistered shares are not qualified dividends seems incorrect. However, where qualified dividend treatment is important (such as where unregistered shares will continue to be held by a private equity fund with substantial U.S. individual partners), serious consideration should be given to ensuring the company is eligible for treaty benefits before taking it public, as described in greater detail above.
1 Corporations are subject to the same tax rates on all income.
2 See Notice 2011-64, 2011-37 I.R.B. 231 (listing applicable treaties).
3 A complete listing of the exchanges registered with the SEC is available at http:// www.sec.gov/divisions/marketreg/mrexchanges.shtml.
4 Notice 2003-71, 2003-43 I.R.B. 922; Notice 2003-79, 2003-2 C.B. 1206; Notice 2004-71, 2004-2 C.B. 793.
5 See footnote 3 above for a link to a listing of the exchanges registered with the SEC.
6 We note that the IRS held in PLR 9803009 (Jan. 16, 1998) that the installment method of accounting (which permits gain to be recognized over the period over which payments are made) was available to a taxpayer that sold listed shares, but, as an affiliate of the company, could only sell subject to the volume limitations in Rule 144. Although installment accounting is not permitted with respect to stock tradable on an established securities market, the IRS held that the legislative history indicated that the rule was intended to deny installment treatment only where the taxpayer in question could easily dispose of stock for cash in the public market. S. Rep. No. 99- 313, 99th Cong., 2d Sess. 124.
Thomas D. Phelen would like to give special thanks to Donald Readlinger for his advice on securities law matters discussed herein.