Think Your Foreign Dividends Are “Qualified”? Think Again.

Investors too often assume that dividends, whether from U.S. companies or foreign corporations, are taxed similarly. Under U.S. tax law, however, that assumption is incorrect and making mistakes can mean losing out on your investment.

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 long-term capital gains tax rate. For most individuals this rate is currently at 15%, but the rate can be 0% or 20% depending on the taxpayer’s income levels.

The taxation of foreign company dividends is more nuanced. They may be “qualified” but must pass certain hurdles. If they don’t pass the tests, foreign dividends may end up with a surprising a 37% U.S. tax rate.

With both kinds of dividends, qualified and regular, a 3.8% net investment income tax may be tagged on top.

What Are “Qualified Dividends”?

U.S. tax law grants reduced tax rates on what it calls “qualified dividend income”. Dividends from U.S. corporations are typically treated as QDI. But dividends from foreign corporations face more restrictions. There are various ways a dividend paid by a non-U.S. corporation can be treated as a qualified dividend.

Dividends Paid By A Foreign Corporation Can Be “Qualified”

A dividend from a foreign corporation will meet the QDI criteria if any of the following apply:

• The foreign corporation is incorporated in a U.S. possession (e.g., Puerto Rico);
• The foreign corporation is a resident of a country that has a comprehensive income tax treaty with the United States that the IRS deems “satisfactory” for this purpose. This is referred to as the “Treaty Test.”
• Finally, even if no treaty applies, a foreign corporation can pay qualified dividends if its shares are “readily tradable on an established securities market” in the United States (e.g., the NYSE or Nasdaq).

Which Treaties Have IRS Approval for Paying Qualified Dividends?

The most recent list of approved treaties meeting the Treaty Test can be found in Internal Revenue Service Notice 2024-11. This Notice updated the list of income tax treaties considered “satisfactory” for determining whether a dividend paid by a foreign corporation qualifies for reduced tax rates in the hands of the U.S. investor. Most notably, the United States added Chile to the list, following the long-awaited ratification of the U.S.–Chile tax treaty in December 2023. In contrast, the treaties with Hungary and Russia were removed from the favorable list.

U.S. investors must take note since foreign companies incorporated in countries without an IRS-approved treaty, or whose structures fail the other specific tests, will not pay QSI, meaning dividends can potentially be taxed at 40.8% (37% maximum income tax rate plus the 3.8% Net Investment Income Tax).

The Treaty List: What It Means—and Doesn’t Mean

Inclusion on the IRS treaty list does not automatically mean that every corporation formed in that country qualifies. It’s not enough that a treaty exists or that the country appears in an IRS notice. The foreign corporation itself must be eligible for treaty benefits under the terms of that specific treaty.

In practice, this means the corporation must qualify under what’s called the “Limitation on Benefits” article of the treaty. These LoB provisions are designed to prevent “treaty shopping”, when companies from non-treaty countries route income through favorable jurisdictions just to reduce taxes. The LoB clause is designed to prevent such exploitation of treaty benefits.

In the more modern U.S. income tax treaties (particularly those entered into or amended in the past few decades) the LoB clause is found in either Article 22 or Article 23. The LoB rules often require that a substantial portion of the foreign corporation’s ownership or business activity be in the treaty country. For example, a treaty may only permit reduced withholding rates if a certain percentage of the company’s shareholders are residents of the United States or of the treaty partner.

This distinction is critical, and unfortunately, often overlooked by tax advisors and return preparers. Some assume that if a treaty exists, dividends paid by a corporation formed in the foreign country that is a treaty signatory will automatically qualify. Not so. Each treaty’s LoB article must be analyzed in detail. A foreign corporation that fails to meet the ownership or activity tests of the treaty will not be treated as a qualified, and its dividends will be taxed at the higher ordinary income tax rates.

Controlled Foreign Corporations Or Passive Foreign Investment Companies

U.S. taxpayers who own shares in a “controlled foreign corporation” face additional complexity. Even if the foreign company pays no dividend at all, certain types of income may still be taxable to the U.S. shareholder under certain anti-deferral tax regimes (Subpart F or GILTI tax rules). When a dividend is paid by the CFC determining whether it is “qualified” involves more than just treaty eligibility. CFC shareholders should not assume dividends will qualify for favorable rates and should seek specialized tax counsel.

Dividends from so-called “passive foreign investment companies” are not qualified dividends. They are taxed harshly at ordinary income rates, not the reduced rates for capital gains and they can trigger interest charges and other penalties. PFIC distributions require special tax help for U.S. persons and with the proper advice, the tax treatment can be made more favorable.

Takeaway for Investors

Understanding whether dividends are “qualified” is more than a box to check on a tax return. It can be the difference between paying lower capital gain rates typically 15% or 20% or higher ordinary income rates 37% (plus 3.8%). U.S. investors holding shares in foreign companies (especially through private holdings or controlled entities) must dig deeper into the U.S. tax rules and look beyond treaty lists. This will often involve examining whether the corporation qualifies under treaty terms, including the often misunderstood LoB clauses.

With certain global issues in turmoil, tax agreements and treaties are evolving. This means the rules on which foreign companies qualify to pay QDI to their shareholders continue to shift, making expert advice more essential than ever.

Stay on top of tax matters around the globe.

Reach me at vljeker@us-taxes.org

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NO ATTORNEY-CLIENT RELATIONSHIP OR LEGAL ADVICE

This communication is for general informational purposes only. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the reader in making a decision.