The New Participation Exemption: An Opportunity to Convert Ordinary Dividends into Qualified Dividends

Overview


In Depth


The Tax Cuts and Jobs Act introduced an important new benefit to US corporations that own 10 percent or more of a foreign corporation. Specifically, a full participation exemption has been enacted that exempts certain foreign sourced dividends paid to 10 percent US corporate shareholders from US federal income tax. The participation exemption applies to foreign sourced income that is not considered Subpart F, Global Intangible Low Taxed Income (GILTI) or income paid from a passive foreign investment company (collectively, the Foreign Corporation Regimes). Further, the participation exemption does not apply to “hybrid dividends,” which are dividends paid from a controlled foreign corporation (CFC) that received a deduction (or other tax benefit) with respect to any income, war profits, or excess profits taxes imposed by any foreign country or possession of the United States. If the participation exemption applies, the US corporate shareholder will not be entitled to claim foreign tax credits for any foreign tax imposed on the foreign sourced income.

US individuals and US trusts that own interests in foreign corporations, directly or through a partnership or S corporation, may find the participation exemption to be especially useful to the extent they own at least 10 percent of the shares in a foreign corporation located in a jurisdiction that does not have an income tax treaty with the United States (e.g., Brazil, Hong Kong, Singapore). Under present law, if a US individual or trust shareholder receives a dividend from a foreign corporation organized in a jurisdiction that has entered a tax treaty with the US or from a US domestic corporation, the dividend income typically will be treated as a “qualified dividend,” which is subject to the maximum federal income tax rate of 20 percent plus the 3.8 percent Medicare tax and applicable state and local tax. On the other hand, a dividend paid from a foreign corporation organized in a country that has not entered a tax treaty with the US will be taxed up to the highest individual federal rate of 37 percent plus the 3.8 percent Medicare tax and applicable state and local tax. Thus, a qualified dividend is taxed at a federal tax rate that is 17 percent less than an ordinary dividend. Furthermore, an individual or trust that owns an interest in a CFC would be provided an additional benefit by either contributing the CFC interest into a C corporation or by making a Code Section 962 election because the tax liability generated by the so-called Global Intangible Low Taxed Income Tax (GILTI) would be reduced.

To convert what otherwise would be ordinary dividend income into qualified dividends, a US non-corporate shareholder may consider contributing his or her shares in the foreign corporation into a newly formed or already existing US C corporation in a tax-free contribution transaction. At a later date, when the foreign corporation pays a dividend to the US corporate parent, the dividend should be exempt from US federal tax provided it does not fall under the Foreign Corporation Regimes and is not considered a hybrid dividend. Moreover, the participation exemption and the qualified dividend rules impose certain holding period requirements that must be satisfied to enable a US non-corporation shareholder to qualify for such favorable tax treatment. When the foreign corporation is a CFC, some or all of the corporation’s income will likely be GILTI and some of the CFC’s income may be Subpart F. A distribution of GILTI income and Subpart F income will also be exempt from US federal income tax as previously taxed income. If the foreign corporation is not a CFC, it cannot generate GILTI or Subpart F income, so that all distributions from such entity likely would qualify for the participation exemption.

Therefore, the US corporation can receive the dividend without incurring any US income tax liability. The US corporation may be able to reinvest the funds received in a business venture or other investment but should be wary of the so-called personal holding company rules and the accumulated earnings tax rules. Subsequently, when the US corporation pays a dividend to the US individual or trust shareholder, the dividend income should be considered qualified dividends.