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New Tax Legislation Creates Opportunities for Issuers, Investors

Client Advisory

June 2, 2003
by Jerome J. Caulfield and Richard Horne
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “Act”) was signed by the President last week. It is intended as an economic stimulus. To that end, the Act encourages investment by businesses in tangible personal property by increasing the first-year “bonus” depreciation (to 50%) and by increasing the ability of small businesses to expense the entire cost of some property. The Act also seeks to encourage the investment of capital: in addition to accelerating into 2003 the reductions in individual tax rates previously scheduled to become effective in 2004 and 2006, the Act reduces the maximum marginal rates for long-term capital gains and “qualified dividend income” for individuals to 15%. These reductions appear to create significant new opportunities for issuers and investors, as described below. Unfortunately, the fact that these changes are scheduled to “sunset” after 2008 makes planning difficult. (A more technically oriented tax bill is a possibility later this year.)

Reduction in Long-Term Capital Gains Rate for Individuals

The Act reduces the maximum marginal tax rate for long-term capital gains of individuals to 15%, effective for sales and exchanges (and installment payments received) between May 6, 2003 and December 31, 2008. Beginning in 2009, the rate would revert to 20%.

Reduction in Rate for “Qualified Dividend Income” for Individuals

The Act reduces the maximum marginal tax rate for “qualified dividend income” of individuals to 15%, effective for taxable years 2003 through 2008. “Qualified dividend income” includes any dividends (as defined under existing tax law) received from a domestic corporation or from a “qualified foreign corporation.” A “qualified foreign corporation” is any foreign corporation which is 1) incorporated in a possession of the United States, 2) eligible for the benefits of a comprehensive income tax treaty with the United States, if that treaty contains what the IRS determines is a “satisfactory” exchange of information program (the legislative history indicates that, initially, only the treaty with Barbados should be considered “unsatisfactory”), or 3) a corporation whose stock is readily tradable on an established U.S. securities market.

The last category is perhaps the most interesting. It should be noted that the reduced rate applies only to the class of securities that are considered readily tradable in the United States. It does include, however, stock represented by depository receipts traded in the United States. Certain foreign investment companies are excluded from the qualified status. Specifically, a foreign corporation which would otherwise be treated as a qualified foreign corporation will not be so treated if, during the year in which the dividend was paid or in the preceding year the foreign corporation is or was a “foreign personal holding company,” a “foreign investment company,” or a “passive foreign investment company.”

With respect to domestic corporations, dividends paid by tax-exempt organizations, by mutual savings banks receiving a deduction under section 591 of the Internal Revenue Code, or by employers taking deductions on the issuance of the dividends are disqualified. Regulated investment companies (mutual funds) and real estate investment trusts (REITs), which are essentially pass-through entities, generally may pay qualified dividends to the extent that they have received qualified dividend income.

The Act also limits the circumstances under which individuals may take advantage of the new rate. In order to qualify for the reduced rate, a shareholder must hold the dividend-paying stock for more than 60 days during the 120 day period beginning 60 days prior to the stock’s ex-dividend date (or, in the case of preferred stocks, for 90 out of 180 days beginning 90 days prior to the ex-dividend date). These periods are “tolled” whenever the taxpayer has substantially diminished its risk of loss, i.e., through hedging. In addition, a taxpayer will not qualify for the reduced rate to the extent that the taxpayer elects to treat the dividend as “investment income” that may be offset by an interest deduction; nor will a taxpayer qualify for the reduced rate if the taxpayer is required to make “in lieu of” payments with respect to the dividends (as is commonly the case, for instance, when an investor has entered into a short sale or a hedging transaction). If a taxpayer receives an “extraordinary dividend,” any loss realized on subsequent sale of the underlying stock will constitute a long-term capital loss to the extent of the dividend. Finally, taxpayers benefiting from the reduced tax rate for dividends will be limited in their ability to claim foreign tax credits with respect to foreign-source dividends, in a manner that should prevent them from reducing their effective U.S. tax rate on such dividends below 15%.

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Under the Act, most dividends will now be taxed at a rate significantly lower than those applicable to short-term capital gains and ordinary income, including interest. Further, unlike the President’s original proposal, the Act does not require corporations to have paid corporate tax in order to pay qualified dividend income. (Thus, the inclusion of foreign corporations.) Accordingly, many economists expect some shift in the market in favor of stocks which reliably produce substantial dividends. It is also possible to envision new types of tax-advantaged products created in response to this legislation. For example, foreign corporations may issue securities which are treated as dividend-paying “stock” for U.S. federal income tax purposes, but as debt instruments for purposes of the taxing regime of their home country. Under the Act, U.S. investors could then receive tax-favored dividends, in respect of which the issuer could claim interest deductions in its home jurisdiction. Often there would be no withholding tax imposed in this situation.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
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