15% DIVIDEND RATE EXTENDED TO MORE FOREIGN CORPORATION DIVIDENDS

Section 1(h)(11) of the Internal Revenue Code provides that qualified dividends received by an individual shareholder are taxed as net capital gain. This presently results in a a 5% or 15% tax rate.

When the dividend payor is a foreign corporation, the rate only applies to foreign corporations eligible for the benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory and which includes an exchange of information program. However, the special treatment also applies to foreign corporations whose stock is publicly traded.

In 2003, the IRS published a list of countries whose corporations meet these requirements. Recently, in Notice 2006-103, the IRS has revised that list.

New to the list are Barbados, Sri Lanka, and Bangladesh. The IRS notes that U.S. agreements with Bermuda, the Netherlands Antilles, and those former Soviet Republics still covered by the old U.S. - U.S.S.R. treaty are insufficient to provide net capital gains treatment for dividends issued by corporations of those countries.

Note that dividends of passive foreign investment companies (PFICs) do not qualify for this net capital gain treatment. Also, dividend recipients who do not meet certain minimum holdings periods also cannot get the benefit of the capital gains treatment.

SOFA's AND USAID AGREEMENTS

U.S. persons working abroad are subject to U.S. taxes on their worldwide income. If a foreign country taxes the U.S. person on their income earned in that country, relief may be available through foreign tax credits, or the earned income exclusion provisions of Code Section 911.

Most practitioners also know to consult any applicable income tax treaties, to determine if there are any special provisions that limit what types or amounts of income the foreign country can tax. What is less widely known is that there are other types of international agreements that may apply to this issue and that may need to be consulted.

The first of these is a Status of Forces Agreement (SOFA). These agreements generally provide rules regulating the presence of armed forces and civilian supporting personnel of one country in the jurisdiction of another. These agreement can provide for the exclusion of such forces from local income taxes based on residence in the other country. For example, Article X.1. of the NATO Status of Forces Agreement provides:

"Where the legal incidence of any form of taxation in the receiving State depends upon residence or domicile, periods during which a member of a force or civilian component is in the territory of that State by reason solely of his being a member of such force or civilian component shall not be considered as periods of residence therein, or as creating a change of residence or domicile, for the purposes of such taxation. Members of a force or civilian component shall be exempt from taxation in the receiving State on the salary and emoluments paid to them as such members by the sending State or on any tangible movable property the presence of which in the receiving State is due solely to their temporary presence there. "

Another type of treaty or international that can also provide similar benefits are agreements of the United States Agency for International Development (USAID). These agreements may provide exemptions from local taxation for aid workers present in a foreign country.

Therefore, where military personnel, their supporting civilian personnel, or international aid workers are working in a foreign country, such agreements should be reviewed for applicability.

NEW TAX REPORTING ON TRANSFERS TO TRUSTS

A popular estate tax planning technique is a sale of an interest in a corporation or a partnership to a grantor trust (also known as a sale to a defective grantor trust). If properly structured, future growth in the value of the sold interest will not be subject to estate tax when the transferor dies. Further, no income tax arises on the sale.

If the sales price equals the fair market value of what was sold, there is no gift on the transaction, and no gift tax return reporting is of the transaction is required. Since valuing an interest in an entity is not an exact science, gift tax exposure exists if the IRS can establish a higher value than the sales price. Many practitioners elect not to report the transaction, so as to avoid the risk of IRS scrutiny. Since the transaction doesn't typically show up on a gift tax or income tax return, IRS scrutiny is thus substantially diminished.

This type of thinking may shortly fall by the wayside. On a recently released draft Form 706 (estate tax return), the IRS now has a question whether a decedent at any time during his or her lifetime transferred or sold an interest in a partnership, a limited liability company or a closely-held corporation to a trust that was in existence at the decedent’s death and that was (1) created by the decedent during his or her lifetime or (2) created by someone other than the decedent under which the decedent possessed any power, beneficial interest or trusteeship. This question will bring to the IRS' attention a sale to grantor trust transaction, at least at the time of the decedent's death, thus inviting IRS scrutiny of the transaction.

If the IRS determines that a gift occurred on the sale, it can impose gift taxes, penalties, and interest, even if the sale transaction occurred many years prior to death. If this question makes it into the final Form 706, practioners may now want to specifically disclose sale to grantor trust transactions on gift tax returns to get the statute of limitations running since there is a good chance that IRS scrutiny may arise later at the time of estate tax audit due to the Form 706 disclosure. If the IRS does not challenge the transaction within 3 years, this will usually foreclose further tax adjustments by the IRS (including at the subsequent death of the transferor). This is especially true since very few gift taxes are audited.