ACT PROVIDES NEW 15% DIVIDEND TAX

This article was authored by Robert I. Ury, who chairs the Firm's Tax and Estate Planning Department. He is celebrating his 40th anniversary with the Firm

For purposes of both the regular tax and the alternative minimum tax, The Jobs and Growth Tax Relief Reconciliation Act of 2003 provided for the taxation of qualified dividend income at the same rate that applies to net capital gain. Qualified dividends will thus be taxed at either 5% or 15% for taxable years beginning after 2002 and before 2009.

Qualified Dividend Income

Only qualified dividend income is entitled to the new rates, and qualified dividend income includes dividends from domestic corporations, as well as those received from qualified foreign corporations, on both preferred and common holdings.

"Qualified foreign corporations" includes a foreign corporation that is eligible for the benefits of a comprehensive income tax treaty with the United States which the Treasury Department determines to be satisfactory for purposes of qualified foreign corporation classification, and which includes an exchange of information program. It was intended that until the Treasury issues guidelines regarding the determination of which treaties are satisfactory for this purpose, a foreign corporation will be considered to be a qualified foreign corporation if it is eligible for the benefits of a comprehensive income tax treaty with the United States that includes an exchange of information program. A company is intended to be eligible for the benefits of a comprehensive income tax treaty where it would qualify for the benefits of the treaty with respect to substantially all of its income in the taxable year in which the dividend is paid.

A foreign corporation is also treated as a qualified foreign corporation with respect to any dividend paid by the corporation on stock that is readily tradable on an established securities market in the United States. The stock will be treated as if it is traded on such a market if it has an American depository receipt (ADR) backed by shares of such stock.

Dividends received from a corporation that was a foreign investment company, a passive foreign investment company, or a foreign personal holding company in either the taxable year of the dividend distribution or the prior year are not considered qualified dividends.

A series of special rules is provided for determining a taxpayer's foreign tax credit limitation where qualified dividend income exists. For these purposes, rules similar to the existing ones concerning adjustments to the foreign tax credit limitation to reflect any capital gain differential will apply to any qualified dividend income. It is also anticipated that regulations will be promulgated which will coordinate the operation of the rules applicable to qualified dividend income and capital gain.

The Holding Period

If a shareholder does not hold a share of stock for more than 60 days during the 120 day period beginning 60 days before the ex-dividend date, then the dividends received on the stock are not eligible for the reduced rates. Under another anti-abuse rule, the reduced rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property. New Section 1(h)(11)(B)(iii)(I) of the Internal Revenue Code ("Code") provides that, with respect to holding period requirements, the rules of Section 246(c), which apply to related corporate dividends, are to be considered.

Under Section 246(c) the 60 day holding period is to be reduced for any period or periods in which (i) the taxpayer has an option to sell, (ii) is under a contractual obligation to sell, (iii) has made and has not closed a short sale of substantially identical stock or securities, (iv) is the guarantor of an option to buy substantially identical stock or securities, or (v) has diminished his risk of loss of holding one or more positions with respect to substantially similar or related property.

Holding a qualified covered call should not affect the holding period for the underlying stock.

Other Aspects

If a taxpayer receives an extraordinary dividend eligible for the reduced rates with respect to any share of stock, any loss on the sale of stock generating a dividend is treated as a long-term loss to the extent of the dividend.

A dividend is treated as investment income for purposes of determining the amount of deductible investment interest only if the taxpayer elects to treat the dividend as not eligible for the reduced rates.

The amount of dividends qualifying for reduced rates that may be paid by a regulated investment company (RIC) or a real estate investment trust (REIT) for any taxable year that the aggregate qualifying dividends received by the RIC or REIT are less than 95% of its gross income may not exceed the amount of the aggregate qualifying dividends received by the company or trust.

The reduced rates do not apply to (i) dividends received from an organization that was exempt from tax under Section 501 of the Code or was a tax-exempt farmer's cooperative in either the taxable year of the distribution or the preceding year, (ii) dividends received from a mutual savings bank that received a deduction under Section 591, or (iii) deductible dividends paid on ESOP securities.

Amounts treated as ordinary income on the disposition of so called Section 306 preferred stock are treated as dividends for purposes of applying the new rates.

When it comes to pass-thru entities, such as partnerships, common trust funds, and S Corporations, special rules apply. Under the rules applicable to the taxation of partnerships, partners should take into account separately the distributive share of the partnership qualified dividend income. Evidently the holding period and related payment tests are applied at the partnership level. Participants in common trust funds will be treated as having received a pro-rata share of any qualified dividends received by the underlying common fund. S Corporation shareholders should have the S Corporation qualified dividend income pass through to them for purposes of applying the lower rates to their taxable incomes.

Qualified dividend income will be reported on Schedule D of the individual taxpayer's Form 1040, and no new tax forms are anticipated.