The U.S. generally imposes a 30% withholding tax on dividends paid by U.S. corporations to nonresident aliens and foreign corporations. This 30% rate is typically reduced to 15% under U.S. income tax treaties for residents of the treaty countries that beneficially own shares in the U.S. corporation. Further, the withholding rate is often reduced to 5% for treaty country corporate residents that beneficially own at least 10% of the voting stock of the U.S. company paying the dividend.
Direct / Non-Direct Investments
The 10% threshold marks the dividing line used by the Department of Commerce in defining whether income from foreign assets is categorized as income from “direct investments” or income from “non-direct investments.” The Department of Commerce defines an investment as direct when a single person owns or controls, directly or indirectly, at least 10 percent of the voting securities of a corporate enterprise or the equivalent interest in an unincorporated business. Non-direct investments consist mostly of holdings of corporate equities and corporate and government bonds, generally referred to as “portfolio investments,” and bank deposits and loans.
Taxation of U.S. Mutual Funds
U.S. mutual funds are generally structured as “regulated investment companies” or “RICs.” U.S. tax law generally treats a RIC as both a corporation and as an entity not subject to corporate tax to the extent it distributes substantially all of its income. The purpose of a RIC is to allow investors to hold diversified portfolios of securities. Dividends paid by a RIC generally are treated as dividends received by the payee, and the RIC generally pays no tax because it is permitted to deduct dividends paid to its shareholders in computing its taxable income.
Treaty Limitations on Dividends Paid by U.S. Mutual Funds
U.S. tax treaties generally deny the five-percent rate of withholding tax to dividends paid by U.S. RICs. The 15% rate of withholding generally is allowed for dividends paid by a RIC. This restriction is intended to prevent the use of a RIC to gain inappropriate U.S. tax benefits.
For example, a company resident in the treaty country that wishes to hold a diversified portfolio of U.S. corporate shares could hold the portfolio directly and would bear a U.S. withholding tax of 15% on all of the dividends that it receives. Alternatively, the company could hold the same diversified portfolio by purchasing 10% or more of the interests in a RIC. If the RIC is a pure conduit, there may be no U.S. tax cost to interposing the RIC in the chain of ownership. Absent the special rule, such use of the RIC could transform portfolio dividends, taxable in the U. S. at a 15% maximum rate of withholding tax, into direct investment dividends taxable at a 5% maximum rate of withholding tax.