SECTION 2. BACKGROUND

.01 The 2003 Act Section 1(h)(1) of the Internal Revenue Code generally provides that a taxpayer’s “net capital gain” for any taxable year will be subject to a maximum tax rate of 15 percent (or 5 percent in the case of certain taxpayers). The 2003 Act added section 1(h)(11), which provides that net capital gain for purposes of section (1)(h) means net capital gain (determined without regard to section 1(h)(11)) increased by “qualified dividend income”. Qualified dividend income means dividends received during the taxable year from domestic corporations and “qualified foreign corporations.” Section 1(h)(11)(B)(i). Subject to certain exceptions, a qualified foreign corporation is any foreign corporation that is either (i) incorporated in a possession of the United States (the “possessions test”), or (ii) eligible for benefits of a comprehensive income tax treaty with the United States which the Secretary determines is satisfactory for purposes of this provision and which includes an exchange of information program (the “treaty test”). ¹ Section 1(h)(11)(C)(i). Subject to the same exceptions, a foreign

corporation that does not satisfy either of these two tests is treated as a qualified foreign corporation with respect to any dividend paid by such corporation if the stock with respect to which such dividend is paid is readily tradable on an established securities market in the United States (the “readily tradable test”). ² Section 1(h)(11)(C)(ii). A qualified foreign corporation does not include any foreign corporation which for the taxable year of the corporation in which the dividend was paid, or the preceding taxable year, is a foreign personal holding company (as defined in section 552) (a “FPHC”), a foreign investment company (as defined in section 1246(b)) (a “FIC”), or a passive foreign investment company (as defined in section 1297) (a “PFIC”) (the “foreign investment company exclusion test”). Section 1(h)(11)(C)(iii).

A distribution with respect to a security issued by a qualified foreign corporation also is subject to the other limitations in section 1(h)(11). In particular, the recipient must satisfy the holding period requirements of section 1(h)(11)(B)(iii) (the “holding period test”). In addition, the distribution must constitute a dividend for U.S. federal income tax purposes. Accordingly, the security with respect to which the distribution is made must be equity rather than debt for U.S. federal income tax purposes (the “equity test”), and the distribution must be out of the corporation’s earnings and profits rather than a return of capital (the “E&P test”).

The determination whether a distribution with respect to a security issued by a foreign corporation is eligible for the reduced rates of tax under the 2003 Act therefore requires a series of separate determinations. These determinations are discussed in more detail in Section 3. First, the security with respect to which the distribution is made must satisfy the equity test. Second, the distribution must satisfy the E&P test. Third, the security must satisfy the readily tradable test, or the foreign corporation must satisfy either the possessions test or the treaty test. Fourth, the foreign corporation must satisfy the foreign investment company exclusion test. Fifth,

1 Notice 2003–69, 2003–42 I.R.B. 851, contains the current list of the U.S. tax treaties that meet these requirements.

2 Notice 2003–71, 2003–43 I.R.B. 922, provides guidance on when ordinary or common stock is considered readily tradable on an established securities market in the United States.

3 Notice 2003–67, 2003–40 I.R.B. 752, provides guidance to brokers and individuals regarding provisions in the 2003 Act that affect information reporting for payments in lieu of dividends.

4 Revenue Procedure 2002–57, 2002–2 C.B. 575, provides circumstances under which a person required to file Form 1099 may file a substitute.

December 15, 2003 1207 2003-50 I.R.B.

For 2004 and future information reporting, Treasury and the IRS intend to issue regulations providing a certification procedure under which foreign corporations may certify that a security with respect to which a distribution is made meets the equity test. As discussed below, it is expected that it will be possible to make such certification either in a public SEC filing (such as in a Form 20–F) or in a public statement with a copy filed with the IRS.

.02 E&P Test In order to be a qualified dividend, a distribution must be a dividend. Section 316 generally provides that a dividend means any payment made by a corporation to its shareholders out of earnings and profits. A person required to file an information return under section 6042 may not know in a given circumstance whether a distribution by a corporation represents a distribution of earnings and profits. If a person making a payment of or with respect to a distribution by a corporation is unable to determine the portion of such a payment that is a dividend or is paid with respect to a dividend, then under section 6042 the person making the payment must treat the entire payment as a dividend or as an amount paid with respect to a dividend. Section 6042(b)(3). .03 Tests in the Alternative: Readily Tradable Test, Possessions Test, and Treaty Test

(a) Readily Tradable Test . A foreign corporation is treated as a qualified foreign corporation with respect to any dividend paid by such corporation if the stock with respect to which that dividend is paid is readily tradable on an established securities market in the United States. Notice 2003–71 defines when ordinary or common stock is considered readily tradable on an established securities market in the United States. In addition, for 2003, a security (or an American depositary receipt in respect of such security) issued by a foreign corporation that is other than ordinary or common stock (such as preferred stock) will satisfy the readily tradable test if it is listed on a national securities exchange that is registered under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. § 78f) or on the Nasdaq Stock Market as described in Notice 2003–71. (See Section 3.01 for discussion of the equity test.)

28 (March 31 if filed electronically) of the year following the calendar year in which the dividend was paid. Section 1.6042–2(c) of the Income Tax Regulations. A person required to furnish a payee statement under that section generally must do so not later than January 31 of the year in which the information return is to be filed. ⁵

Penalties . Section 6721 imposes a penalty if a person fails to file a timely correct information return, including a return under section 6042. Section 6722 imposes a penalty if a payor fails to furnish to a payee a timely correct information statement, including a statement under section 6042. Section 6724(a) provides that the penalties under sections 6721 and 6722 do not apply if the failure to comply is due to reasonable cause and not to willful neglect.

Recipients of Payee Statements . Section 6662 imposes a penalty if a taxpayer substantially understates its income tax liability. Section 6664(c) provides that no penalty shall be imposed under section 6662 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. The regulations under section 6664 provide that the determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Under those regulations, a taxpayer’s reliance on erroneous information reported on a Form 1099 indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Section 1.6664–4(b)(1) of the Income Tax Regulations. For these purposes, a taxpayer generally knows, or has reason to know, that the information on an information return is incorrect if such information is inconsistent either with other information reported or furnished to the taxpayer or with the taxpayer’s knowledge of the transaction. Id.

The instructions to Form 1040 for 2003 state that some distributions that are reported as qualified dividends in Box 1b of Form 1099–DIV may not actually be qualified dividends. For example, the

instructions provide examples illustrating situations in which amounts reported as qualified dividends in Box 1b of Form 1099–DIV are not qualified dividends because the recipient of the dividends failed to satisfy the holding period test.