A withholding tax is an amount of income that a company withholds from an employee’s paycheck or from dividends paid to a foreign shareholder. The corporation pays the money withheld to the IRS directly, instead of to the employee or shareholder. This article will be limited to taxes withheld on nonresident investors’ dividends. For an overview of the different components of a distribution, including dividends, return of capital, and capital gains, read The ABC’s of Distributions. All of these terms will be relevant to this explanation of withholding taxes on distributions paid to foreign investors.
Dividends
A dividend paid by a U.S. corporation to a foreign shareholder is usually subject to a withholding tax. The amount of the withholding tax depends on whether the United States has tax treaties with the foreign shareholder’s country, and on how much of the U.S. corporation the foreign shareholder owns. Consider the following example regarding the impact of treaties on nonresident investors’ withholding taxes:
Two investors, Donna and Josh, have a partnership that owns interest in a U.S. corporation. Donna lives in foreign Country X, and Josh lives just across the border in Country Y. The United States has a tax treaty with Country X, but not Country Y. Residents of Country X are exempt from U.S. withholding taxes, but residents of Country Y are subject to a 30% withholding tax. The U.S. corporation pays a dividend of $100 to the partnership. The corporation takes into account the fact that Josh, who is a resident of a country that does not have a tax treaty with the United States, owns half of the partnership. Donna receives her full dividend of $50, but Josh will only receive $35 due to the withholding tax. The U.S. corporation will withhold $15 from Josh’s dividend and pay it to the IRS.
Return
of Capital
A return of capital occurs when a corporation returns a portion of an investor’s original investment, which reduces the investor’s adjusted tax basis. A return of capital is not a dividend, meaning that it is not withdrawn from current or accumulated earnings and profits.[1] See our article on Calculating Earnings and Profits to read about how to calculate this sum and learn about how distributions impact earnings and profits. The return of capital is applied against and reduces the shareholder’s adjusted stock basis. This type of distribution usually represents a tax-free recovery of the taxpayer’s investment in the stock.
An exception to this rule is when the distribution is from a U.S. real property holding corporation (USRPHC). A corporation is a USRPHC if the fair market value of the U.S. real property interests held by the corporation on any applicable determination date equals or exceeds 50 percent of the sum of the fair market values of its: U.S. real property interests, interests in real property located outside the United States, and certain business assets. Real property includes land, any property attached to it and the rights associated with the ownership of that land. [2] A USRPHC is usually subject to a 15% withholding tax on:
- The portion of the distribution that is in excess of the distributing corporation’s earnings and profits,
- The portion that is treated as a return of capital, and
- To the portion of the distribution treated as capital gain.[3]
Capital Gains
Capital gains are not usually subject to withholding taxes, unless the distribution is from a USRPHC. If this is the case, then a 15% withholding tax applies to the portion of the distribution treated as a capital gain. As with withholding taxes on dividends and return of capital, the amount of withholding taxes on capital gains are determined by the U.S. federal tax code and the treaties, if there are any, that the United States may have with a specific foreign country.
Conclusion
Both foreign shareholders and American organizations should be aware of withholding taxes. From the foreign shareholder’s standpoint, understanding this concept and being aware of the tax agreements their country may have with the United States can help clarify how much in distributions they can expect to receive. Likewise, corporations and partnerships (see Choice of Entity) must know which shareholders require withholding taxes and how much to pay to the IRS. Both buyers and sellers in an M&A deal involving a foreign firm should consider the impact of withholding taxes when structuring the deal. In such a case, asset purchases might be a more attractive option than a stock deal, since the latter might require distributing dividends to foreign shareholders. The differences between these two deals are described in Asset Sales vs. Stock Sales. Finally, withholding taxes impact how a corporation models its earnings and profits. To read more about this subject, see Earnings and Profits. In turn, the calculation of earnings and profits plays an important role in determining a firm’s valuation, which plays an important role in M&A negotiations.
[1] IRC § 301 (c)(2).
[2] CFR §§ 1.897-2 (b)(1), 1.897-1 (b)(1).
[3] IRC §§ 897(I), 1445(e)(3).