Sunset on the Horizon: Changes in Tax Planning for Foreign Investments

Excerpt from Practical US/International Tax Strategies by Isaac Grossman (Morrison Cohen LLP)

It doesn’t take long for investment professionals to adjust to changes in the tax rules governing investments. Application of the 15 percent long-term capital gains rates to individuals receiving qualified dividend income from domestic and certain foreign corporations is no longer news. As a result, investment decisions are based on the expectation that these rates will remain in effect. However, these changes among others will sunset after 2010, if no further legislation is adopted. Currently, it is not clear that further legislation will be on the national agenda when President Bush, the force behind many of these tax rate cuts, leaves the White House. Moreover, some would suggest that tax rates may be increased even sooner depending on the identity of the next president. If the rates sunset as currently drafted, the individual income tax rates will return to close to 40 percent and no special rate will be applied to dividends.

As many investments have a shelf life of several years, it is essential to think ahead of the curve and consider the impact of these upcoming changes.

In light of the expected increase in the tax rates for dividends from 15 percent to close to 40 percent, several basic assumptions for tax structuring investments must be reconsidered. First, the most basic decision in structuring a new operating or holding corporation both domestically and offshore is the proper capitalization of the corporation, i.e., the proper mix of debt and equity. Under current law, there is a tension between favoring debt or equity. Debt generally permits the issuing corporation to deduct current payments of interest to investors and interest payments often qualify for lower withholding tax rates than dividends. In addition, it is easier to return the principal amount of a debt instrument to the holder than to return the principal amount of an equity instrument to the holder due to the tax provisions relating to redemptions. Equity permits individual investors to pay capital gains rates on dividend payments and permits corporate recipients a dividends received deduction (for domestic investments) or indirect foreign tax credits (for foreign investments). When the tax rates sunset and individuals become taxable at ordinary rates on dividends, equity may become less tax effi cient for individual investors. Thus, the decision on capitalization will further favor debt.

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