In this article I address equally foreign investors as well as U.S. investors who would like to gain a deeper understanding of the tax regulations that apply to foreign investors who receive dividend income from U.S. companies. The article highlights a special tax exemption rule that applies to very few U.S. companies, including Philip Morris International (NYSE:PM) -in the following referred to as PMI.
In the course of the article I provide concrete examples of the differences in taxation for dividend payments made by Altria (NYSE:MO) over those made by PMI. The examples given to the readers will provide a clear explanation of the significant tax advantage PMI's dividend offers to foreign investors. The FAQ Section at the end of the article provides additional hands on investment knowledge.
Basic Information About U.S. Dividend-Income-Tax
To start with, please note that the U.S. Internal Revenue Service's website states: "Most types of U.S. source income paid to a foreign person are subject to a withholding tax of 30%, although a reduced rate or exemption may apply if stipulated in the applicable tax treaty." See here for source details.
To the foreign investor it means 30% of the dividend paid by a U.S. company is automatically withheld by his financial institution (bank, brokerage, or stock transfer agent) as U.S. dividend-income-tax.
This is demonstrated by the following example:
Altria - Example Without Tax Treaty - Hong Kong
- In 2011 Altria pays a total dividend of $1.58.
- After a 30% tax withholding a mere $1.11, remains in the hands of the investor residing in Hong Kong ($1.58*0.70 = $1.11).
- The difference of $0.47 is withheld by the financial institution and then transferred to U.S. Internal Revenue Services (IRS), which is an arm of the U.S. Federal Government.
- As there is no Double Taxation Agreement (DTA) between the United States and Hong Kong, it is not possible to claim this money back from Hong Kong tax authorities or to reduce the overall income tax burden.
Now let's look at another example, this time of a country that has a tax treaty with the United States:
Altria - Example With Tax Treaty - P.R. China
- To start with, in order to claim the rate stipulated in the DTA it is necessary for the foreign investor to submit a W-8BEN form to his financial institution. Only with a W8-BEN form on file will the institution apply the rate stipulated in the DTA in its tax withholding calculation.
- In P.R. China's DTA with the United States the dividend-income-tax withholding rate is stipulated at 10%.
- Therefore, Altria's $1.58 dividend payment in 2011 turns into $1.42 after 10% tax withholding ($ 1.58*0.90 = $ 1.42).
- That is 28% more in after-tax dividend income than with no tax treaty in place ($1.42 vs $1.11).
Conclusion On Altria's Dividend Attractiveness To The Foreign Investor
The attractiveness of dividends paid by Altria depends on two factors: the existence of a Double Taxation Agreement, and the dividend-income-tax withholding rate stipulated in it. The lower the withholding rate the more attractive Altria is to foreign investors who seek dividend income.
The previous examples showed the two standard calculation procedures, with and without tax treaty. However, when PMI pays a dividend in either case an additional calculation step is required, which precedes the standard calculation procedure.
This will be shown in the following examples:
PMI - Example Without Tax Treaty - Hong Kong
- In 2011 PMI pays a total dividend of $2.82.
- To the foreign investor it is of the utmost importance to understand that for dividends paid by PMI a special U.S. tax exemption rule applies. Due to the fact that more than 80% of PMI's income is generated outside the United States, PMI qualifies as an "80/20" company. (For details on the definition of an "80/20" company and how it affects dividend taxation, please peruse PMI's website under Investor Relations FAQ. On that page under section "Dividend and Withholding Tax Information" it is stated: "As a non-U.S. shareholder of PMI how does PMI qualifying as an "80/20" company affect me?" The answer given is "PMI has determined that 93% of any dividend it declares in 2011 to a non-U.S. shareholder is exempt from U.S. withholding tax." In other words, it means that only the remaining 7% of PMI's dividend paid to a foreign investor are subject to U.S. withholding tax. That brings us to our 'Preceding Calculation Step' mentioned earlier.
- Instead of a 30% tax liability on the whole dividend of $2.82, the investor has a 30% tax liability on $0.20 only ($2.82*0.07 = $ 0.20).
- Having arrived at this result, we continue with the standard calculation procedure. The final result is $ 0.06 cents in total tax for a foreign investor residing in Hong Kong ($0.20*0.30= $ 0.06).
Let's analyze whether or not a tax treaty provides even more tax savings than the "80/20" company rule already does.
PMI - Example With Tax Treaty - P.R. China
- Using the same calculation as above, simply take the 10% withholding tax rate stipulated in the DTA and insert that figure into the calculation ($0.20*0.10% = $ 0.02)
- To a foreign investor residing in P.R. China it means $0.02 in total tax. That is 2/3 less than with residency in Hong Kong. Although it appears to be a huge difference in dividend income tax, in total dollar terms it does not make a significant difference.
Thus a tax treaty does not provide significantly more tax savings than the "80/20" company rule already does.
Conclusion On PMl's Dividend Attractiveness To The Foreign Investor
Under the current U.S. dividend-income-tax law, the attractiveness of dividends paid by PMI does not depend on the existence of a DTA nor on a favorable dividend-income-tax rate stipulated in it. Instead, the charm of PMI's dividend is highly dependent on the "80/20" company rule.
Investors that benefit the most from the "80/20"company rule are those residing in countries that have no tax treaty with the United States and that do not levy tax on dividend income received from U.S. stocks. Under such circumstances, PMI's after-tax dividend can be as attractive as Altria's despite the usual one to two percentage points market difference in pre-tax dividend yield between these two stocks.
Even to investors residing in countries that have a tax treaty with the United States the "80/20" company rule's benefit is of higher significance than a tax treaty's low withholding rate. In the P.R. China, the investor's tax liability without the "80/20" company rule would amount to $0.28 instead of $0.02 with it.
However, should the "80/20"company rule be repealed the difference in taxation between PMI and Altria dividends ceases to exist. More information on the latest development pertaining to the "80/20" company rule can be found here.
Additional Remarks As To Investment Practice
From my own experience, many foreign investors do not know about the "80/20" company rule and the tremendous tax benefit it provides. In addition to that, it appears as if many financial institutions do not automatically apply the "80/20" company tax rule for dividends paid by PMI. Instead, they seem to follow standard calculation procedure and withhold 30% or whatever is the rate stipulated in the DTA. Therefore, it is of significant importance to raise investors' awareness and to enforce the correct tax computation by financial institutions. Another benefit of doing so would be that foreign investors have more financial funds available for dividend reinvestment, which eventually helps all PMI investors.
1. I still believe my dividends should be income tax free.
This is a common misunderstanding by investors who reside in countries that levy no tax on dividend income. It is important to understand that the topic of this article is about U.S. dividend-income-tax law that applies to all investors in U.S. stocks. In other words, every foreign investor is subject to this tax, regardless of where he resides, or where he holds his stocks, and regardless of the actual dividend taxation law in his country of residence. The sole taxation criterion is that the dividend is paid by a U.S. company.
In conclusion, it also means that dividends paid by non U.S.companies are not subject to U.S. dividend-income-tax law. Instead, the dividends are subject to the tax law of the country where the company is incorporated.
For example, a foreign investor residing in Hong Kong and holding British American Tobacco ADRs (NYSEMKT:BTI) with a stockbroker in the United States would have to pay U.K. dividend-income-tax, because British American Tobacco is incorporated in the U.K.
2. What is a W8- BEN Form?
The W8-BEN form is a U.S. tax document that must be submitted by the foreign investor to his financial institution in order to claim the dividend-income-tax withholding rate as per Double Taxation Agreement between the U.S. and his country of residence.
3. Will dividends paid by PMI always be eligible for a 93% exemption from U.S. withholding tax for non-U.S. shareholders?
The interested investor will find PMI's answer to this question on their Investor Relations website. Personally, I have observed that the tax exemption rate has varied slightly year over year which I see as normal as it is a ratio of PMI's income from outside the United States and from within the United States. The exemption itself depends on the continuous validity of the "80/20"company rule as U.S. tax law or any changes made to it.
4. Philip Morris International only sells its products outside the United States, why then is 100% of its dividend not exempt from U.S. dividend income tax?
According to the information that was given by PMI Investor Relations to me, some interest income is received from within the United States and this portion is liable to dividend income tax.
5. How are Q4 dividends treated that are paid to my account in the next year?
Such a dividend is called "Spill Over Dividend." An explanation of this finance term can be retrieved here.
In short, a Spill Over Dividend credited to the account in January of a given year falls into the tax exemption rate of the previous year. E.g., for a PMI dividend declared and recorded in Q4 2011 but paid in January 2012, the exemption rate of 93% in 2011 applies. However, in practice it seems that many financial institutions are not familiar with these technicalities and thus - incorrectly - apply the rate of the current tax year instead.
6. The financial institution holding my stocks has already withheld too much (too little) tax as it was not aware of the "80/20"company tax rule.
If too much tax has been withheld I assume the institution cannot claim the money back from U.S. tax authorities. However, I further assume the institution is liable to the investor. My advice is to verify whether or not the institution is a member of The Financial Industry Regulatory Authority (FINRA).
According to their website, FINRA is the largest independent regulator for all securities firms doing business in the United States. FINRA offers arbitration as well as mediation services.
If too little tax has been withheld I advise the investor to inform his institution and instruct them to pay the correct amount of tax to the U.S. tax authorities, otherwise the Tax Withholding Agent is subject to significant penalties.
Details are listed here, see the section "Withholding Agent's Obligation."
Disclaimer: I am not a tax advisor, nor do I hold any degree in tax law. The above article as well as the views and findings expressed in it are solely derived from my experience as a private investor. I do not exclude the possibility of inaccuracies or significant mistakes. Moreover, I shall not be held liable for any financial loss that derives from any investment decision that is made based on the content of this article or the hyperlinks given in the article.