Dividends are a way for a company to distribute profits to shareholders in the form of cash or additional stock. Companies may choose to pay dividends if their stock is overvalued, or to secure shareholders’ investment in the company while still receiving a consistent source of income. Those who receive dividends generally pay a tax rate between zero and 23.8%, depending on their income tax bracket. High-income earners may also be subject to an additional net investment income tax of 3.8%.
A dividend paid by a U.S. corporation to a foreign shareholder is subject to a withholding tax, with the dividend tax rate usually being 30%. The withholding tax amount depends on tax treaties between the U.S. and the foreign shareholder’s country, and how much the foreign shareholder owns of the U.S. corporation. However, exemptions include if the dividends are paid by foreign companies, are interest-related dividends, or short-term capital gain dividends.
A return of capital is the payment a company pays back to an investor as part of their original investment. Since it simply returns the investor’s own money, it is not considered a taxable event, and it is not taxed as income. This return of capital lowers the amount of an investor’s original investment, or cost basis. Once an investor’s cost basis reaches zero, any additional return of capital received is taxed as a capital gain. In comparison, a return of capital is taken from its paid-in capital or shareholders’ equity, while a dividend is paid from the company’s earnings.
Shareholders in many foreign companies who have invested capital in a corporation may designate a distribution as a return of capital. This distribution allows shareholders to receive it tax-free in many jurisdictions. Even if a corporation has available earnings to distribute, it still has the possibility to make a return of capital distribution. The general notion is that a shareholder’s capital invested in a company should be returned first, if they so choose.
When a shareholder lends real money to a company through a bona fide loan, the amount they loaned becomes their debt basis within the company. Thus, the shareholder is able to receive repayments up to the amount of their debt basis without any tax consequences. When a company pays interest on a shareholder loan, the shareholder must note that interest as taxable income on their personal return. Simultaneously, the company usually has the opportunity to deduct the interest expense, which lowers its taxable income. Therefore, a loan may be beneficial for both the shareholder and the company.
When a U.S. individual or corporation receives a loan from a foreign person or entity, they are responsible for adhering to the specific tax withholding and reporting requirements associated with repaying that debt. When a U.S. individual pays interest to a foreign individual, a 30% withholding tax applies unless a tax treaty between the U.S. and the foreign country permits a lower tax rate or exemption. IRS Forms 1042 and 1042-S must be filed annually to report withholdings and to inform the IRS and the foreign recipient of the interest paid and the tax withheld. Form 1042 is sent to the IRS to report the total withholdings, while Form 1042-S is provided to both the IRS and the foreign recipient to show the amount of income paid and tax withheld. Any interest a U.S. individual pays to a foreigner is treated as U.S. source income for tax purposes. Overall, all loan interest payments are generally subject to a 30% U.S. withholding rate and annual IRS reporting requirements, unless a tax treaty states otherwise.
The absence of a tax treaty between the U.S. and certain places like Hong Kong impacts withholding rates and tax treatment. For dividends, individuals from locations without a tax treaty are subject to a federal withholding tax on U.S.-source income at a standard flat rate of 30%, with no way to reduce or eliminate this rate without a treaty. In contrast, a return of capital is not tied to U.S. tax or withholding if it doesn’t surpass the shareholder’s cost basis. Any excess is considered capital gain, which is generally not taxed by the U.S. unless it relates to real property interests. Therefore, foreign investors are treated similarly to U.S. citizens in this matter. Yet, most foreigners won’t be taxed on U.S.-source capital gains, often escaping U.S. tax entirely. Notably, the repayment of loan principal is not taxable in the U.S., and there is no withholding. This applies regardless of the receiver’s place of residence. However, interest paid on a loan to a Hong Kong resident is subject to the full 30% U.S. withholding tax, since there is no treaty to reduce this rate for Hong Kong.
The United States and China have several International Tax Treaties with each other, which impact dividends, returns of capital, and loan repayments. Dividends are subject to a reduced U.S. withholding tax of 10% instead of 30% for most payments to Chinese residents. Yet, it is the Chinese resident’s responsibility to file for eligibility, usually through IRS Form W-8BEN, to claim this reduced rate. Additionally, the U.S. and China have agreed to allow investors to claim foreign tax credits on dividend income to avoid double taxation. Although the standard 10% treaty rate has exceptions for cases when the shareholder is more than just an investor. Returns of capital remain tax-free up to the recipient’s cost basis and aren’t liable to U.S. withholding. Any excess is treated as capital gain; the capital gains of Chinese residents are generally not taxed. The treaty between the U.S. and China doesn’t change any rules for the returns of capital. Repayment of the loan principal to a Chinese lender is not subject to U.S. tax. Under the U.S.-China tax treaty, the withholding tax on interest paid to Chinese residents is reduced from 30% to 10%. Similar to dividends, Chinese residents can usually claim a foreign tax credit in China for U.S. withholding taxes paid on interest income. This ensures the taxpayer is taxed on the income once and not twice.
The tax treaty between the U.S. and South Korea provides significant reductions and clarifications for U.S. withholding rates for dividends, but does not generally affect returns of capital or loan principal repayments. The standard dividend tax is a 15% maximum withholding on dividends paid to a South Korean resident. However, there is also a reduced rate of 10% maximum withholding if the recipient owns at least 10% of the voting stock of the U.S. corporation for part of the current year, and the previous year if applicable. As per usual, the South Korean recipient must file IRS Form W-8BEN to claim this treaty rate. The treaty does not affect the returns of capital, as it remains as a non-taxable income without U.S. withholding for South Korean residents. Any amount that exceeds the recipient’s cost basis must be treated as U.S. source capital gains, which is also generally not taxed or withheld. Although the repayment of loan principal is not taxable and does not trigger U.S. withholding, interest payments are subject to a withholding rate. Yet, the treaty lowers the U.S. withholding tax on interest payments to 12% as long as Form W-8BEN is filled out.
With a tax treaty between the United States and Japan, there are notable reductions in the U.S. withholding rates and tax treatment. Dividends paid by a U.S. corporation to a Japanese resident are subject to a 5% withholding rate if the Japanese recipient owns at least 10% of the voting stock of the company paying the dividends. Otherwise, they are subject to a 10% withholding rate. To claim these rates, Japanese recipients must fill out IRS Form W-8BEN. As usual, returns of capital distributions are not considered to be taxable income and are not liable for U.S. withholding up to the point of the shareholder’s basis. Any amount given above the investment basis is considered a capital gain, which is generally not taxed by the U.S. for Japanese residents. Thus, the treaty does not alter these standard U.S. rules. Furthermore, the repayment of loan principal also remains protected from U.S. tax or withholding for Japanese lenders. However, as of 2019, the treaty has now provided Japanese residents with a 0% U.S. withholding tax rate for most interest payments.