President Bush signed into law on May 28, 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 ("Act"). This summary is limited to the key provisions of the Act of interest to regulated investment companies ("RICs") and their shareholders. Specifically, it addresses the reduced rates of tax on certain capital gains, dividends and backup withholding. Please see our update Jobs and Growth Tax Relief Reconciliation Act of 2003, June 2003, for more information on the Act as it applies to individuals.

Reduction in Long-Term Capital Gains Tax Rate

The Act reduces the maximum individual income tax rate on net long-term capital gain (i.e., generally net gain on the sale of assets held for more than one year) from 20 percent to 15 percent. This lower rate applies both to the regular income and the alternative minimum taxes. The lower rates do not apply to gains attributable to unrecaptured depreciation on real property, gain from the sale of "collectibles" or gain from the sale of qualified small business stock. The previous 8 percent and 18 percent rates that applied to certain property with a five-year holding period are eliminated.

The rate reduction applies to sales and exchanges (and payments received) on or after May 6, 2003. Without further Congressional action, the rates on net long-term capital gains will revert to the pre-Act rates in 2009, and the rates on five-year holding period property will be reinstated.

Individual shareholders who redeem their shares in a RIC or who receive distributions attributable to capital gains generally will be taxed on such gains at the new reduced rates. The date on which a RIC sells or exchanges a security is the date used to determine whether any net long-term capital gain from such sale or exchange distributed to an individual shareholder will qualify for the pre-May 6 or post-May 5 net capital gain tax rate.

• Due to the May 6th cut-off imposed by the Act, RICs will be required to calculate and report to their shareholders pre-May 6 and post-May 5 capital gains in 2003.

Reduction in the Dividends Tax Rate

The Act lowers the rate of tax on "qualified dividend income" by taxing such income at the reduced long-term capital gain rate rather than at ordinary income rates. This reduced rate of tax is applicable to qualified dividend income received on or after January 1, 2003. As with the reduction of long-term capital gain rate, this rate reduction is scheduled to expire in 2009.

Qualified Dividend Income Generally. Qualified dividend income includes certain dividends received from domestic corporations and qualified foreign corporations. Qualified foreign corporations include foreign corporations whose shares are listed on U.S. exchanges, those incorporated in a possession of the United States and foreign corporations eligible for benefits under a comprehensive income tax treaty identified by the IRS. To date, the IRS has not identified any qualifying treaties. A foreign personal holding company, foreign investment company, or passive foreign investment company is not a qualified foreign corporation.

Qualified dividend income does not include dividends paid by tax-exempt corporations, amounts allowed as a deduction for dividends paid by mutual savings banks and other institutions pursuant to Internal Revenue Code ("Code") Section 591, or amounts allowed as a deduction for dividends paid on certain employer securities pursuant to Code Section 404(k).

A taxpayer must hold the shares of stock producing the dividend for more than 60 days during the 120-day period beginning on the date that is 60 days before the date such shares become ex-dividend. As an example, assume an individual has owned a share of common stock for 15 days when the share becomes ex-dividend. The individual must hold the share for at least 46 more days in order to qualify for the reduced rate of tax on the dividend. For preferred stock, the required periods are increased from 60 days to 90 days and from 120 days to 180 days. A dividend is not qualified dividend income to the extent that the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. The application of this rule to RICs and their shareholders is discussed below.

Extraordinary Dividends. If an individual receives an "extraordinary dividend" (as defined by Code Section 1059) that is eligible for the reduced dividend tax rate, any subsequent loss on the sale of such stock is treated as a long-term capital loss to the extent of the dividend. In general, an "extraordinary dividend" is a dividend which exceeds 10 percent of the shareholder's tax basis in his or her stock.

Foreign Tax Credit Limitation. A taxpayer's foreign tax credit will be limited to the extent it relates to qualified dividend income taxed at the reduced rates of tax, using rules similar to the rules applied to foreign capital gains subject to favorable rates of tax.

Real Estate Investment Trusts. Dividends received by a RIC from real estate investment trusts ("REITs") will not qualify for the reduced dividend tax rates unless and to the extent that the REIT's dividends were attributable to qualified dividend income received by the REIT, the REIT paid income tax on the income from such dividends, and the REIT distributed such dividends to its shareholders. (However, similar to RICs, REITs can pass-through to their shareholders capital gain income, which generally will qualify for reduced taxation to individuals under the new law.)

RIC Distributions. If 95% or more of a RIC's gross income constitutes qualified dividend income, all of its distributions will be treated as qualified dividend income in the hands of individual shareholders if certain holding period requirements are met. If less than 95% of the RIC's income is attributable to qualified dividend income, then only the portion of the RIC's distributions that are attributable to and designated as such in a timely manner will be so treated in the hands of an individual shareholder. Within 60 days after the end of a RIC's taxable year, the RIC will be required to mail its shareholders a written notice stating the dollar amount of each shareholder's qualified dividend income. RICs will use IRS Form 1099-DIV to satisfy this obligation which the IRS is updating to reflect the new law.

A RIC shareholder will only be permitted to treat RIC distributions attributable to qualified dividend income as qualified dividend income on his or her individual tax return if a dual holding period requirement is met. First, the RIC must hold the shares of the stock producing the dividend for more than 60 days during the 120-day period beginning on the date that is 60 days before the date on which such shares became ex-dividend (a longer holding period applies to preferred stock). Second, the individual RIC shareholder must hold the RIC shares producing the distribution for more than 60 days during the 120-day period beginning on the date that is 60 days before the date on which such shares became ex-dividend.

Backup Withholding

The Act accelerates income tax rate reductions enacted by the Economic Growth and Tax Relief Act of 2001. The backup withholding rate, which is based upon the fourth lowest individual rate of tax, is thus reduced from 30 percent to 28 percent.

Some Practical Consequences

• Because of the minimum holding periods, a RIC cannot "buy dividends" by purchasing shares shortly before the dividend record date and then selling the shares immediately thereafter. RIC shareholders are subject to similar limitations with respect to their RIC shares.
• These changes may cause some investors to consider the holding of stock more attractive relative to the holding of debt, since qualifying dividends will be subject to a much lower tax rate than interest. However, this benefit is tempered by the payor corporation's inability to deduct dividends it has paid out in contrast to the payment of interest which continues to be deductible.
• These changes can be expected to make the holding of stock outright more attractive relative to receiving payments in lieu of dividends from securities lending transactions, short sales, or other similar transactions--such as acting as the purchaser-lender in repurchase transactions--since payments in lieu of dividends will not constitute qualified dividend income entitled to a reduced rate of tax.
• Although the Act makes clear the distinction between dividends and payments in lieu of dividends, this distinction has always been present for determining amounts eligible for certain benefits, such as dividends qualifying for the dividends-received deduction and tax-exempt interest on municipal securities. Accordingly, RICs should continue to evaluate their practices with respect to such transactions to ensure that an appropriate level of such benefits pass through to their shareholders.
• RICs should take into account their practices with respect to risk reduction, hedging transactions and income maximization in light of the potential impact on qualifying dividend income. RICs also should consider enhancing their disclosure to reflect such impact and limitations imposed by the new law, such as the holding period requirements.
• It is unclear whether RIC shareholders who received distributions attributable to the RIC's dividends on corporate stock on or after January 1, 2003 that would otherwise constitute qualified dividend income will be permitted to treat distributions as such if the RIC failed to meet the 60-day notice requirement because its taxable year ended in January, February or March of 2003. Similar concerns may also arise for RICs with tax years ending thereafter that are unable to accurately calculate their shareholders' qualified dividend income within this 60-day period due to reporting system limitations. (These systems were not be designed to separately track the RIC's dividends on corporate stock before and after January 1, 2003.) Informally, the IRS has indicated that it is considering providing administrative relief for tax years ending in 2003.