Participation exemption
Traditionally if you had dividends paid to you from a company that would be taxable.
Very often you’d have that company owned by another company and they would receive dividends tax free.
The question is what if that company was foreign?
Let’s imagine you have a company in Bahamas, and that company pays dividends to a holding company in UK or Hong Kong. What’s the tax situation like?
Obviously if the second company is in the country where they don’t tax dividends you don’t have to worry about anything at all. If there is tax on dividends, very often there will be something called participation exemption.
This means that if you own certain shares of the company for the certain period of time, that dividend might be received tax free or for very low tax.
So why would you want this instead of receiving dividends directly?
Back at the time they didn’t have the participation exemption in the USA, which means that any dividends received from the foreign company was fully taxable in the domestic parent. This resulted in all the money being kept abroad, billions of dollars outside of the USA. By creating this participation exemption it encourages those companies to bring money back to the country.
If you are a shareholder this gives you the opportunity to invest money locally without having to keep it abroad.
Another thing. Let’s say that you want to qualify for a mortgage. As a small business you want to show as little income as possible because you want to pay less tax, this means maximizing your write offs. On the other hand it makes you less likely to qualify for a loan.
In order to avoid this situation you can show companies income and claim it as your income so you can use it to qualify for a mortgage. If you can receive the foreign dividends to your domestic company tax free it can help you show banks that you have decent income without paying the tax.
Besides this, you could end up in situation of paying double tax. If you are in a situation where your foreign company pays no tax then you receive it to let’s say USA C corp which is a holding company. That company pays tax, and then it pays dividends out to you and you pay tax on those dividends as well. So in this situation you are taxed double, so you were better off by receiving the money directly. This is why participation exemption is a good thing because you can reduce layer of taxation.