The debate over the US health care system will soon be over. Taking its place will be, among other issues, the matter of the so-called Bush Tax Cuts and their expiration, which, without Congressional action, will happen Jan. 1, 2011. Among other cuts, included in the 2003 legislation were provisions that reduced rates on dividend and long-term capital gains.

Despite what you may hear from the shriller corners of the political universe, the Obama administration is populated with mainstream, Washington Consensus economists and policymakers who favor markets and capitalism.

The Obama administration’s position is likely to be more investor-friendly than arguments that will come from Congressional Democrats on the issue of the dividend and cap-gains rates, but a return to 39.6 percent on dividends, for example, is highly unlikely.

And good news emerges from the process of amending the US-Canada Tax Treaty: An interpretation contained with Annex B to the Fifth Protocol to the US-Canada Income Tax Convention probably means Canadian income and royalty trusts are suitable for holding within a US IRA. This news comes too late–it would have been absolutely awesome to have had this interpretation in 2004–to make a profound difference, but every little bit counts.

The job now is to bring this–the Annex B to the Fifth Protocol of the US-Canada Income Tax Convention–to the attention of Canadian transfer agents and US brokerage houses.

US: Sunsets

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Act), among other provisions, reduced the maximum tax rate on dividends from 38 to 15 percent. A related provision in the bill lowered the top rate on long-term capital gains from 20 percent to 15 percent, putting this and the rate on dividends at the same level for the first time since 1990.

The dividend tax cut was a contentious issue, but the 2003 Act passed the Senate on a vote of 51-50, and President George W. Bush signed it on May 28, 2003.

During the Congressional debate, proponents ascribed many benefits to the dividend tax cut. A primary argument was that reducing taxes on investment income would lower the cost of capital to business, stimulating investment and job creation. The lower cost of capital would result from a rise in US corporate equity prices. One estimate, based on capitalizing the Congressional Budget Office projection of the annual flow of foregone dividend taxes, pegged the likely boost for US equities resulting from cutting the dividend rate at around 6 percent.

This valuation argument is likely to be central during the coming debate. Although researchers for the Federal Reserve were unable to find conclusive evidence that the dividend tax cut, specifically, impacted the overall value of the US stock market when they studied its impact in 2006, this doesn’t end the argument. “On the other hand,” they wrote, “high-dividend stocks outperformed low-dividend stocks by a few percentage points over the event windows, suggesting that the tax cut did induce asset reallocation within equity portfolios.”

Given the uncertainty that always surrounds future tax policy, compounded in this case by sunset provisions and projections of large budget deficits, investors may well have discounted more heavily the tax savings on far-future dividends. If so, stocks with high current dividend yields would have been affected more than “growth” stocks paying little or no dividends.

Because the tax break was explicitly temporary, investors probably capitalized only a small part of the future benefits. The Obama administration–populated by mainstream, Washington Consensus economists and policymakers–will recognize the advantages of making permanent, albeit selectively, lower dividend and cap-gains rates.

Obama is likely to propose dividend and capital-gains tax rates of 20 percent for taxpayers in the two highest income-tax brackets, and let the 15 percent and 0 percent rates continue for those in lower brackets.

The difficulties, as ever, lie at the other end of Pennsylvania Avenue. If Congress doesn’t act, the dividend rate, among several more of the so-called George W. Bush-era tax cuts, will expire at the end of 2010. Under current law, capital-gains rates would go back to 20 percent (10 percent for some lower-income filers) and qualified dividends would be taxed as ordinary income up to the top rate of 39.6 percent.

But Congress will act to “protect” middle- and lower-income taxpayers in 2010. This is an election year. It’s not in Congressional Democrats’ or the administration’s interests to leave the question of tax cuts for the middle class unresolved heading into November.

Incumbents on both sides of the aisle want to fly home for their fall campaigns armed with a vote in favor of extending tax cuts for the middle class. And any bill that addresses marginal rates is going to take on the dividend and cap-gains situations as well.

The clock starts ticking when President Barack Obama’s tax panel, headed by former Federal Reserve Chairman Paul Volcker publishes its ideas on possible tax reform strategies. These ideas could form the basis of a proposal, though Mr. Volcker is likely taking aim at a big step, along the lines of one of the twin mantras “overhaul” or “simplification,” while all the evidence to date suggests the new decider is an incrementalist.

 As for the particulars on marginal rates, the general sense has been that the Bush tax cuts for the people below $200,000 a year are going to get extended. The Bush tax cuts for singles above $200,000 and married couples above $250,000 are not going to get extended.

Right now, the marginal income tax rates are 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. Obama and some Democrats propose to keep the lowest four rates, but let the highest two revert back to their pre-2001 levels of 36 percent and 39.6 percent.

If lawmakers do nothing, the tax rates would revert to their earlier levels of 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent.

Canada: Income and Royalty Trusts and US IRAs

According to US tax law, individuals with foreign-based dividend-paying stocks in their IRAs or other qualified tax-deferred accounts aren’t eligible to claim a foreign tax credit for those amounts because the income is received by a tax-exempt trust and isn’t currently subject to income tax.

The “tax-exempt trust”–not you–receives the dividend. The trust doesn’t pay taxes, so it can’t get credit for having done so. There is no form to claim it on. It makes sense if you’re at all familiar with the nuance of the Internal Revenue Code (IRC) and the bureaucracy of Terry Gilliam’s Brazil. 

Canada, with exceptions usually related to failures at the US brokerage level, had been taking only the 15 percent it’s entitled to according to its Income Tax Act (ITA) and the US-Canada Tax Treaty (Treaty). The trouble is it was withholding from distributions paid by Canadian trusts to taxable US brokerage accounts as well as those paid in respect of trust units held within tax-advantaged pension and retirement accounts such as IRAs.

Because the distributions weren’t treated as “dividends” within the meaning of the ITA and because Treaty Article XXI (Exempt Organizations) applies only to dividend or interest payments, the exemption from Canadian withholding tax under Article XXI of the Treaty didn’t eliminate withholdings on distributions from income and royalty trusts to US pension funds and qualified retirement plans. Rather, most distributions to non-residents from a trust were subject to withholding tax at a rate of 25 percent, according to the ITA; this 25 percent rate was reduced to 15 percent under Article XXII of the US-Canada Tax Treaty.

But a little-noticed interpretation contained in Annex B of the Fifth Protocol of the Treaty, which came into force on Dec. 15, 2008, likely made Canadian income trusts suitable for US IRAs. Annex B states that distributions from “income trusts and royalty trusts” that are treated as dividends under Canadian tax law will be treated as dividends under the Treaty.

Such treatment provides relief for US investors in Canadian trusts that are subject to the new Canadian entity-level tax on “specified investment flow-through” (“SIFT”) trusts. Although “income trust” and “royalty trust” aren’t defined in Canadian tax law, this provision would likely apply to trusts to which the SIFT rules apply.

Under the SIFT rules, a distribution made by a SIFT trust to its investors is generally deemed to be a dividend for Canadian tax purposes to the extent that it’s paid out of the trust’s earnings that have been subject to the new tax on SIFT trusts. The effect of Annex B to the Treaty is to confirm that such deemed dividend treatment also applies for Treaty purposes.