For many investors today, diversification goes beyond owning businesses in a variety of industries, it also means adding holdings from different parts of the world. In fact, many wealth management experts recommend diverting a third or more of its equity allocation to foreign companies to create a more efficient portfolio.
But if you are not aware of the tax treatment of international securities, you are not maximizing your true earning potential. When Americans buy stocks or bonds from a foreign-based company, any investment income (interest, dividends) and capital gains are subject to US income tax. Here’s the kicker: The government of the company’s home country can also take a share.
If this double taxation seems drastic to you, don’t worry. The US tax code offers what is called the âforeign tax creditâ.Fortunately, this allows you to use all or at least some of those foreign taxes to offset your liability to Uncle Sam.
Key points to remember
- When Americans buy stocks or bonds of companies based abroad, all investment income (interest, dividends) and capital gains are subject to US income tax and taxes levied by the country. origin of the company.
- The US tax code offers the âforeign tax credit,â which allows foreign taxes to offset part of your liability to Uncle Sam.
Basic principles of the foreign tax credit
Each country has its own tax laws, and they can vary widely from government to government. Many countries do not apply or waive capital gains taxes for foreign investors. But many do. Italy, for example, takes 26% of the proceeds that a non-resident derives from the sale of its shares.Spain retains 19% of these gains.The tax treatment of dividend and interest income also runs the gamut.
While it doesn’t hurt to research tax rates before making an investment, especially if you’re buying individual stocks and bonds, the IRS offers a way to avoid double taxation anyway. For any “eligible foreign tax” you paid, and that includes income taxes, dividends, and interest, you can claim either a tax credit or a deduction (if you itemize) on your tax return. .
So how do you know if you paid foreign tax? If you have assets abroad, you should receive a 1099-DIV or 1099-INT beneficiary statement at the end of the year. These forms will show how much of your income has been withheld by a foreign government.(The official IRS website provides a basic description of the foreign tax credit.)
In most cases, it is better to go for credit, which reduces your actual tax owed. A $ 200 credit, for example, results in a tax savings of $ 200. A deduction, although easier to calculate, offers a reduced benefit. If you’re in the 25% tax bracket, a $ 200 deduction means you only save $ 50 on your tax bill ($ 200 x 0.25).
The amount of foreign tax you can claim as a credit is based on the amount you would be taxed on the same product under U.S. tax law, multiplied by a percentage.To understand this you will need to complete Form 1116 of the Internal Revenue Service.
If the tax you paid to the foreign government is more than your US tax payable, the maximum foreign tax credit you can claim will be US tax owing, which is the lesser amount.If the tax you paid to the foreign government is less than your tax payable in the United States, you can claim the full amount as a foreign tax credit. Suppose you had $ 200 withheld by an outside government, but you are subject to $ 300 in home tax. You can use all of that $ 200 as a credit to lower your US tax bill.
|Foreign tax paid||$ 200|
|U.S. tax liability||$ 300|
|Foreign tax credit||$ 200|
Now imagine the opposite. You paid $ 300 in foreign taxes, but you only owe the IRS $ 200 for that same income. When your taxes abroad are higher, you can only claim the amount of U.S. tax as a credit. Here it means $ 200. But you can carry the remaining $ 100 forward for one year – if you’ve completed Form 1116 and file an amended return – or up to 10 years.
|Foreign tax paid||$ 300|
|U.S. tax liability||$ 200|
|Foreign tax credit||$ 200|
|Amount of deferral||$ 100|
The whole process is a bit easier, however, if you’ve paid $ 300 or less in creditable foreign taxes ($ 600 if you’re married and filing jointly). You can ignore Form 1116 and report the total amount paid as a credit on your Form 1040. In order to qualify for this de minimus exemption, foreign income earned on taxes paid must be qualified passive income.
Who is eligible?
Any investor who must pay taxes to a foreign government on investment income earned from a foreign source may be eligible to recover some or all of the tax paid through this credit. But they must have paid foreign income taxes, excess profit taxes, or other similar taxes. More specifically, they include:
- Taxes that look like U.S. income tax
- Any tax paid by a domestic taxpayer in lieu of income tax that would normally be charged by a foreign country
- Foreign income tax measured in terms of output due to inability to determine base or income in the country
- Pension, unemployment or disability funds from a foreign country (certain foreign social security-type income is excluded)
The credit is not given to non-resident aliens unless they have been residents of Puerto Rico for a full tax year or have been engaged in a business or work in the United States that brought them direct income. Citizens living in US territory other than Puerto Rico are also excluded.Finally, no credit is available for investment income made from any source in a country that has been designated as hosting terrorist activity (IRS publication 514 provides a list of these countries.)??
Be careful with overseas fund companies
Given the difficulty of sourcing foreign securities and the desire for diversification, mutual funds are a common way to gain exposure to global markets. But U.S. tax law treats U.S. investment firms that offer international funds very differently from overseas-based funds. It is important to realize this distinction.
If a foreign-based mutual fund or partnership has at least one U.S. shareholder, it is referred to as a passive foreign investment corporation, or PFIC. The classification includes foreign entities that derive at least 75% of their income from passive income or use 50% or more of their assets to generate passive income.
Tax laws regarding PFICs are complex, even by IRS standards. But overall, these investments are at a significant disadvantage compared to US-based funds. For example, current distributions from a PFIC are generally treated as ordinary income, which is taxed at a higher rate than long-term capital gains. Of course, there is a simple reason for this: to discourage Americans from parking their money outside the country.
In many cases, US investors, including those living overseas, have an interest in sticking with US-based investment firms.
The bottom line
For the most part, the foreign tax credit protects US investors from having to pay investment taxes twice. Just beware of overseas-based mutual fund companies, for which the tax code can be much less lenient. If in doubt about your situation, it is a good idea to consult a qualified tax expert who can guide you through the process.
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Internal Tax Service. “Foreign tax credit.“Accessed December 7, 2019.
Waterhouse Cooper Award. “Italy’s 2018 finance bill includes important provisions on the digital economy, cross-border taxation,“Page 3. Accessed November 29, 2019.
Waterhouse Cooper Award. “Spain: Individual taxes on the income of natural persons.“Accessed November 29, 2019.
Internal Tax Service. “Instructions for Form 1099-INT and 1099-OID (2020).“Accessed December 7, 2019.
Internal Tax Service. “Instructions for Form 1099-DIV (2020).“Accessed December 7, 2019.
Internal Tax Service. “Foreign tax credit: how to calculate the credit.“Accessed November 29, 2019.
Internal Tax Service. “Publication 514: Foreign Tax Credit for Individuals,“Page 4. Accessed November 29, 2019.
Internal Tax Service. “Publication 514: Foreign Tax Credit for Individuals,“Page 24. Accessed November 29, 2019.
Internal Tax Service. “Publication 514: Foreign Tax Credit for Individuals,“Page 12. Accessed November 29, 2019.
Internal Tax Service. “Publication 514: Foreign Tax Credit for Individuals,“Pages 7-8. Accessed November 29, 2019.
Internal Tax Service. “Publication 514: Foreign Tax Credit for Individuals,“Pages 6-7. Accessed November 29, 2019.
Internal Tax Service. “Publication 514: Foreign Tax Credit for Individuals,“Page 9. Accessed November 29, 2019.
Internal Tax Service. “Instructions for form 8621-A,“Page 2. Accessed November 29, 2019.