Understanding Taxation of Foreign Investments

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Understanding Taxation of Foreign Investments

Diversification for many modern investors extends beyond holding firms in several sectors to include assets from across the world. Indeed, many wealth management professionals advise investing a third or more of one’s stock portfolio in overseas companies to construct a more efficient portfolio.

However, if you are unaware of how overseas securities are taxed, you are not realizing your full profits potential. When Americans purchase stocks or bonds from a corporation headquartered in another country, all investment income (interest, dividends, and capital gains) and capital gains are liable to US income tax. The kicker is that the government of the firm’s home nation may also get a cut.

Take heart if this double taxation seems to be oppressive. The “foreign tax credit” is a provision in the United States’ tax law. Fortunately, you can utilize all, or at least part, of those overseas taxes to offset your Uncle Sam payment.

Key Takeaways

  • When Americans purchase stocks or bonds from foreign-based corporations, all investment income (interest, dividends, and capital gains) and capital gains are liable to US income tax as well as taxes charged by the company’s home country.
  • The “foreign tax credit” provision in the United States tax law permits foreign taxes to offset part of your Uncle Sam liabilities.

Basics of the Foreign Tax Credit

Every nation has its own tax rules, which might differ greatly from one administration to the next. Many governments either do not charge capital gains tax or waive it for overseas investors. However, many do. Italy, for example, takes 26% of the revenues from the sale of a non-shares. resident’s Spain retains 19% of such benefits. The taxation of dividend and interest income is very complicated.

While it’s a good idea to examine tax rates before investing, particularly if you’re purchasing individual stocks and bonds, the IRS provides a mechanism to prevent double taxation in any case. You may claim a tax credit or a deduction (if you itemize) on your tax return for any “qualified foreign taxes” you’ve paid, which include taxes on income, dividends, and interest.

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So, how can you tell whether you’ve paid international tax? If you have any foreign interests, you should get a 1099-DIV or 1099-INT payee statement at the end of the year. These documents will detail how much of your wages have been withheld by a foreign government. (The IRS website provides a basic explanation of the international tax credit.)

In most circumstances, you’re better off taking the credit, which lowers your real tax liability. A $200 credit, for example, equals a $200 tax savings. A deduction, although easier to compute, provides a lower benefit. If you’re in the 25% tax rate, a $200 deduction will only save you $50 ($200 x 0.25 = $50).

The amount of foreign tax you may claim as a credit is calculated by multiplying how much you’d be charged on the identical revenues under US tax law by a percentage. To find out, you’ll need to fill out Internal Revenue Service Form 1116.

If the tax you paid to the foreign government is more than your US tax burden, the maximum foreign tax credit you may claim is the smaller of the two amounts. If the tax you paid to the foreign government is less than your tax due in the United States, you may claim the difference as a foreign tax credit. Assume you have $200 withheld by an outside agency but owe $300 in taxes at home. You may deduct the whole $200 from your tax bill in the United States.

Example 1
Foreign Tax Paid$200
U.S Tax Liability$300
Foreign Tax Credit$200

Consider the inverse situation. You paid $300 in international taxes but owe the IRS just $200 for the same profits. When your taxes are greater in another country, you may only claim the US tax amount as a credit. In this case, $200. However, if you completed Form 1116 and filed an updated return, you may carry the remaining $100 forward for up to ten years.

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Example 2
Foreign Tax Paid$300
U.S. Tax Liability$200
Foreign Tax Credit$200
Carryover Amount$100

However, if you paid $300 or less in creditable foreign taxes ($600 if married and filing jointly), the whole procedure becomes much simpler. You may omit Form 1116 and instead record the total amount paid as a credit on Form 1040. The foreign income earned on taxes paid must be qualifying passive income in order to qualify for this de minimus exemption.

Who Is Eligible?

Any investor who is required to pay taxes to a foreign government on investment income earned in a foreign country may be able to reclaim part or all of the tax paid via this credit. They must, however, have paid foreign income taxes, excess profit taxes, or other comparable taxes. More exactly, they are as follows:

  • Income taxes similar to those in the United States
  • Any taxes paid by a domestic taxpayer in lieu of income tax that would otherwise be due by a foreign nation
  • Because of the difficulty to identify base or income inside the nation, foreign income tax is calculated in terms of output.
  • A foreign country’s pension, unemployment, or disability funds (some foreign social security-type income is excluded)

Nonresident aliens are not eligible for the credit unless they lived in Puerto Rico for the whole taxable year or worked in a U.S. company or line of work that provided them direct income. Citizens residing in a US territory other than Puerto Rico are also barred. Finally, no credit is allowed for investment income generated inside a nation classified as sheltering terrorist operations (IRS Publication 514 provides a list of these countries.)

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Be Careful with Overseas Fund Companies

Mutual funds are a popular technique to obtain exposure to global markets due to the complexity of studying foreign equities and the need for diversity. However, tax law in the United States handles American investment businesses that provide overseas funds quite differently from funds headquartered abroad. This difference must be understood.

A Passive Foreign Investment Company, or PFIC, is a foreign-based mutual fund or partnership that includes at least one U.S. shareholder. Foreign companies that generate at least 75% of their revenue from passive income or employ 50% or more of their assets to generate passive income are included in this category.

Even by IRS standards, the tax regulations governing PFICs are complicated. However, compared to US-based funds, such investments have a major disadvantage. Current dividends from a PFIC, for example, are normally classified as ordinary income and are taxed at a higher rate than long-term capital gains. Of course, there’s a straightforward reason for this: to dissuade Americans from storing their money abroad.

In many circumstances, American investors, especially those residing overseas, would be better served keeping with investing businesses established in the United States.

The Bottom Line

The overseas tax credit, for the most part, shields American investors from having to pay investment-related taxes twice. Just be wary of foreign-based mutual fund businesses, since the tax rules might be considerably harsher. When in question about your circumstances, seek the advice of an experienced tax specialist who can walk you through the procedure.

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