Allocating a portion of an investment portfolio of bonds and stocks emanating from foreign countries is considered a good investment diversification strategy. But foreign investing can also create some tax challenges and headaches. This column discusses what investors need to know when it comes to foreign tax withholding and the reporting of foreign investment income on their US tax returns.
When an investor owns stocks of companies located outside the United States, it is common for the foreign country to withhold taxes of that country on stock dividend payments. This could be for dividends paid on individual stocks or through income coming from stocks held in a mutual fund or exchange traded fund.
Typical foreign tax withholding rates range from 15 percent to 25 percent. Some countries such as Switzerland withhold as much as 35 percent. The withheld foreign taxes can significantly diminish the foreign investment’s total return.
Fortunately for foreign stock investors, there is some tax relief. US investors need not worry about paying both US taxes and foreign taxes on the same investment income coming from outside the US. For countries in which the US has some type of tax treaty (there are many such countries), there are two remedies to minimize, if not eliminate, the foreign tax expense. These remedies are the foreign income tax deduction and the foreign tax credit, which are now discussed.
Foreign Income Tax Deduction
Similar to an individual being able to deduct on his or her federal income tax return:
(1) State and local income or sales taxes;
(2) real estate taxes; and
(3) personal property taxes paid to their state and localities, individuals can also deduct taxes paid to a foreign country.
But under the Tax Cuts and Jobs Acts of 2017 (TCJA) which became effective Jan. 1, 2018, income or sales taxes, personal property taxes, and real estate taxes are capped at $10,000 for individuals who itemize on their federal income tax return. Fortunately, foreign taxes are not included in the $10,000 limit. But individuals should be aware that taxes paid to a US territory – this includes Puerto Rico and Guam – are considered like state income taxes, which means they are subject to the $10,000 limit.
Foreign Tax Credit
Most foreign investors recover at least some of the foreign taxes withheld on their foreign income by claiming the foreign tax credit (FTC). As a tax credit, the FTC reduces one’s actual tax liability “dollar-for-dollar”, meaning a tax credit provides a greater overall benefit and reduces one’s tax liability to greater extent.
The challenge to claiming the FTC is filling out the tax form required to claim it.
IRS Form 1116 is used to determine how much of the foreign tax paid during a particular year can be used as a credit against one’s federal tax liability. In many, but not all, cases the full amount of foreign tax paid during the year is available as a tax credit.
In preparing Form 1116, an individual first calculates the percentage of total taxable income that is foreign-sourced. Foreign-sourced income includes not only investment income but also salary wages or other income earned overseas. That percentage is then multiplied by the total US tax liability for the year in order to determine the amount of US tax paid on foreign income. The result is the maximum foreign tax credit for the year. If the amount of foreign tax actually paid is more than the maximum foreign tax credit, the excess credit can be carried back one year and forwarded up to 10 years before it expires.
In reporting one’s foreign income and taxes paid on Form 1116, one must report the income and taxes paid on a country-by-country basis. Those individuals who own investments of registered investment companies – this includes mutual funds – can skip these details and instead combine all of their information under the code “RIC”, which stands for “registered investment company”.
One exemption from filing Form 1116 is when the only foreign income consists of interest and dividends and the total foreign tax paid on that investment income is less than $300 ($600 for married couples filing jointly). In that case, a full ftc can be claimed directly on IRS Form 1040 using Schedule 3 (new for 2018).
One other consideration with respect to foreign investments generating a foreign tax is if the foreign tax is withheld from income in an individual retirement arrangement (IRA) or other tax-sheltered asset, then no foreign tax credit is available. Some countries offer withholding exemptions for income paid to retirement accounts. It is therefore important that before individuals invest their IRA money in international investments, that they investigate whether the countries offer withholding exemptions for income paid to retirement accounts including IRAs. This is because the lack of a foreign tax credit for the foreign taxes paid to these accounts can make those investments more expensive.
While investing in foreign countries can do much to diversify one’s investment portfolio, foreign taxes do increase the complexity and can increase the cost of holding these type of investments.