Understanding Taxation of Foreign Investments

For many of today’s investors, diversification goes beyond owning companies in a variety of industries—it means adding securities from foreign companies, too. In fact, many wealth management experts recommend diverting a third or more of one’s stock allocation into foreign enterprises to create a more efficient portfolio.

But if you’re not aware of the tax treatment of international securities, you’re not maximizing your true earnings potential. When Americans buy stocks or bonds from a company based overseas, any investment income and capital gains are subject to U.S. income tax. Here’s the kicker: The government of the firm’s home country may also tax your gains.

If double taxation sounds draconian, take heart. The U.S. tax code offers a “foreign tax credit.” This allows you to use all—or at least some—of those foreign taxes to offset your liability to Uncle Sam.

Key Takeaways

• When Americans buy stocks or bonds from foreign-based companies, the investment income and capital gains may be subject to both U.S. income tax and taxes levied by the company’s home country.
• The U.S. foreign tax credit allows a taxpayer to deduct the foreign taxes to offset the liability to the U.S.
• For any qualified foreign taxes you’ve paid, such as income, dividends, and interest, you can claim a tax credit or a deduction (for those who itemize) on your tax return.

Basics of the Foreign Tax Credit

Every country has its own tax laws, and they vary dramatically. Many countries have no capital gains tax or waive it for foreign investors.

But plenty do. Italy, for example, takes 26% of whatever proceeds a non-resident makes from selling stocks issued in Italy. Spain withholds 19% of such gains. The tax treatment of dividend and interest income runs the gamut as well.

It doesn’t hurt to research local tax rates before making an investment—especially if you’re buying individual stocks and bonds. However, the IRS offers a way to avoid double taxation.

For any qualified foreign taxes that you’ve paid—and this includes taxes on income, dividends, and interest—you can claim either a tax credit or a deduction (if you itemize) on your tax return.

How do you know if foreign taxes have been withheld from your earnings? If you have any holdings abroad, you should receive either a 1099-DIV or 1099-INT payee statement from the IRS at year’s end. These forms will show how much of your earnings were withheld by a foreign government.

(The official IRS website offers a basic description of the foreign tax credit.)

Credit or Deduction?

In most cases, you’re better off opting for the credit, which reduces your actual tax due. A $200 credit, for example, translates into a $200 tax savings. A deduction, while simpler to calculate, offers a reduced benefit. If you’re in the 25% tax bracket, a $200 deduction means you’re only shaving $50 off your tax bill ($200 x 0.25).

The amount of foreign tax you can claim as a credit is based on how much you’d be taxed on the same proceeds under U.S. tax law, multiplied by a percentage. To figure that out, you’ll have to complete Form 1116 from the IRS.

If the tax you paid to the foreign government is higher than your U.S. tax liability, then the maximum foreign tax credit you can claim will be the U.S. tax due, which is the lesser amount. If the tax you paid to the foreign government is lower than your tax liability in the U.S., you can claim the entire amount as your foreign tax credit.

Say you had $200 withheld by an outside government, but are subject to $300 of tax at home. You can use that entire $200 as a credit to reduce your U.S. tax bill.

Now imagine just the opposite. You paid $300 in foreign taxes but would only owe $200 to the IRS for those earnings. When your taxes abroad are higher, you can only claim the U.S. tax amount as your credit. Here, that means $200.

You can carry the remaining $100 over to the following year—if you completed Form 1116 and filed an amended return—or forward up to 10 years.

The whole process is quite a bit easier, however, if you paid $300 or less in creditable foreign taxes ($600 if married and filing jointly). You can skip the Form 1116 and report the entire amount paid as a credit on your Form 1040.

To use this de minimus exemption, the foreign income earned on the taxes paid must be qualified passive income.

Who Is Eligible?

Any investor who must pay taxes to a foreign government on investment income from a foreign source may be eligible to recoup some or all of the tax paid via this credit. But they must have paid foreign income taxes, excess profit taxes, or other similar taxes. More specifically, they include:

• Taxes that resemble U.S. income tax
• Any taxes that are paid by a domestic taxpayer as a substitute for income tax that would ordinarily be required by a foreign country
• Foreign income tax measured in terms of production because of an inability to determine the basis or income within the country
• Pension, unemployment, or disability funds from a foreign country (some foreign Social Security-type income is excluded).

The credit is disallowed for nonresident aliens unless they were residents of Puerto Rico for a full taxable year or were engaged in a U.S. business or line of work that paid them direct income. Citizens living in a U.S. territory other than Puerto Rico are likewise excluded.

Finally, no credit is available for investment income realized from any source within a country that has been designated as harboring terrorist activities.

(IRS Publication 514 provides a list of these countries.)

Be Careful With Overseas Fund Companies

Mutual funds focused on global markets are a common way for investors to gain exposure to foreign growth. However, U.S. tax law treats American investment firms that offer international funds much differently than funds based offshore. It’s important to know this distinction.

If a foreign-based mutual fund or partnership has at least one U.S. shareholder, it’s designated as a passive foreign investment company (PFIC). The classification includes foreign entities that make at least 75% of their revenue from passive income or use 50% or more of their assets to produce passive income.

The tax laws involving PFICs are complex even by IRS standards. But overall, such investments are at a significant disadvantage in taxation to U.S.-based funds. For example, current distributions from a PFIC are generally treated as ordinary income, which is a higher rate than long-term capital gains for most taxpayers.

Of course, there’s a simple reason for this: The IRS wants to discourage Americans from parking their money outside the country.

In most cases, American investors, even those living abroad, are better off sticking with investment firms based on U.S. soil.

How Do You Report Foreign Assets?

If you have foreign bank and financial accounts with an aggregate value exceeding $10,000, you must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts. This can be filed electronically with the Financial Crimes Enforcement Network.

If you meet the thresholds for foreign financial assets, you may also have to file Form 8938, Statement of Specified Foreign Financial Assets, with your annual federal income tax return.

How Can I Avoid U.S. Tax on Foreign Income?

You can’t avoid U.S. tax on foreign income but you can reduce the tax burden using the foreign tax credit. In short, you can show the U.S. how much money you paid in taxes to a foreign country and receive a credit for that amount.

You claim the foreign tax credit by filing Form 1116.

Who Can Claim the Foreign Tax Credit?

U.S. citizens and resident aliens who paid foreign income tax and are also subject to U.S. tax on that same income can claim the foreign tax credit. Also, nonresident aliens can take the foreign credit if they are bona fide residents of Puerto Rico or pay foreign income taxes connected to a trade or business in the U.S.

The Bottom Line

For the most part, the foreign tax credit protects American investors from having to pay investment-related taxes twice.

Just be cautious about investing in mutual funds offered by foreign-based companies. The tax code is less forgiving of profits derived from these sources.

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