Foreign Investments have Global Tax Implications
by Christopher G. Galakoutis and James M. Cassidy. January 29, 2009Print
With the global financial market declines taking their toll on investor portfolios in 2008, and with tax return filing season upon us, it is important to keep note of the international tax issues confronting investors holding foreign dividend paying stocks in their regular taxable investment accounts and/or qualified pension plans and IRA’s, so that portfolios are not impacted further by unnecessary global income taxes.
U.S. citizens and residents are subject to U.S. Federal income tax on worldwide income regardless of where they live or whether a foreign country has already taxed that income. Generally, a credit or deduction of foreign income tax may be claimed against an individual’s Federal tax liability for income taxes paid to most foreign countries on foreign sourced income, such as dividends received from foreign stocks.
The U.S. has many income tax treaties with foreign countries that provide a reduced rate of income tax withholding on dividends paid to U.S. resident shareholders. The lower withholding tax rate is typically 15%, (which we will use for the remainder of this article) and is significantly lower than the typical statutory rates of 25%, 28% and even 30% that are applicable in countries that have not concluded a treaty with the United States (for example, Brazil). Generally, because dividends from treaty countries are considered qualified dividends the IRS only allows as a maximum 15% foreign tax credit against Federal income tax, regardless of how much foreign tax is actually withheld.
However, despite the reduced tax rate provided by these treaties, on occasion foreign income tax is withheld at higher rates (particularly on dividends from European shares) on dividends paid to U.S. resident shareholders. This is because U.S. transfer agents, the entities that settle these transactions for U.S. brokers, are unaware that the beneficial owners of the dividend – that is, the brokerage account holders – qualify for the reduced treaty rate.
For example, assume a foreign stock trades as an ADR in New York, and declares a dividend. The U.S. bank that acts as a depository for those ADR’s will, through the Depository Trust Company (DTC), alert transfer agents of the impending dividend payment, and give those transfer agents the opportunity to certify on behalf of the U.S. beneficial owners of the dividend, that they indeed qualify for the reduced treaty rate.
When all the right steps have been taken, this simplified tax relief arrangement enables investors to receive their dividend net of the reduced foreign withholding tax.
But it may not always be as simple as advising a broker, or their transfer agent, that one qualifies for the reduced treaty rate. Depending on the individual circumstances, foreign taxes might continue to be withheld at a higher rate unless the ADR holder provides evidence that the reduced tax treaty rate of 15% applies.
In addition, to the extent foreign taxes continue to be withheld at a rate greater than 15%, the ADR shareholder, with the help of a professional tax advisor, would likely have to file a claim for refund of the over-withheld foreign taxes directly with the foreign tax authority. Depending on the country, this claim for refund may also be available for prior years.
Also, individuals with foreign dividend paying stocks in their IRA’s or other qualified tax-deferred accounts are not eligible to claim a foreign tax credit because the income is received by a tax-exempt trust and not currently subject to income tax. In most cases, the dividends are received net of tax and these foreign taxes are treated similar to other expenses. IRA owners, much like regular taxable account holders, must also be vigilant and ensure that their dividends are being subject to the lowest foreign income tax rates applicable.
While the treaty rate of 15% also applies to dividends received in an IRA, the Income Tax Treaty Protocol under the U.S. – Germany treaty, for example, provides that dividends paid by a German company to a qualified U.S. pension fund (defined to include an IRA) is exempt from German withholding tax under the revised Treaty. This means that U.S. investors in German dividend paying stocks held in an IRA account can receive 100% of the declared dividend, and pay no German income tax. This change is not isolated to Germany, as the U.S. has signed, and continues to sign, several new protocols with various foreign countries.
We recommend that investors in foreign dividend paying stocks consult with tax advisors familiar with international taxation rules to ensure their global income tax costs are being minimized.
© 2009 Christopher G. Galakoutis
IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding tax penalties that may be imposed under the Internal Revenue Code.
Christopher Galakoutis and James Cassidy have over 40 years combined international tax experience assisting investors and other taxpayers conducting business overseas. They can be contacted through their website at ExpatTaxPros.com
Christopher Galakoutis is an independent investor and commentator, who in 2002 re-directed his attention to studying the macroeconomic issues that he believed would impact the United States, and the world, for many years to come. He works diligently to seek out investments for his own portfolio that align with his views, and writes about them on his website. With a background in international tax, he also works with clients holding foreign investments (ExpatTaxPros.com), ensuring their global income tax costs are being minimized.
The MurkyMarkets.com website by Christopher G Galakoutis is a running macroeconomic commentary on the state of the financial markets with emphasis on gold, silver, the currency markets and energy. Visitors to our new site are always welcome.