The rapid growth of the international marketplace has created many opportunities for investors in recent years. Unfortunately, it has also created a complicated and difficult to understand foreign investment tax situation. In addition to paying U.S. tax on all income earned from foreign sources, international investors may also have to pay taxes to the foreign country in which their investment is located.
While this double-taxation can often be recouped via foreign tax credits, international investors should still familiarize themselves with foreign tax rules and regulations. These regulations differ from country to country, but with information, you will become a more knowledgeable investor.
Albert Einstein once said, "The hardest thing in the world to understand is the income tax."
- If you have mutual funds and ETFs that earn money from foreign investments, your taxes are likely covered by the fund managers.
- The tax scheme for American depository receipts (ADRs) is complex, and investors may be liable for taxes on capital gains and other income.
- Foreign tax credits or deductions are available to investors who meet certain criteria via Form 1116.
- Many countries have treaties with the U.S. to avoid the problem of double taxation.
Do You Have to Pay Foreign Taxes?
Investors looking for exposure to foreign markets have several options that include mutual funds, exchange-traded funds (ETFs), and American depository receipts (ADRs).
Both mutual funds and ETFs are pooled-money investments that allow the investor to buy shares. These are typically professionally managed, and the fund will pay the foreign taxes on the investors' behalf. However, some funds may allocate foreign taxes to shareholders, providing a tax benefit for the pooled asset entity.
Investing in ADRs shares can prove somewhat more complicated. Financial institutions will buy the foreign shares and hold them and sell the ADR representing the bundle of shares of that foreign entity. ADRs will allow a foreign company to trade on a U.S. stock exchange in the same manner as do shares of American companies. ADRs generally trade the same as domestic investments.
Most ADRs will have tax withholding on any investment income or capital gains that come from owning the shares. The amount withheld will vary by home country of the business. The U.S. will also levy a tax on investment income from ADRs.
Reporting is complicated and investors are encouraged to consult a professional investment or tax advisor to ensure they are properly reporting and paying taxes on their foreign holdings.
Are You Eligible for a Foreign Tax Credit?
The U.S. Internal Revenue Service offers a foreign tax credit or deduction to eligible investors who realize income from foreign sources. While all foreign investment income must be reported on Form 1040 in U.S. dollars, investors may file Form 1116 to receive the credit or deduction.
Investors who paid less than $300 in creditable foreign taxes as shown on Form 1099-DIV, Form 1099-INT, or Schedule K-1 do not have to file Form 1116. According to the IRS, the following basic criteria must be met in order to be eligible:
- The tax must be imposed on you.
- You must have paid or accrued the tax.
- The tax must be the legal and actual foreign tax liability.
- The tax must be an income tax (or a tax in lieu of it).
Additional criteria, including restrictions on resident and non-resident aliens, may also apply.
For a complete listing of all the criteria to be eligible for a foreign tax credit or deduction, and for instructions for completing Form 1116, see IRS Publication 514.
How Do You Pay Foreign Taxes?
Investment income generated in foreign countries is taxed at various rates, depending on the laws and regulations in each country. Fortunately, many countries have tax treaties with the United States making it easier to avoid double-taxation. In the case of dividends, these taxes are often withheld automatically, but capital gains taxes may also apply.
Capital gains tax rates and rules vary significantly by country, so investors are advised to consult a professional investment or tax advisor.