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If you live in the U.S. and invest in foreign stocks and bonds, you may be required to pay taxes on any income and capital gains by the tax laws of the U.S. and the country in which the company is headquartered.
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 (if you 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.
So, it doesn’t hurt to research local tax rates before investing in foreign companies, 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.
Tip
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.
For instance, 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.
| Foreign Tax Paid | $200 |
| U.S Tax Liability | $300 |
| Foreign Tax Credit | $200 |
| U.S. Tax After Credit | $100 |
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.
| Example 2 | |
|---|---|
| Foreign Tax Paid | $300 |
| U.S. Tax Liability | $200 |
| Foreign Tax Credit | $200 |
| Carryover Amount | $100 |
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 minimis 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.
Important
If you have over $10,000 in a foreign financial account, you must file Form 114 with the Financial Crimes Enforcement Network (part of the U.S. Treasury).
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 according to 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 Pay Taxes on Foreign Investments?
You must pay U.S. taxes on any foreign income or capital gains, and may be required to pay taxes to the government of the country the company is headquartered in. However, the U.S. allows you to file for a deduction or tax credit on these gains, which can help offset the total taxes you pay.
How Can I Avoid Double Taxation on Foreign Capital Gains?
You can’t avoid taxes on foreign income or gains, 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.
How Much Foreign Interest Is Tax-Free in the US?
The IRS considers interest unearned income and generally taxes it at the capital gains rate, so all interest earned from a foreign asset is reportable and taxed, but you may be able to claim the foreign tax credit if the other country also taxes you.
The Bottom Line
The foreign tax credit generally protects American investors from having to pay investment-related taxes twice. However, it’s important to be cautious about investing in mutual funds offered by foreign-based companies. The tax code is less forgiving of profits derived from these sources.
