Know the Tax Implications of Foreign Investing

When it comes to investing, there is diversification, and then there is diversification. The U.S. financial markets are rich enough that it is certainly possible to extensively diversify a portfolio and never leave American shores.

However, as the recent financial crisis and recession (among other events) have proved that nearly every sector of the economy suffers at the same time. While it is still generally true that when America sneezes the rest of the world catches a cold (or at least gets the sniffles), as the current reaction of emerging markets in particular to the announced drawdown of the Fed’s QE program demonstrates, there are plenty of opportunities to be found in foreign investments.

What is important is that understand the distinction between buying stock of a foreign company listed on a U.S. exchange and actually making purchases in foreign markets. This discussion regards entry into the financial markets of other countries.

Your Foreign Investment: Taxed and Taxed Again

There are (at least by certain counts) 196 different countries in the world today. While many are not exactly attractive destinations for investment (Syria or Libya, anyone?), there are still enough that U.S. investors face a dizzying array of tax codes and rules on the treatment of the investment income of foreign nationals. In some cases foreign investors get a pass and pay no taxes at all on certain classes of income (dividends, interest, and capital gains being the main three at issue here). In others the country in question does not tax capital gains for anyone.

Unfortunately, many attractive investment destinations are found in places like Europe that have extensive social safety nets—and extensive tax regimes to support them. Italy and Spain are prime examples, with capital gains rates of 20 percent and 21 percent respectively.

Those particular numbers are not exactly exorbitant when compared to U.S. long-term capital gains rates, especially for those in high income brackets. However, for U.S. citizens the IRS will also be waiting to take its own bite of any money made overseas. Just because capital gains, interest, or dividends are earned in a foreign country does not mean they are exempt from U.S. income tax.

Thank Uncle Sam for the Foreign Tax Credit

The good news is that the U.S. tax code does take some pity on those who incur foreign taxes on investment income. Just as small businesses can avoid the double taxation of corporate profits through the use of the subchapter S option, U.S. taxpayers investing overseas can take advantage of the Foreign Tax Credit.

Although it is called the Foreign Tax Credit, in actuality it may be taken as either a tax credit or a tax deduction. Tax credits (which reduce the amount of tax owed on a dollar-for-dollar basis) are usually preferable to tax deductions (which reduce the amount of taxable income, meaning the tax reduction is equal to the deduction multiplied by the taxpayer’s marginal tax rate—this ignores the added complexity if the deduction eliminates all income in the highest tax bracket). This likewise applies to the Foreign Tax Credit.

The fundamentals are fairly simple. The taxpayer may reduce his or her tax liability by an amount equal to the U.S. dollar value of foreign taxes paid. Unlike certain other tax credits (such as the Earned Income or Child Tax Credits), however, the Foreign Tax Credit cannot produce a refund. In other words, the maximum possible value of the Foreign Tax Credit is the amount of U.S. income tax owed by the taxpayer.

Everything Has Its Limits--Including the Foreign Tax Credit

Reaching that maximum is rare, however, as there is more to the story. There are limits on the amount of the Foreign Tax Credit apart from the amount of foreign tax paid that often preclude the complete elimination of U.S. tax liability. Form 1116 is used for the calculation, which in simple terms divides total foreign investment income by total taxable income from all sources to produce a percentage. This percentage is multiplied by the taxpayer’s foreign tax liability to determine the amount of the credit.

Fortunately, there is also a de minimis exception. If the taxpayer’s foreign tax liability was $300 or less ($600 or less for married taxpayers filing jointly), there is no requirement to file Form 1116 and the credit may simply be taken on Form 1040.

In addition, unused Foreign Tax Credit amounts may be carried forward to future tax years for up to 10 years until the credit is used up. So if, for example, a taxpayer had $2,500 in foreign taxes but had a U.S. tax bill of $2,200, his or her U.S. tax bill could be reduced to zero and $300 would then be carried forward to reduce tax liability in future years. (Of course, if future years similarly produce excess Foreign Tax Credits, the situation becomes more complex.)

Ins and Outs of the Foreign Tax Credit

Shocking though it might be to learn that the tax code can be complicated, the Foreign Tax Credit has a number of subtleties, distinctions, exceptions, and stipulations. They are so numerous, in fact, that anyone with taxed foreign investment (or passive, in IRS terms) income should consult a tax advisor with experience in foreign income.

For one, the taxed foreign income must qualify as passive income under IRS rules. (Generally speaking, any capital gains, interest, or dividends will meet this standard.) For another, only foreign taxes that generally resemble income taxes qualify. Any sales or property taxes, for example, are excluded.

Another significant issue is that a taxpayer with foreign earned income is subject to subject to another set of rules and will not be eligible to exclude taxes on foreign investment income. (Foreign earned income is likely to be significantly greater than investment income, so the foreign tax exclusion will probably be more beneficial anyway.)

Understand the Intricacies of Foreign Investment Taxes

As with any tax rule, there are a handful of relatively obscure technicalities: Nonresident aliens are not eligible for the credit, with a few exceptions. U.S. citizens living in any U.S. territory besides Puerto Rico are also ineligible. And if the investment income originated in a country that has been identified as harboring terrorists, it is excluded.

There is certainly money to be made in overseas investments, but such investments must be carefully structured (investing in Passive Foreign Investment Companies, for example, will generally produce a higher tax liability). Researching the tax laws for foreign investors in any target country is also advisable in order to obtain the best tradeoff between income potential and tax liability, both domestic and foreign.