If you're investing in the stocks of dividend-paying foreign corporations, sooner or later you'll encounter foreign tax withholding. If it happens, don't blame your broker. Foreign withholding on dividends is a painful but sometimes avoidable feature of investing offshore. The details vary from one country to the next and change with U.S. tax laws and the status of tax treaties the federal government has with other countries.
Whys and Hows
Many foreign governments reserve the right to withhold tax on company dividends that are paid abroad. A French bank, for example, will pay out regular dividends but withhold taxes on U.S. shareholders. In theory, this compensates France for the loss of tax revenue that occurs when the income of a French company leaves the country. If you hold shares of the bank, your broker will automatically adjust the amount of your dividend to reflect the withholding. If the company pays dividends directly, it will calculate the withholding, send you an "adjusted" dividend and submit the withheld funds to the local tax authority.
Country by Country
The withholding rate on dividends varies by country. For Dutch corporations, for example, the withholding rate is 15 percent. If the cash dividend paid by your Dutch company this quarter is $1 a share, you will receive 85 cents. Several countries, including the Netherlands, have reciprocal tax treaties with the United States and adjust their "statutory" rate, which is 25 percent in the Netherlands, for U.S. investors. To encourage foreign investment, several countries impose no withholding; they are Argentina, Brazil, Hong Kong, Hungary, India, Ireland, Mexico, Singapore, South Africa, the U.K. and Venezuela.
If you are entitled to a reduction or refund of foreign-source taxes, you may be able to claim "relief at source." This involves contacting the withholding agent -- usually a broker -- and submitting documents that prove you are entitled to a reduction in the tax rate. If successful, a relief at source claim will forestall the withholding and permanently reduce any withheld taxes that are normally paid through that agent. Without relief at source, you would have to claim a refund of the tax withheld, which would mean either submitting documentation to the tax authority that you are exempt or filing a foreign tax return and waiting -- in some cases years -- for the repayment.
IRS Credits and Deductions
The Internal Revenue Service will allow you to claim taxes paid to a foreign tax authority against your U.S. tax liability, as long as those taxes have not been refunded. To claim the foreign tax credit, you must submit Form 1116 to the IRS along with documentation of the taxes you've paid. This allows you to avoid double taxation on foreign dividends and interest income, which are considered taxable investment income in the U.S. Alternatively, you may claim foreign taxes paid as an itemized deduction on Schedule A.
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