Posted by Abundant Wealth Planning LLC

How Taxation of Foreign Investments Works

How Taxation of Foreign Investments Works

Diversification in this present world is way more than having shares in a series of companies. Several investment experts recommend having investments in various parts of the globe. With this, one can have an efficient portfolio. 

To maximize your earning potential, you need to have a good idea of how international securities are treated. Americans with bonds or shares in an overseas-based firm will pay tax from such investment income to the U.S. government. A percentage of the profit also goes to the firm's home country as tax. 

We know this double taxation breaks the heart. This is why Uncle Sam offers the foreign tax credit. With this, investors can use some or all of the foreign taxes to checkmate their tax liability.


Understanding the Foreign Tax Credit 

Tax laws in each region differ. This also varies from country to country. For some countries, there are no capital gains taxes at all. In a bid to attract foreign investors, some governments might waive this for them.

You will do yourself a lot of favor by researching the tax rates before investing. This makes sense if you consider buying individual bonds and stocks. Uncle Sam has some strategy to save you from double taxation.  If you pay any "qualified foreign taxes" (income, dividend, and interest taxes), you are qualified for a tax credit on your tax return or a deduction provided you itemize.

People with holdings in foreign countries generally will get a 1099-INT or 1099-DIV statement at the end of the year. This will reveal the detail of your earnings that the government has withdrawn as tax. You can get more information on the foreign tax credit on the official IRS website

You are better off with the credit in many cases as it reduces your overall tax due. For instance, you will get a $250 tax saving with a $250 credit. A deduction, on the other hand, gives a reduced credit. For folks in the 25% tax bracket, a $250 deduction translates to $62.5 saving in your tax bill ($250 x 0.25). 

You can claim that the foreign tax credit is a factor of the amount you will be taxed if it were the U.S. tax laws—multiplied by a factor. Form 1116 of the IRS helps you figure this out.

There are cases when the foreign government's tax is higher than what you paid to the U.S. government. With this, you can claim the U.S. tax due to the maximum foreign tax credit since it is a lesser amount. 

On the other hand, if the foreign government’s tax is lower, you can claim the whole amount as your tax credit. 


Eligibility 

As long as you are an investor and you pay tax to a foreign government on investment from a foreign source, you can use this credit to recoup some or all of your tax. To qualify, however, the party must have paid foreign income taxes or other similar ones. Examples of similar taxes are:

  • Taxes in the same category as U.S. income tax

  • Taxes coming from domestic taxpayers paid to stand for income tax, which is the ideal in a foreign company

  • Foreign income tax is judged by production. This happens due to the inability to determine the income within the country. 

  • Disability, pension, and unemployment funds for the country. 

Nonresident aliens do not qualify for this, except they were located in Puerto Rico for a full tax year. They also qualify if they are in a U.S. business in which they were paid. All citizens of U.S. territory asides from Puerto Rico do not qualify. 

On a final note, there is no credit for investment income from whatever source in a country linked to terrorist activities.


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