For many of today’s investors, diversification goes beyond owning companies in a variety of industries - it means adding securities from different parts of the globe, too. In fact, many wealth management experts recommend diverting a third or more of one's stock allocation into foreign enterprises to create a more efficient portfolio.

But if you’re not aware of the tax treatment of international securities, you’re not maximizing your true earnings potential. When Americans buy stocks or bonds from a company based overseas, any interest, dividends and capital gains are subject to U.S. tax. Here’s the kicker: the government of the firm’s home country may also take a slice.

If this double taxation sounds draconian, take heart. The U.S. tax code offers something called the “Foreign Tax Credit.” Fortunately, this allows you to use all - or at least some - of those foreign taxes to offset your liability to Uncle Sam.

Basics of the Foreign Tax Credit

Every country has its own tax laws, and they can vary dramatically from one government to the next. Many countries have no capital gains tax at all or waive it for foreign investors. But plenty do. Italy, for example, takes 20% of whatever proceeds a non-resident makes from selling his/her stock. Spain withholds slightly more, 21%, of such gains. The tax treatment of dividend and interest income runs the gamut as well.

While it doesn’t hurt to research tax rates prior to making an investment - especially if you’re buying individual stocks and bonds - the IRS offers a way to avoid double taxation anyway. For any “qualified foreign taxes” that you’ve paid - and this includes taxes on income, dividends and interest - you can claim either a credit or a deduction (if you itemize) on your tax return.

So how do you even know if you’ve paid foreign tax? If you have any holdings abroad, you should receive either a 1099-DIV or 1099-INT payee statement at year’s end. Box 6 will show how much of your earnings were withheld by a foreign government. (The official IRS web site offers a basic description of the foreign tax credit here.)

In most cases, you’re better off opting for the credit, which reduces your actual tax due. A $200 credit, for examples, 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 Internal Revenue Service (download the form here).

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. 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 trim your U.S. tax bill.

Example 1

Foreign Tax Credit

Now imagine just the opposite. You paid $300 in foreign taxes but would only owe $200 to the IRS for those same earnings. When your taxes abroad are higher, you can only claim the U.S. tax amount as your credit. Here, that means $200. But you can carry the remaining $100 over one year - if you completed Form 1116 and file an amended return - or forward up to 10 years.

Example 2

Foreign Tax Credit with Carryover amount

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 in your Form 1040.

Be Careful with Overseas Fund Companies

Given the difficulty of researching foreign securities and the desire for diversification, mutual funds are a common way to gain exposure to global markets. But U.S. tax law treats American investment firms that offer international funds much differently than funds based offshore. It’s important to realize 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, or PFIC. The classification includes foreign entities that make at least 75% of their revenue from passive income or uses 50% or more of their assets to produce passive income.

The tax laws involving PFICs are complex, even by IRS standards. But overall, such investments are at a significant disadvantage to U.S.-based funds. For example, current distributions from a PFIC are generally treated as ordinary income, which is taxed at a higher rate than long-term capital gains. Of course, there’s a simple reason for this - to discourage Americans from parking their money outside the country.

In a lot of cases, American investors, including those living abroad, are better off sticking with investment firms based on U.S. soil.

The Bottom Line

For the most part, the Foreign Tax Credit protects American investors from having to pay investment-related taxes twice. Just watch out for foreign-based mutual fund companies, for which the tax code can be much less forgiving. When in doubt about your situation, it’s a good idea to consult a qualified tax expert who can guide you through the process.

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