Paying income tax on investment income that is earned from foreign investments can be a tricky proposition in some cases. This type of income may be taxed by a foreign jurisdiction as well as domestically in some cases, and advisors need to understand the tax rules that will govern how much they owe and also partially determine their return on capital. One key rule to understand is for dividends that are earned on foreign investments.
Foreign Taxation of Dividend Income
Many investors who hold shares of stock in a foreign corporation are taxed twice on their dividends. First the foreign jurisdiction will levy a certain percentage on this amount, and then Uncle Sam will come in and demand his share from the remainder. This dual taxation obviously substantially lowers the rate of return that is realized by the investor after taxes. And it applies to a rather large number of corporations, as 70% of the corporations in the world that pay dividends are located outside of U.S. soil. For the most part, domestic investors in any issuer of stock that pays dividends outside of U.S. soil are likely to face this double tax whammy. (For more, see: Advisors: Warn Clients About These Audit Triggers.)
However, advisors also need to be aware that much of the tax that is initially assessed by the foreign jurisdiction on client dividends can be recouped by claiming an exemption based upon a treaty between the foreign country and the U.S. Our government has reciprocal agreements with about 20 other countries that reduce or eliminate the taxes levied on corporate dividend income in each country. The list of countries that have treaties with the U.S. includes Belgium, Canada, France, Switzerland, Spain and Germany. The agreements don’t completely eliminate the tax for many of them, but they do substantially reduce them in most cases. For example, if one of your clients earned $1,000 of dividend income in France, then the French government would tax him for 30% of that money. However, by claiming a refund under the reciprocal treaty, you would get 15% of that tax returned, effectively cutting your foreign tax bill in half. Of course, your client will also pay domestic tax on that amount, but they’re still coming out ahead in the end.
When it Matters
Small investors who hold just a few shares of stock from a company that is domiciled outside the U.S. will usually not see much of a difference on their tax returns, but wealthy individuals who hold large blocs of shares of this type of stock would be wise to look into any possible reduction in foreign tax for which they may be eligible. If you have clients who hold at least one to two million dollars’ worth of foreign securities, then it will probably be worth their time to apply for a rebate on their foreign tax. (For more, see: Tax Tips for Financial Advisors.)
There are companies that specialize in this process and are willing to handle the entire process in return for a portion of the rebate that is earned, such as 10% or 20%. This is probably a good service to hire out as an advisor because the procedures for claiming this rebate can be complex and tedious, and require the knowledge of exactly who to talk to, what forms to use and where and when to file them. The procedures also differ from one country to the next, so unless you’ve really done your homework on how to do this, you are probably best off referring your clients to an expert such as GlobeTax or Acupay.
The Bottom Line
If you have wealthy clients with large holdings of foreign securities, then you need to alert them to any possible foreign tax rebate to which they may be entitled. But don’t try to do this yourself unless you are trained and experienced in this process, as it is very easy to commit an error in this process that could prevent your client from getting their refund. (For more, see: IRA Tax Mistake? There Still Might Be Time to Fix It.)