There are complications that arise when a client receives a dividend from a company that is headquartered outside the U.S.
Many times the amount received is not the full amount of the dividend because taxes are withheld as dictated by the treaty (or lack of one) between the dividend-paying companys country of residence and the U.S. The existence of a treaty also can have an impact on whether the foreign dividend receives the favorable tax treatment afforded to U.S. qualifying dividend income.
BEING MADE WHOLE
If clients have money withheld by a foreign jurisdiction, they are to be made whole by the U.S. government through a dollar-for-dollar foreign tax credit when the investor pays the tax on the foreign income.
As an example, a client invests in a Canadian corporation that pays a dividend equal to one U.S. dollar. Because of the U.S.-Canada treaty, the dividend is withheld at a rate of 15%. Without a treaty, the withholding rate would most likely be higher.
The client receives only 85 cents of the $1 dividend because of the withholding, and yet when it comes time to do her taxes, she is treated as if she received the whole $1 dividend. This foreign dividend from a treaty country could be eligible for qualified dividend treatment. If the client satisfied the 61-day-holding-period requirement for the dividend, the dividend would be taxed at only 20%.
The clients tax return lists the full $1 dividend as qualifying dividend income, creating a 20-cent tax liability.
The client is then able to use her foreign tax credit of 15 cents generated by the withholding against the 20-cent tax liability.
At the end of the day, the client pays the same 20 cents that she would have paid on a U.S. qualifying dividend; however, in this instance she pays 15 cents to the Canadian government and 5 cents to the U.S. government.
If the client does not satisfy the 61-day-holding-period requirement, then the tax on the dividend would be 39.6%. If she can use the foreign tax credit, then the 15-cent credit can be used to help pay the 39.6% tax.
Even if the client does not satisfy the 61-day rule, she may still be able to take the tax credit. There is only a 16-day minimum required holding period in order to be entitled to the foreign tax credit.
If a dividend comes from a nontreaty country, then the withholding will be at 30% and the client could still get a tax credit. The rules state that dividends from nontreaty countries cannot be qualifying dividends; however, there is an exception for nontreaty country shares of companies that trade in the U.S.
So if a company has American depositary receipts traded on a U.S. exchange, the dividends from the ADRs could be taxed at 20%.
The rules that apply to federal returns may not apply to state returns. Most states do not allow a tax credit for foreign taxes withheld.
Therefore, it is quite likely that a stockholder would wind up paying tax in his state on the full $1 dividend although he has received only 85 cents and has received no credit for the foreign taxes withheld.
Clients in these states pay a phantom income tax on the 15 cents they never received.
Warning: there is a hidden cost when buying puts on dividend-paying stocks. Any day a client owns a put is not counted when calculating the 61-day-holding-period needed to qualify the dividend for the 20% tax rate.
This is directly on point when holding shares over the record date for the dividend.
The purchase of a put on a foreign stock not only disqualifies the dividend, thereby doubling the tax, but it also eliminates the 16-day minimum holding period required to be entitled to a foreign tax credit.
These rules are applied every record date, no matter how long one has held the stock unhedged before the purchase of the hedge.
A put-hedged $1 dividend from Canada will cause a 39.6 cent tax; if you net that against the 85 cents in cash received, you wind up keeping only 45.4 cents on the dollar. As a comparison, an unhedged $1 dividend from Canada will net a U.S. taxpayer 80 cents after taxes.
Alternatively, the put-hedged U.S. client could elect to take the 15 cents withholding as a tax deduction instead of a tax credit, but then she would be electing to turn all of her foreign tax credits into deductions. If she owns other foreign assets, or more of these shares, this would not be economical.
Clients electing a deduction instead of a credit would end up receiving and paying tax on 85 cents, thereby netting themselves 51.34 cents on the dollar. All of the above calculations do not include the 3.8% Medicare surtax on net investment income.
An IRA (or other tax-exempt account) is usually not the optimum place for foreign dividend-paying stocks. An IRA would receive 85 cents and no tax credit. If, instead, a client bought the shares in her taxable account, she would get the benefit of every dollar. Some countries recognize this fact and have their treaty allow for no withholding on tax-exempt investors.
But countries sometimes over withhold. As an example, Switzerland withholds dividends at the 35% nontreaty rate, even if you live in a country like the U.S. that has a treaty that allows for a 15% withholding rate. The U.S. limits tax credits to the amounts that are supposed to be withheld by treaty.
In this kind of case, shareholders must go back to the distributing country to prove who they are and why their dividends should be withheld at a lower rate and get the over withheld 20% back from that government.
This usually laborious reclaim process for over withheld amounts is many times not pursued and much money is left on the table.
There are specialist reclaim firms, such as GlobeTax, that do the reclaims on an institutional basis for a percent of the recovery.
In some instances, if you fill out and file all the proper paperwork beforehand, the over withheld amount will be refunded at source and will not need to be further pursued. Note that owning a put does not interfere with the clients ability to reclaim over withheld amounts of money.
The best-positioned unhedged diligent client who pursues reclaims and is living where there are no state taxes, like Texas, could keep 80 cents of every $1 dividend paid by, say, Nestlé. At the other end is a New York resident hedging part of his Nestlé shares with a put that does not pursue any reclaim.
This client would pay about 50 cents in federal and state taxes on the $1 dividend even though he received just 65 cents of cash flow, leaving just 15 cents of every $1 in his pocket.
Clearly, income taxes should be figured into the investment equation when analyzing the benefits of adding non-U.S. investments to the portfolio.
Robert Gordon is a contributing writer for On Wall Street, adjunct professor at New York University Stern School of Business and president of Twenty-First Securities.
- Gay Marriage Ruling: 5 Estate Planning Steps for Clients
- New Morningstar Tool Seeks to Settle Active-Passive Debate
- Retirement Planning: Can We Do Better for Clients?
Register or login for access to this item and much more
All Financial Planning content is archived after seven days.
Community members receive:
- All recent and archived articles
- Conference offers and updates
- A full menu of enewsletter options
- Web seminars, white papers, ebooks
Already have an account? Log In
Don't have an account? Register for Free Unlimited Access