There is nothing simple about taxes. Complex as our arcane and voluminous tax code is here in the U.S., combining taxation in dozens of countries with that of the U.S. brings even more complexity.
Investing in foreign countries is typically done in one of three vehicles; mutual funds, exchange traded funds, and American Depository Receipts (ADRs) of individual foreign companies traded on a U.S. exchange.
Foreign companies are first taxed by their home government on income they distribute. Thus when you pay taxes on those dividends, they would be double taxed. Your client can typically take a tax credit or deduction on the taxes paid to that foreign government up to the tax rate you’d have paid in the U.S. The credit is typically filed on IRS form 1116 as a foreign tax credit though, in certain rare circumstances, a deduction can be better for the client.
Mark Patterson, partner of MAP CPAs, LLC in Colorado Springs, notes that dividends for all foreign companies aren’t qualified dividends taxed at the 15 percent tax rate (or 20% for those earning more than $600,000 single or $650,000 married filing jointly). If not qualified, those dividends are taxed as ordinary income. Looking at the Vanguard Total International Index Fund (VTIAX), roughly 68% of those dividends were qualified. In most cases, dividends from ADRs trading on U.S. exchanges are treated as qualified dividends.
Buying either individual stocks or broad index funds can build the same tax-efficiency of deferring capital gains, such as that which can be achieved by investing in U.S. stocks or broad index funds. International investing can therefore be achieved in a very tax efficient manner, though not quite as efficient as the U.S. where nearly all dividends are treated as qualified.
While the area of taxation of foreign investments is complex, if you invest your clients’ funds through a mutual fund, ETF, or ADR, they will send a 1099 to your client and the IRS that will simplify the reporting by telling you how the income is classified. Their CPA or tax software should easily be able to handle the reporting.
In my view, the need for globally diversified investing outweighs both the complexities, and the slightly lower tax efficiency that comes with international investing.
