Taxation of foreign dividends: What US expats need to know

Understanding the taxation of foreign dividends is vital for US taxpayers, especially expats who invest globally.

Foreign dividends are payments from companies outside the US, and their tax treatment differs based on several factors.

This guide explains what foreign dividends are, how they’re taxed in the US, and how you can properly report and potentially reduce the tax burden on your investment income.

What are foreign dividends?

Foreign dividends are distributions of earnings made by foreign corporations to their shareholders. Under US tax law (IRC §316), a dividend is any distribution of property made by a corporation to its shareholders from earnings and profits.

For dividends to be considered foreign, the paying corporation must be organized outside the US or operate primarily outside the US.

Foreign dividends can come from stocks, mutual funds, or other investments in foreign companies. Recognizing what qualifies as a foreign dividend is important for correct tax reporting and eligibility for special tax treatment.

Are foreign dividends taxable in the US?

Yes. The US taxes its citizens and residents on their worldwide income, which includes foreign dividends.

Common sources of foreign dividends include shares in foreign companies, international mutual funds, and foreign exchange-traded funds (ETFs).

Regardless of the dividend’s country of origin or the currency in which it’s paid, all foreign dividends must be reported on your US tax return.

Ordinary vs. qualified foreign dividends

Foreign dividends fall into two categories for tax purposes: ordinary and qualified.

• Ordinary foreign dividends are taxed at your ordinary income tax rate.
• Qualified foreign dividends enjoy lower tax rates, similar to long-term capital gains.

To qualify, a foreign dividend must meet specific criteria:

If these conditions are not met, the dividend is treated as ordinary income.

Foreign dividend income reporting

Filing requirements and IRS forms

Proper reporting of foreign dividend income is critical.

Here’s a checklist of common IRS forms related to foreign dividends:

• Form 1040: Report total dividend income on your annual individual tax return.
• Schedule B: If your total dividends and interest exceed $1,500, you must complete Schedule B, including a section detailing foreign accounts.
• Form 1116: To claim a Foreign Tax Credit (FTC) for foreign taxes paid on dividends, use this form.
• FBAR (FinCEN Form 114) and FATCA (Form 8938): If your foreign financial accounts exceed certain thresholds, you must report them via these forms.

Always keep accurate records of dividend payments, foreign taxes withheld, and currency conversions for proper filing and compliance.

Avoiding double taxation

Foreign Tax Credit (FTC) and tax treaties

The US tax system provides the Foreign Tax Credit (FTC) to prevent double taxation on foreign dividends.

You can claim a credit against your US tax liability for taxes paid to foreign governments on dividend income. This credit reduces or eliminates double taxation.

Tax treaties between the US and many countries often reduce foreign withholding tax rates on dividends, easing your overall tax burden.

Example: If you earn $1,000 in foreign dividends taxed at 15% abroad, you pay $150 foreign tax. You owe $200 US tax on the $1,000, but claiming the FTC reduces your US tax by the $150 paid overseas, so you pay $50 more to the IRS.

Dividends vs. exclusion of foreign earned income

The Foreign Earned Income Exclusion (FEIE) does not apply to dividends.

FEIE covers earned income, like wages and salaries, but investment income such as dividends is fully taxable and must be reported.

Additional filing requirements for US expats

US expats must comply with additional reporting rules for foreign financial accounts holding dividends:

• FBAR (FinCEN Form 114): File if foreign accounts aggregate over $10,000 at any point in the year.
• FATCA (Form 8938): Report foreign financial assets exceeding IRS thresholds, which vary based on filing status and residence.

NB! Failing to file these can result in severe penalties, so compliance is critical.

Examples of US expatriate dividend tax scenarios

Example 1: Expatriate in a non-treaty country

An expat living in a country without a tax treaty faces higher foreign withholding taxes on dividends, resulting in a larger FTC claim and possibly more complex filings.

Example 2: Expat in a treaty country

An expat in a treaty country benefits from reduced withholding tax rates on dividends, lessening the foreign tax paid and simplifying FTC claims.

Example 3: PFIC/Complex investment

Holding shares in Passive Foreign Investment Companies (PFICs) complicates taxation, often requiring special IRS forms and possibly higher taxes on dividends and gains.

Capital gains and additional taxes on investment income

Capital gains on foreign investments are taxed differently from dividends, generally at favorable long-term rates.

High-income taxpayers may also be subject to the Net Investment Income Tax (NIIT), a 3.8% surtax on investment income, including dividends.

Common mistakes to avoid

• Using incorrect exchange rates for currency conversion.

• Forgetting to report foreign dividends on Schedule B.
• Misclassifying ordinary dividends as qualified.
• Failing to file required FBAR or FATCA forms.

Avoid these errors to ensure accurate reporting and minimize penalties.

Conclusion

Understanding the taxation of foreign dividends is crucial for US expats to stay compliant and optimize tax outcomes.

Reporting requirements, tax credits, and treaty benefits can significantly affect your tax liability.

Consult a tax professional for personalized advice and to ensure you take full advantage of available credits and deductions.