Global Income Hunters: Beware Tax Trap
03/20/2013 10:30 am EST
Tax treaties set the rate at 15% for most countries, but your liability could be much higher or lower, so it pays to check, writes Rob Carrick, reporter and columnist for The Globe and Mail.
[Editor's Note: Much of the advice given in this article was written for a Canadian audience. Wherever you live, if you are unclear as to the tax treatment of your portfolio, please consult your investment or tax advisor.]
The craze for dividend investing has taken some people into unfamiliar territory, and we’re not just talking about buying stocks from distant countries.
There are tax issues associated with foreign dividend stocks, and they apply whether or not you’re investing in tax-advantaged accounts. A quick summary: As a result of the withholding taxes applied to dividends paid by most foreign companies, your actual flow of dividend income could be lower than what you understood from the information contained in online stock quotes.
No one tells you this as you place your order for the likes of Total (TOT), the French oil company, or Israel’s Teva (TEVA). From the e-mails I’ve had from readers buying global dividend stocks, it seems that investors are finding out about withholding taxes by reading their account statements and finding out they’re not collecting as much in dividends as they anticipated.
Withholding taxes have nothing to do with your obligations to the Canada Revenue Agency. They’re set by foreign governments and applied to your dividends by financial intermediaries before reaching your brokerage account.
Let’s quickly dispense with Canadian liability for US dividend stocks. In registered retirement accounts, there are no withholding taxes on US dividends. In non-registered accounts, the 15% withholding tax can be recouped by claiming a foreign tax credit on your income tax return. In a tax-free savings account, you can’t recover the withholding tax.
Internationally, there are tax treaties that set the withholding tax rate at 15% for most countries. Information supplied by RBC Wealth Management shows that India and Brazil are exceptions at 25%.
Unfortunately, there are complications in figuring out how much withholding tax will actually apply to international dividends. As RBC explains it, the full foreign withholding tax can be both higher and lower than the treaty rate.
Let’s use Total as an example. This global oil giant’s shares trade on the New York Stock Exchange as an American depositary receipt. An ADR is a US bank-issued certificate that represents one or more share in a foreign company. As shown on Globeinvestor.com, Total offered a dividend yield of 6.4% late this week.
As with most countries, the French treaty rate for withholding taxes is 15%. But RBC reports that the full withholding tax rate of 25% has been charged on Total shares, in its experience. Why doesn’t the treaty rate apply in cases like this?
Abby Kassar, vice president of high-net-worth planning services at RBC Wealth Management, explains that foreign financial institutions administering the withholding tax for stocks like Total are often unsure where investors buying shares are located. “As a result, they end up applying the maximum withholding rate.”
In a registered account, the dividends lost to withholding taxes are not recoverable. In a cash account, you have limited recourse.
Start the process by declaring the gross amount of dividends paid (pre-withholding tax) on your income tax return. Remember that non-Canadian dividends don’t qualify for the dividend tax credit, and thus are taxed as regular income.
Next step: Claim a foreign tax credit for the withholding taxes you paid. The hitch here is that the foreign tax credit is limited to 15% of foreign income.
With those Total shares, then, you’ll still face an additional ten percentage points of withholding tax. This means a lower net dividend yield and total return (share price gain plus dividends) than you would expect based on the gross dividend.
“Ultimately, when you’re looking at diversifying your portfolio with foreign dividend stocks, you need to consider your after-tax rate of return and compare it to your other options,” Kassar said.
You can try to recover additional foreign withholding taxes through what’s known as a subsection 20(11) deduction. But it’s unlikely to work in most cases, said Wayne Bewick, a partner at the chartered accounting firm Trowbridge Professional Corp.
He explains that the 20(11) is designed to be used on withholding taxes applied by countries with which Canada has no tax treaty. These days, there are treaties with the vast majority of countries that are home to attractive dividend stocks.
“A lot of times, people just put [the 20(11) deduction] on their return, and if it’s a minor amount—say you’re getting $200 in dividends—sometimes it’s fine,” Bewick said.
As for CRA’s response to larger claims involving treaty countries, “they would definitely disallow it.” One further note on the 20(11): RBC says it could help you recover some additional withholding tax, but not the entire amount.
If a substantial chunk of extra withholding tax has been taken off your foreign dividends, one last option is to go directly to the government of the country where your stock is based through a consulate or embassy. “This is a possibility, but it’s a lengthy process, it’s costly, and it has a very low rate of success,” Kassar said.
And now for some good news on foreign withholding taxes. First, RBC’s information shows there are none when you buy the shares of companies based in the United Kingdom.
Second, the actual withholding rate on dividends may turn out to be lower than expected. For reasons that aren’t entirely clear, withholding taxes on stocks from some countries are applied at a lower rate than specified.
Consider Teva Pharmaceuticals—the treaty rate for withholding tax on Israeli companies is 15% and the basic rate is 20%, but the actual rate applied to Canadian investors has, in RBC’s experience, been 9%.
Access to stocks listed on global exchanges is available through most brokerage firms and a couple of discount brokers offer online access to several global exchanges. Many global companies also list on the NYSE either as a conventional stock or an ADR.
Kassar said both foreign stocks and ADRs listed on the NYSE are not covered by US tax law. “From a US perspective, an ADR is traded on a US stock exchange, but it’s not considered a US stock for tax purposes.”