Resolving Currency and Tax Concerns When Investing Globally
Currency issues in foreign shares arise because, well, they trade on foreign markets in foreign currencies. If you're buying foreign stocks with U.S. dollars, every buy and sell transaction or dividend payment needs to be converted from dollars to the local currency. If you’ve ever traveled to a foreign country, you know that exchanging currencies is not only a hassle but also often costly and confusing. Even a stock that experiences no movement on the market can see its price move because of the exchange rate.
Currency concerns when buying foreign stocks
Although several factors can affect the actual exchange rate you receive, including fees charged to process the exchange, the biggest changes occur due to the relative strength or weakness of the dollar.
A depreciating dollar helps foreign equities because the value of the foreign currency, and hence the foreign profits, are worth more compared to the dollar. Since 2002, the dollar has been in a sharp decline against the euro, yen, and British pound. This weak dollar has been good for owning foreign equities and receiving their profits.
An appreciating dollar hurts foreign investments. A stronger dollar suddenly makes foreign investments less valuable. If a foreign company sees earnings growth but its currency falls versus the dollar, the profits aren’t worth as much in the U.S.
Potential tax issues when buying foreign stocks
When investing in international stocks, you also face a type of double-taxation — having your dividends taxed by the foreign country and then having to pay taxes in the U.S.
To calculate your foreign withholding taxes and credits, fill out IRS Form 1116.
Taxing qualified dividends
Certain U.S. dividends qualify for the lower tax rate of 15 percent rather than the stockholder’s ordinary tax rate. What qualifies for the lower tax rate in the U.S. can change when those dividends come from companies in foreign lands.
Accounting for withholdings
For tax purposes, when U.S. investors own ADRs they’re treated as owning underlying stock in the foreign company. Hence, they’re subject to taxes in a foreign country. The foreign company, the bank making the ADR, or even your stockbroker withholds the taxes you owe on the dividends and sends them to the local taxman. You receive the difference.
The United Kingdom doesn’t withhold taxes on dividends to U.S. investors. You receive the same amount as a local shareholder.
Foreign equities held in U.S. mutual funds and ETFs experience the same tax withholding as an individual. The fund’s custodian receives a dividend after the tax is paid. Like regular taxes, mutual funds and ETFs pass through the dividend, tax withholding deduction, and the tax credit to the shareholders paying the taxes.
Remembering tax credits for withholdings
If you pay a tax withholding to a foreign country, the Internal Revenue Service typically gives you some sort of credit on the taxes you paid to the other government. If the foreign tax rates are higher, you don’t get any money back. If the foreign withholding tax is 20 percent, for example, but you qualify for the 15 percent tax rate in the U.S., the IRS isn’t going to issue you a refund for the extra 5 percent. But you have satisfied your obligation to the IRS.
If you directly purchase a foreign stock outside the U.S., you’re responsible for determining the correct foreign withholding tax so you can claim your tax credit. Failure to do so may result in a double-taxation scenario in which you lose your tax credit.