Foreign Investment Income US Tax & Reporting Implications
With the globalization of the US economy, it has become much more common for US persons to have foreign investment income. A US person is not limited to US citizens; rather, from an income tax perspective, a US person (individual) includes a US citizen, Lawful Permanent Resident, and Foreign National who meets the Substantial Presence Test. While there are many different types of foreign investment income, the general categories of foreign passive income are still the same as the United States passive income categories – even if they are labeled differently by the Foreign Financial Institution. Let’s take a brief look at the US tax treatment of foreign investment income such as overseas interest, capital gains, and dividends – as well as the reporting requirements from international information reporting forms such as the FBAR and Form 8938.
Tax-Exempt Overseas Income in the US
One big misconception that US taxpayers have regarding foreign income is that if the income is tax-exempt overseas then it is also tax-exempt in the United States — unfortunately, that is incorrect. In general, investment income is taxable in the United States even if the foreign income is tax-exempt (or not taxable) in the foreign country. There are some exceptions such as certain pension income under the tax treaty rules (if applicable) – in addition to the punitive tax deferral scheme — such as PFIC. With PFIC, taxes are avoided now on undistributed gains (unless an election such as a QEF or MTM was made) but ultimately results in a much higher tax burden regarding the foreign investment income.
Foreign Interest Income
Foreign interest income is taxable in the United States. In some countries, especially Asian countries, passive income such as interest is not taxable — but that blanket rule does not apply in the United States. Thus, foreign interest income is reported on the US tax return the same way as US interest, and it is taxed at the taxpayer’s progressive tax rate and identified on 1040 Form Schedule B.
Foreign Capital Gains Income
Foreign capital gains are also taxable in the United States, and the typical computation involves determining the specific spot rate of both the date the asset was acquired and the date it was relinquished – which are then used to determine the capital gain. The long-term capital gains rules and short-term capital gains rules also apply to foreign property.
Foreign Dividends Income
Foreign dividends are taxable in the United States as well, and are identified on IRS 1040 Schedule B. Foreign dividends can also be considered qualified dividends if they meet the specific requirements set forth by the Internal Revenue Service as to what qualifies as a “qualified” dividend.
Foreign Tax Credit
If foreign taxes were already paid or withheld on the foreign income, then the Taxpayer in the United States can claim a foreign tax credit by filing Form 1116 with their US tax return. There are some limitations with applying foreign tax credits such as each HTKO – and if there are insufficient tax credits the taxpayer may still have to pay US taxes on a portion of the income – but oftentimes applying the foreign tax credits will minimize, if not eliminate US tax liability.
FBAR, FATCA, & PFIC
Beyond just the tax implications of having foreign investment income are the pesty international information reporting requirements that must be met. There are several different reporting forms that a Taxpayer may have to file to comply with the IRS rules. Some of the more common forms involve the FBAR (Foreign Bank and Financial Account Reporting Form aka FinCEN Form 114); FATCA (Foreign Account Tax Compliance Act a.k.a. Form 8938); and PFIC (Passive Foreign Investment Companies a.k.a. form 8621).
If a taxpayer is out of compliance with the reporting aspect of these foreign investments, they may be subject to significant fines and penalties — although these penalties can be avoided, minimized, and even eliminated through the different offshore tax amnesty programs.
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