How are Dividends Generated from Foreign Shares that are Taxed in the US?

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

The massive bull run that the U.S. stock market has experienced for the last decade or so has resulted in a huge increase in many investors’ portfolios. Despite the fact that most dividend-paying stocks do not normally experience the same type of gain in share price that startup stocks can, they remain a crucial part of many investors’ portfolios. Indeed, dividend-paying stocks can be a reliable and steady stream of income for investors. 

Dividends, in this scenario, and in the traditional sense, are distributions of property, typically in cash, that a corporation may pay you if you own stock in that company. These dividends, of course, are paid out of the earnings and profits of the corporation. In terms of reporting dividends on one’s U.S. tax return, dividends can be classified either as ordinary or qualified. Whereas ordinary dividends are taxed at the higher, ordinary income rates, qualified dividends are taxed at lower capital gain rates. 

So the treatment of dividends in the U.S. is quite straightforward, which begs the question, how about the treatment of dividends that are generated from foreign shares? You will be relieved to hear that at least for once, the U.S. tax code is quite simple: these dividends are treated exactly the same way as dividends from U.S. corporations are: they are either considered ordinary dividends (and taxed at ordinary income tax rates) or qualified dividends (and taxed at the lower capital gains rates). Further, dividends received from foreign corporations should be reported on Schedule B of Form 1040 (just below the section for reporting interest income). But how do we know whether a dividend received from a foreign corporation is ordinary or qualified? Dividends received from a qualified foreign corporation, are, not surprisingly, taxed at the lower rates. How does a foreign corporation qualify? It either has to be a company incorporated in the U.S., be eligible for the benefits of a tax treaty with the U.S., or has to have its stock tradeable on a securities market in the U.S.   

Why is all of this so important? Well, the maximum tax rate for qualified dividends, for tax year 2021, is 20 percent, whereas for ordinary dividends, it is 37 percent. Therefore, it is important to report dividend income correctly, as not doing so has consequences in terms of how much tax you might be liable for. 

Of course, this is assuming that we are discussing shares of individual foreign companies, and not foreign mutual funds. This is because the tax treatment and reporting requirements around foreign mutual funds are different from foreign dividends being paid out by individual companies. What’s more, having an ownership in a foreign corporation over a certain threshold may trigger additional (and different) reporting requirements in the U.S.; namely, Form 5471 and its numerous, Hydra-like schedules. 

Also, please note that if you receive dividends from foreign companies on foreign stock markets, you are not likely to receive a 1099-DIV or 1099-B consolidated form reporting the dividends paid to you. Therefore, you will have to keep track of when the dividends were paid to you, along with, of course, the amount of dividends, and whether they are ordinary or qualified.

Inevitably, too, one may ask about the tax paid on foreign dividends. The good news is that if you have paid tax in a foreign country on those dividends, you will be able to take a foreign tax credit on your U.S. tax return. However, even though that is the case, the foreign tax credit you would receive for tax paid on ordinary dividends versus qualified dividends differs, and sometimes, you may be better off holding foreign shares that pay ordinary dividends rather than qualified dividends, based on the fact that you may have a larger foreign tax credit available to you on your U.S. tax return, and hence less tax owed. 

If you have an ownership in foreign shares and are currently receiving dividends or will be receiving dividends in the future, please get in touch today to ensure that you are reporting the dividends properly, not to mention that you are receiving the tax credit that you should for taxes paid overseas on foreign dividends. As mentioned previously, many taxpayers have an ownership in foreign companies but either do not report the ownership properly, or sometimes, do not report it at all. There can be tremendous penalties levied for failure to report an ownership in foreign companies, and foreign mutual funds, not to mention the penalties stemming from underreporting income on one’s U.S. tax return.