If you own shares in a corporation based overseas, either directly or through a financial product such as a mutual fund, you may receive dividends. As a U.S. citizen or permanent resident, you are subject to taxation on your worldwide income. Nevertheless, a foreign government might withhold taxes from your dividends before you ever receive them. To avoid double taxation, the IRS offers the foreign tax credit and the foreign tax deduction.
IRS Taxation of Foreign Dividends
The IRS taxes foreign dividends in the same way it taxes domestic dividends. It recognizes two types of dividends: ordinary dividends and qualified dividends. It taxes ordinary dividends as ordinary income at standard graduated income tax rates, and taxes qualified dividends as capital gains. To be classified as qualified dividends, the investor must have held the stock for more than half of the 121-day period that begins 60 days before the ex-dividend date.
Foreign Tax Credit
The foreign tax credit is a credit of foreign taxes paid or accrued against your total tax due. It is available for the tax year you actually pay it, or the tax year you are billed for it. This depends on whether you use the cash method or the accrual method of accounting. Individuals claim it by including form 1116 with their federal income tax return. Corporations claim it by filing Form 1118 with their federal income tax returns. Claiming the foreign tax credit reduces your tax liability but not your taxable income.
You cannot claim the foreign tax credit for any tax that you are disputing with a foreign government. If the foreign government withholds too much tax because it ignored the provisions of a bilateral tax treaty, you cannot claim the amount by which you were overcharged, even if you never dispute the overcharge.
Foreign Tax Deduction
You may choose to claim the foreign tax deduction instead of the foreign tax credit, but you cannot claim both during the same tax year. The foreign tax deduction is an itemized deduction -- if you claim it, you can't claim the standard deduction. Since the foreign tax deduction is deducted from your taxable income instead of your total tax due, it usually won't save you as much money as the foreign tax credit will. It might save you money, however, if your taxable income would otherwise fall just above the cutoff for a higher tax bracket.
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