I hold Honda Motor Company ADR (symbol: HMC) stock in my Roth IRA. When a dividend was paid recently, I noticed that my Fidelity records showed a "Foreign Tax Paid" to the tune of about 7% on the dividend. In other words, Fidelity took this off the top of the dividend and presumably paid it to some country (Japan?).
The 2003 article at http://www.upenn.edu/researchatpenn/article.php?692&bus notes that such taxes, at least back in 2003, shafts those holding certain foreign-based companies' within their IRAs. Evidently outside the IRA, there was or is a way around avoiding this tax. The article elaborates.
By contrast, I think my HMC stock's dividends, if held in a taxable account, are like REITs: They may not qualify for the tax break given most other domestic stocks' dividends.
Before I go(ogle) blindly forward, has anyone some good citations on this or other insight (based in experience with foreign-based stocks)?
Elle, if the ADR was held in a taxable account, you'd have a foreign tax credit on your federal tax return, up to the amount of US tax you would have paid on that foreign income on which you paid foreign tax. This is claimed on Form 1116 (if it's a small credit the form isn't required - see the instructions). You can also claim it as an itemized deduction but it's usually better as a credit.
If you hold the ADR in an IRA you aren't allowed to take that credit or deduction because you didn't have taxable income associated with the foreign tax paid. This is a down-side of holding ADRs in an IRA, though on balance it might not be significant.
Incidentally this same foreign tax credit is the reason many corporations pay minimal US taxes. Big oil, as an example.
Tad Borek wrote:
Would this effect be invisible on the statements of a 401(k) investor in foreign mutual funds since they would not receive the type of statement Elle did? I take it that the lost withholding would not appear in the past performance of the fund? But I think expenses incurred to avoid the withholding, as described in the article that Elle cited, would? I don't normally invest in foreign mutual funds, but I would not have thought to check on the effect of foreign taxes in the prospectus...
Will Trice wrote:
Will, Just be sure to look at the nominal (not tax-adjusted) performance figures for the fund and you should see accurate numbers.
The fund will report dividend income received (from the stocks/ADRs held by the fund) on a net-of-tax basis. You can see this if you read through a fund's financial statements. It will say something like "Note: net dividends after $17,000,000 in foreign taxes withheld" or list the $17M as a line item before showing the dividend income. It's the "net" figure that is paid out to shareholders, and used when computing nominal yield for the fund. Or should be, anyway.
But that's not true of the after-tax figures. Under the SEC guidelines for reporting after-tax returns, if a foreign tax credit is distributed out to mutual fund shareholders, the fund needs to adjust performance figures for that (adding in the credit to the dividend and adjusting that total for taxes paid, at the top bracket).
So for comparing IRA/401k fund alternatives be sure to look at pre-tax figures if comparing yields.
And no, as an IRA/401k shareholder you won't see the actual credit, because you don't get a 1099-DIV for a mutual fund held in a qualified account (because you aren't taxed on that dividend income).
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