The IRS imposes income tax on worldwide income for US citizens, residents and taxpayers. All are required to report even foreign investments on their annual returns. This holds true even if US tax forms are not provided for the foreign interests, such as 1099s or 1098s. Let’s look at how this affects your expat taxes.
How Are Foreign Investments Reported?
For US citizens and residents, foreign investments are reported and taxed in the same way that US-sourced investments would be reported and taxed. The interest and dividends are reported on Schedule B, and added to US-source interest/dividends, which are carried over to the main Form 1040. Real estate income is reported on Schedule E, and capital gains and losses on Schedule D. The big difference in terms of taxation of the foreign based investment would be with the dividends – as foreign dividends are generally not qualified, and therefore do not qualify for the reduced tax rate.
Foreign real estate income, although reported on Schedule E as any US-sourced rental, is considered to be a Qualified Business Unit (QBU) and required to have a statement attached to the return, listing out the income and expenses in the functional currency of the property. Furthermore, depreciation needs to be calculated in the functional currency, which captures any foreign currency gains/losses year on the year. Furthermore, in the case of any foreign property sales, foreign currency gains/losses need to be provided for and listed out in the attachment. Once converted to USD using the average exchange rate for the year, the items can be reported on Schedule E.
As such, US citizens and residents should primarily be concerned with the collection of the income and expense details, as they will not be (generally) conveniently consolidated on an end of year tax form. In addition, special care should be taken if the jurisdiction of the investment is on a fiscal year basis – as then the individual will need to keep separate calendar year records. Furthermore, records of any foreign taxes paid will need to be kept, as a foreign tax credit (FTC) is allowed for foreign taxes paid on foreign investment income.
How Can the Foreign Tax Credit Offset My Expat Taxes?
The FTC can potentially eliminate all tax associated with the foreign investment income. An individual needs to file Form 1116 Foreign Tax Credit to report the total amount of foreign taxes paid (or accrued) during the fiscal year towards the investment income. The second page of the Form 1116 takes the total amount of foreign investment income, and defines the tax liability that arises from only the foreign income. Afterwards, the lower of the actual US liability of the foreign tax paid may be taken as a credit against the total US tax liability.
What if I am a Nonresident Alien?
A nonresident alien who files Form 1040NR to report and pay annual taxes is generally required to report on two forms of income – investment income not directly tied to a US trade or business although US-sourced, and business income that is directly tied to a US-source. As such, foreign investment income will generally not be required to be reported and taxed.
What if My Investment is Within a Foreign Corporation?
Although the taxation of foreign investments is fairly straightforward – matters are complicated when the foreign investment lies with foreign corporations that are at least 50% controlled by US persons, and when the taxpayer owns at least 10%. Complex Subpart F Income rules come into play, as well as additional informational reporting requirements (for instance, Form 5471). If income is deemed to be Subpart F Income, the taxpayer’s allocable share of income will need to be included on his/her individual tax return, regardless of whether it was actually received. What is Subpart F Income? There are several categories of income that qualify – but the category most often used is the “Foreign Base Company Income”, which includes:
- Foreign Personal Holding Company Income (items such as dividends, interest, rents, gains, and other equivalent items)
- Foreign Base Company sales income if deriving from a personal property sale with a related party
- Foreign Base Company Service Income
- Foreign Base Company Shipping Income
- Foreign Base Company Oil Related Income
The subpart F income, once calculated, is taxed at ordinary rates at the shareholder level. With these complex rules, if a taxpayer owns more than a 10% share in a Foreign Corporation, it may be wise to seek the assistance of a tax professional.
Need More Information About Expat Taxes?
If you need additional information about expat taxes for your business, our blog has a whole host of resources for you. If you would like help filing your individual and/or business expat tax return, please contact us.