Foreign tax credit - is Uncle Sam just out the money?

Factual Questions
1

Something I’m moderately curious about, and can’t seem to find online.

If a US citizen has foreign investments which pay dividends, sometimes the foreign country takes taxes out of the dividends. If it’s less than $300 ($600 filing jointly), or you fill out form 1116, you can claim a tax credit. That’s a tax credit, not a before tax deduction - you subtract it from the tax you owe.

For instance, Canada and the Netherlands have been taking nibbles out of me, but I’ll presumably be able to recover the whole wad as a tax credit. So, it’s all copacetic as far as I’m concerned - I just wind up paying some tax to Canada and the Netherlands instead of the US.

What I wonder - is the US government actually out that tax revenue, or is there a bill presented by the US to various other nations for income taxes those nations saw fit to levy on US citizens? If such an adjustment is made between nations, there must be a routine rather reminiscent of the old vaudeville hat switching bit with everybody issuing everybody else credits for taxing everybody else.

2

Uncle Sam isn’t out a dime–you made some money from a source outside the US and you paid taxes outside the US.

This is a lot different than say, international telephone calls where there are indeed all kind of arrangements for settling up, as you suggest.

3

But they are out a dime. Or in my case, $1.30 this year on a mutual fund of Japanese stock.

I own 289.572 shares of FJSCX (approx. $3700 worth). From my 1099-DIV, I had $7.06 in ordinary and qualified dividends, $11.52 in capital gain distributions, and $1.30 in foreign tax paid.

Now the gub’mint COULD just take those dividends and distributions and charge the standard taxes for that (which they do), and give no credit for foreign taxes. Who cares what I paid to the government of Japan? That’s just the cost of investing in another country.

But they don’t. They just let me subtract the foreign taxes directly from my tax bill (which is a better deal than normal deductions that reduce your taxable income). [According to TurboTax, you can directly subtract it from your tax bill or you can claim it as a deduction, which is not as beneficial.] If they didn’t give me credit, I wouldn’t have any recourse, and I’d think that was just the cost of having a foreign source mutual fund.

Tax agencies do seem (in my limited experience) not to double tax personal income (like when dealing with two state tax forms, foreign wages, etc). But most of those schemes involve calculating what you would pay uner one scheme, and if you did not pay that much under the other, then your actual payment is the difference. For example, when I lived in Kansas as a student but worked summers in Iowa, I had to calculate Kansas taxes based on my income, and if they were higher than the Iowa taxes, pay the difference to Kansas.

But the way this is done, the US is paying my Japanese taxes. Apparently, if I’d been charged $600, I’d get that right back, and they wouldn’t make it back up with the taxes on $7 of dividends and $11.50 on distributions. The government would really lose about $600 on that (unrealistic) deal.

So, two guesses as to why:

Guess #1: simplification. Easier to just give credit than have people calculate alternate tax schemes, especially if my $1.30 is typical. Maybe above the $300/$600 limits that’s what happens.

Guess #2: treaties or agreements with other governments require it . Maybe done to encourage equities investment between countries.

4

This is your reason right here. A great many countries have bilateral tax treaties which spell out how people potentially subject to taxation on the same money in both countries will be treated.

5

It’s a real issue, but I’m rusty on it, so go easy.

The short answer is yes, the US Treasury effectively makes a gift of the revenue to the foreign treasury.

Slightly longer answer:

When stuff can move about there is an additional complication in tax policy. Taxes may be destination or origin based in the case of impersonal taxes. Payroll taxes are origin based - that is a product made in jurisdiction A is taxed regardless of whether it is used in A or in B. A value added tax is destination based: a product used in jurisdiction A is taxed regardless of whether made in A or B.

I hope it is obvious that this can arbitrarily distort production and consumption decisions, particular if tax rates differ between jurisdictions. Jurisdictions might be tempted to grab a little revenue from other jurisdictions. Firms might relocate. Individuals might choose to earn in one jurisdiction and spend later in another. And so on. A solution is a harmonised system of VATs such as is kind of the case in the EU: everyone adopts the same (destination) method, tax is collected and the locational distortions are minimized.

The same sorts of considerations underlie the foreign tax credit schemes. Personal and company taxes may be on a source or residence principal. Notice it’s not obvious who “should” get the revenue, the source country or the country where the claimant of the income resides. If properly coordinated between countries, either source country keeps revenue or keeps no revenue would work ok. But the temptation is (for a big country) to do a bit of both: tax the income made in the country and tax residents’ foreign source income. The temptation for really small countries is to cut your taxes really low and become a tax haven where for a small fee you allow entities to pay tax in neither the source nor resident jurisdiction. The result of all this would be a highly distorting pattern of taxes on international capital flows with the additional feature of no-one collecting much revenue due to transfer pricing and tax havens.

The (still current I’m assuming) double tax treaties allowing credits for domestic residents for foreign tax paid is an exchange of gifts between treasuries. It prevents double taxation and to an extent it squeezes tax haven countries (since an investor from country A doesn’t mind paying tax in country B if it is fully creditable against country A tax).

It’s a way of sharing the revenue - or if you like, a conspiracy against international tax competition by wealthy industrialized countries. To a fair degree, the revenue nets out: the US Treasury gives some credit, and it gets some from the reciprocal arrangements. In the old days - when the US was the world’s biggest capital exporter – the scheme would have cost the US a fair bit. Now, of course, that situation has reversed.

6

Having had to fight through a similar scenario recently, I can say that yes, a tax treaty does exist between the US and Japan. If you can obtain an IRS form 6166 proving that the IRS considers you to be a US taxpayer, you do not owe the Japanese tax authority on money earned in Japan. Alternately, you can pay your Japanese tax and instead opt to claim the foreign earned income exemption on your US 1040. And some enterprising individuals exploit loopholes or defects in the Japanese tax code to simultaneously exempt themselves from both Japanese and US taxes, although I’m not entirely sure that is legal.

I don’t pretend to know the hows or whys outside of my specific situation, but the general idea is to prevent taxpayers from being taxed doubly.

7

Interesting, thank you. But this brings up another question, perhaps best answered by a non-US citizen who has income-producing investments in US corporations:

For a US citizen, dividend income on US companies does not generally have tax withheld. We merely get a 1099 at the end of the year which lists the income such investments produced so that it can be declared on our income tax returns. Does the IRS (US tax authority) automatically collect tax from dividend payouts to citizens of foreign countries, like Canada and the Netherlands are doing to my payouts? Given the description above, it seems that a country which does not withhold tax from dividends payed to citizens of another country is losing big time - they’re out the revenue they have to credit to their own citizens, without getting any “gifts” from other countries in return.

8

I wouldn’t be surprised to find the US is a net winner in the don’t-tax-money-earned-in-another-country game.

While the US doesn’t tax foreign earnings, as nicely covered above, the citizens foreign countries do pay taxes, in theory, on investments made in the US. I remember reading a while back (which is all the cite I have) that the US relies on some 3-4 billion a day in public debt to not-US citizens to finance the government. Just as a WAG I’d put annual investment in US stocks, bonds, treasury bills, etc by foreign nationals in the 1-1.5 trillion area. One assumes there some taxes paid on that.
Just my $.02.

9

They would get the tax that has already been paid at the corporate level. In Australia, for example, there is no second round of tax on dividends: whilst the dividends are taxable, taxpayers receive an imputation credit for tax paid on their behalf under the company tax. Revenue is raised from foreigners only by denying them an imputation credit.