With yields across fixed income markets at levels many investors find unacceptable, it is not surprising to see widespread interest in stocks that pay healthy dividends. Simultaneously, as the push for building global portfolios continues to grow, you may even own or be considering owning stocks of companies based out of countries all around the world. As an investor with a focus on dividends venturing into foreign stocks, keep in mind that the dividend a company pays out is not always the dividend you will receive in your brokerage account. In fact, your dividend yield on your foreign stocks may be less than you think. This is because of foreign withholding taxes on dividends.
As a result of the foreign dividend withholding taxes imposed by many countries, you should verify before purchasing a stock that the dividend yield you believe you are earning is in fact the net dividend yield you will realize after foreign withholding taxes. Additionally, remember to factor in IRS rules regarding recapturing some of the withheld dividends through credits or deductions. After all, just as bond investors use taxable-equivalent yields to compare yields on bonds with and without tax-exempt features, so too should dividend investors use a fair comparison between dividend yields on domestic stocks and dividend yields on foreign stocks.
With this in mind, I would like to present what I call the "domestic taxable-equivalent dividend yield," which is used to compare the dividend yields of domestic stocks to the dividend yields of foreign stocks. Despite the long name, the domestic taxable-equivalent dividend yield is a relatively simple concept. It strips out the foreign dividend withholding tax of a country to help investors discover the lower bound for the dividend yield of the foreign stock they own. When stripping out the foreign dividend withholding tax of a country, it is important to factor in any tax treaties between the foreign country and your home country, which may change the rate. Examples of this are provided later in the article. The upper bound for the dividend yield is the yield before subtracting out the foreign dividend withholding. In other words, the upper bound yield is the yield based on the full dividend paid out by the company.
It is possible for your yield to end up between the upper and lower bounds. This is because tax laws in your country may allow you to recapture some of the withholding through credits or deductions (as they do in the United States).
Let's take a look at a few examples of how to calculate the yield of a foreign dividend-paying stock and see where the yield falls between the upper and lower bounds.
1. The first example will be the easiest. Currently, there is no withholding from dividends paid by corporations based in the United Kingdom. One such example is BP (NYSE:BP). The company currently pays a $0.54 quarterly dividend to holders of its ADRs, and investors receive the entire amount. Therefore, no adjustments need to be made to calculate the domestic taxable-equivalent dividend yield for BP, and the upper and lower bounds of the dividend yield are the same. At this time, BP's annual dividend yield is 5.14%.
2. Next, let's take a look at another energy company, Total (NYSE:TOT) based out of France. France has a withholding tax of 30% on dividends unless there is a tax treaty stating otherwise. Total's dividend is currently €0.59 per quarter. The fact that the dividend is declared in euros, even for ADR holders, can be a blessing or a curse. It will cause the dividend yield to fluctuate over time based on changes in the currency rate.
For calculating the upper and lower bounds of the domestic taxable-equivalent yield on Total's stock, you would convert the annual dividend of €2.36 into your home currency and then apply the applicable withholding tax. Fortunately for individual U.S. investors, there is a tax treaty that reduces the French withholding rate to 15%. This is consistent with the terms of the tax treaty between the U.S. and France.
At this time, the upper bound of the dividend yield is €2.36 multiplied by the current exchange rate of $1.2963, divided by the current share price of $49.98. This is 6.12%. You will realize this yield if you are able to recapture all the withholding when filing your federal income taxes. The lower bound is calculated by multiplying the €2.36 by 0.85 (one minus the withholding rate), multiplying that result by the current exchange rate of $1.2963, and then dividing the product by the current share price of $49.98. The resulting yield is 5.20%.
Therefore, U.S. investors purchasing shares of Total at its recent price of $49.98 will have a dividend yield somewhere between 5.20% and 6.12%. Whether you end up on the upper or lower bound or somewhere in between will be determined by your specific tax situation and whether you hold the shares in a taxable account or a tax-advantaged account. If you are interested in learning more about tax credits and deductions on foreign dividend withholding taxes, you should consult IRS Publication 514 - Foreign Tax Credit For Individuals.
Also, keep in mind that the upper and lower bounds can fluctuate based on changes in the exchange rate.
3. Last, I would like to comment on Germany's foreign dividend withholding tax. Germany currently withholds 25% of dividends, plus an additional 5.5% of the 25% (called a "solidarity surcharge") for a grand total of 26.375%. However, as a result of a tax treaty between the United States and Germany, the foreign dividend withholding tax is reduced to 15% with no solidarity surcharge on top of that.
Siemens (SI) provides investors with a great example of why corporate websites are not always the most reliable in terms of finding pertinent information to your specific situation. In the "Frequently Asked Questions" on its "US Listing / ADR Holder" page, under the "Capital Market/Shares" tab, you will find the question, "What is the withholding tax applied on the dividend payment?" The question is answered in the following way:
"Dividend distributions made by Siemens are subject to a current withholding tax of 25%. Moreover, a solidarity surcharge of 5.5% on the withholding tax is levied, resulting in a total withholding tax rate from dividends of 26.375%. For many Non-German Holders, the withholding tax rate is currently reduced under applicable income tax treaties."
Siemens does provide investors with accurate information on German withholding tax laws. But it only mentions that income tax treaties exist that will reduce the withholding tax rate for "Non-German Holders," rather than states what those reduced rates are. This is a case in which investors will have to do their own research to find out what the withholding tax will be based on German treaties with their countries.
To help you with your research of foreign dividend withholding taxes and tax treaties between the United States and various countries, I would like to provide readers with links to two very useful sources of information. The first is the "United States Income Tax Treaties - A to Z" on the IRS website. On this page, the IRS has this to say about United States tax treaties with other countries:
"The United States has tax treaties with a number of foreign countries. Under these treaties, residents (not necessarily citizens) of foreign countries are taxed at a reduced rate, or are exempt from U.S. taxes on certain items of income they receive from sources within the United States. These reduced rates and exemptions vary among countries and specific items of income. Under these same treaties, residents or citizens of the United States are taxed at a reduced rate, or are exempt from foreign taxes, on certain items of income they receive from sources within foreign countries."
The second useful source I would like to mention can be found on the U.S. Department of the Treasury's website under "Resource Center," "Tax Policy," "Treaties and Other International Documents," "Treaties and TIEAs." In the words of the Treasury, "Here you can access the texts of recently signed U.S. income tax treaties and tax information exchange agreements (TIEAs) and the accompanying Treasury Department tax treaty technical explanations as they become publicly available, as well as the U.S. Model Income Tax Convention."
If dealing with foreign dividend tax withholding is not to your liking, you may be tempted to venture into ETFs that hold foreign stocks. International ETFs have dividend yields that are calculated net of foreign taxes withheld. Therefore, you can feel more confident that the dividend yield advertised is a dividend yield applicable to your situation. Additionally, you should still receive tax documents detailing the foreign taxes withheld on the ETFs. If you are able to claim a tax credit or a deduction on the foreign taxes withheld, your yield would actually be slightly higher than the advertised yield on the ETF.
With that said, if you do venture into ETFs holding foreign stocks, you will need to understand that all the dividends you are paid might not be considered Qualified Dividend Income (QDI) for tax purposes. In my article, "2 Helpful Tips For Comparing ETFs" I provide more information on this topic, including a detailed comparison between the 2011 QDIs for the Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM). I encourage anyone interested in purchasing shares of VWO or EEM to read the article before making a purchase.
Whether you currently invest in foreign stocks or are thinking of doing so for the first time, the implications of foreign dividend withholding tax rates, tax treaties between various countries, and QDIs on international ETFs are all things to pay close attention to. Perhaps most important to keep in mind is that just because a foreign company has an enticing dividend yield based on the dividend that it pays out does not mean that all shareholders will realize the same yield on their investments. Your dividend yield could very well be much lower.