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Lost Abroad

Michael Flack

ONE OF THE GREATEST business books I’ve ever read is Antifragile by Nassim Nicholas Taleb. In it, he postulates the idea that, while things that become damaged by stress are considered fragile and things that resist stress are considered resilient, “there is no word for the exact opposite of fragile,” things that become stronger due to stress. So, he coined the word “antifragile” and then wrote an entire book about the subject.

Well, we’re all familiar with a tax loophole, which has been defined as an “unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law.” The backdoor Roth IRA is a good example. It allows those who wouldn’t ordinarily be able to make regular annual contributions to a Roth, because their income is too high, to instead contribute to a traditional IRA and then—voilà!—convert it to a Roth.

What’s a word for an “unintentional omission or obscurity in the law that allows the increase of tax liability to a point above that intended by the framers of the law”? There is none, so I’ve coined the word “antiloophole,” though I won’t be writing an entire book about it.

Like many of you, I own shares in publicly traded foreign stocks and have therefore had to pay foreign income taxes on my foreign dividends. Since I was filing a joint return with my wife and we paid less than $600 in foreign income taxes, we claimed the entire credit for these foreign taxes directly on our 1040. I like the diversification that foreign stocks afforded me, so I kept buying more and more, comforted by the innumerable articles and experts that stated that—if we lost more than $600 to foreign income taxes—all we need do was to file Form 1116. And as long as I was working, they were right.

Form 1116 calculates your foreign tax credit based on some convoluted formula that can leave you with a credit that’s less than the total foreign income tax paid. (Trust me, it’s too complicated to explain here.) In 2017, when I was still working, we were able to claim a tax credit for $799 of the $861 in total foreign income tax we paid. While I certainly didn’t like this development, it wasn’t catastrophic. But in 2018, after I retired, we were only able to claim $74 of our total foreign income tax paid, out of a total of $872.

That didn’t seem fair. After all, if a hypothetical taxpaying couple surrendered $599 to foreign income taxes, they would get to skip Form 1116 and claim the entire $599 as a tax credit, but if they paid $601, they would be kicked over to Form 1116 and would possibly get to claim much less.

It all seemed very personal, so I scoured the internet to find similar tales of woe, gain solace from the misery of others and, almost as important, resolve this tax conundrum. I couldn’t find a single mention of this issue on the entire internet. Was I the only one suffering from this injustice? Were others too ashamed to speak of it?

I contacted a good friend, who is a partner at a New York City accounting firm, for a second opinion. He congratulated me on the accuracy of my tax forms and my foreign tax knowledge. But in the end, he confirmed that—in my case—Form 1116 was a screw job (not necessarily the words he used). He gave me two options, live with it or sell some of the offending foreign stocks.

I’m not a live-and-let-live kind of guy and therefore couldn’t let this injustice continue. In January 2020, I sold one of my larger foreign stock holdings, Canadian real estate investment trust RioCan (symbol: RIOCF), which reduced my foreign income tax below $600. Problem solved.

Epilogue: In the end, this actually worked out quite well, as I used the proceeds from my sale of RIOCF to buy an S&P 500-index fund. As the once offending RIOCF has since fallen precipitously, in addition to coining the word antiloophole, I have the added benefit of being able congratulate myself on my investing acumen. Which in the latter case is quite rewarding, as boosting one’s ego can be even more important than reducing one’s taxes.

Michael Flack blogs at AfterActionReport.info. He’s a former naval officer and 20-year veteran of the oil and gas industry. Now retired, Mike enjoys traveling, blogging and spreadsheets. His previous articles were Making the Call and Trading Places.

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Steve Spinella
Steve Spinella
4 months ago

I believe, but I am not sure, that you can use all your foreign investments vs all your foreign taxes. Still, this takes a lot of work, and all because you didn’t qualify for the simple deduction any more. I think another commenter is right in pointing out that there is a blurry line in the tax code between paying foreign taxes as an investor and as earned income. Of course, you don’t have to fill out the form–it just provides a tax benefit if you do the work, and the benefit may not be as great as the cost of filling out the form, especially if you pay someone else to do it.
However, as someone who did live internationally for years, I know governments see no reason why they should limit their tax collection just because someone else is also tax collecting. And in every jurisdiction, I prefer to pay less taxes.
Why does my first statement matter? It turns out some jurisdictions want foreign investors bad enough not to tax them, or tax them less. Accidentally this balanced things out last year. Now, though, I have a nagging concern I don’t know how much extra I’ll be paying every time I invest in a foreign company. Maybe form 1116 is actually having its intended effect in my case?!

India Major
India Major
9 months ago

Michael, We encountered the same situation as you did with international equities. The formula is actually fairly simple, you can only get credit for the proportion of foreign taxes withheld that is the same ratio as your total federal tax divided by your income. Our energy holdings used to include BP, Royal Dutch Shell, and Total in addition to U.S. firms. We sold all our foreign energy holdings, and just use U.S. firms, with their international exposure, for our energy investments. Problem solved!

mjflack
mjflack
9 months ago
Reply to  India Major

India Major, thanks for your reply. If you find it all “fairly simple” then I certainly respect your math skills. You are not correct about “credit for the proportion of foreign taxes withheld . . .” as if you only pay $599 in foreign taxes you can get credit for all of it, if you pay $601, you cannot.

GaryW
GaryW
9 months ago

My one encounter with Form 1116 was a long time ago when it was the only way to claim foreign taxes, there wasn’t any alternative for relatively small amounts. I agree that it’s probably the most convoluted tax form that I’ve ever used. The reason for 1116 is actually quite rational, you can only deduct the amount that the foreign income would have otherwise increased your U.S. taxes. The 1116 has been around for a long time, I recently noticed a line for it on the Form 1040 for the year 1940.

mjflack
mjflack
9 months ago
Reply to  GaryW

Gary W, thanks for your comments. I can understand the reason for form 1116, but not that it only is used when you foreign tax paid is greater than $600.

BestBoy
BestBoy
9 months ago

I have lived and worked in Europe for the last 11 years, retired for the last 5. For the first six, I had the option of claiming the Foreign Tax Deduction (a dollar for dollar itemized deduction, but on earned income only). In retirement, these last five years, I could only use the Foreign Tax Credit (because of passive investment income only), with all of its inherent mysteries and byzantine alleyways. So, I end up paying US and Swiss taxes, never quite being sure that what I am paying isn’t too much (at least to the US). My Swiss tax rate is less than the US; but the US catches me up to the US rate tables in nifty fashion.

My expat friends here who are from the UK, Japan, Germany, etc. only pay Swiss taxes. They are astounded that we Americans have to pay both pipers.

By the way, Jonathan, I went to University and grad school and worked/lived in Philadelphia. And not all that far from your office address for the newsletter. I hope you are enjoying the city, as I did for many years, with my Philly born spouse!

davidrmoran
davidrmoran
9 months ago

a v smart guy, not me!, at mfo had this to point out:

Foreign tax credits can be carried back one year and forward ten years, so he may not have lost his tax credit as much as he would like you to believe. I’ve carried forward and later used foreign tax credits. Basically, you can’t take a credit now for foreign taxes paid at a higher rate than your current overall (not marginal) US rate. For example, suppose you owe $10K in taxes on $100K of taxable income (10%). If $20K of that income was foreign, and you paid $3000 in foreign taxes (15%), you could take a credit now for $2000 (10%) and carry over the remaining $1000 to use in future years.

The way the IRS describes it is different but amounts to the same thing:

Your foreign tax credit cannot be more than your total U.S. tax liability … multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States. The denominator is your total taxable income from U.S. and foreign sources.

More important is whether your mutual fund passes through foreign taxes to you. The way funds generally work is that they pay for expenses (management fees and yes, taxes) out of earnings and pay you the net earnings as divs. The income you see on your 1040 is the usually the net income. But sometimes, even though you’re only getting net divs, the funds pretend that you got extra income and it was you, not the fund, that paid those foreign taxes with that extra income. So you might have $500 in “real” dividends, but on your 1099 you see $550 in divs and $50 in foreign taxes paid.

The question is: which funds pass through foreign taxes to you? A fund must make an election to pass through the taxes. They can’t do so unless “more than 50 percent of the value … of [the fund’s] assets at the close of the taxable year consists of stock or securities in foreign corporations.” 26 U.S. Code § 853(a)(1)

Generally, global funds don’t make this election either because they typically have less than 50% invested abroad or because their portfolio could be near 50% and they want to be clear to investors. (Currently, M* shows 46/246 large cap world stock funds with over 50% non-US stocks.) Somewhat surprisingly (to me) a number of international funds also decide not to pass through foreign taxes.

mjflack
mjflack
9 months ago
Reply to  davidrmoran

davidrmoran, Thank you for your comment. All of my foreign taxes come from investments in foreign stocks (mostly Canadian). You make a valid point about carrying back one and forward ten years, which becomes very complicated. I use turbotax and it has never allowed me to do this.

Rick Connor
Rick Connor
9 months ago

Great article. Tax cliffs can be very frustrating, especially the first time you encounter one. NJ allows a married couple to exclude $100K of retirement income, if your combined income (excluding SS) is below $100K. At $101K you lose the entire exclusion. So, if you had a $50K pension, you could take $49K in IRA distributions, for $99K, and exclude the entire amount. If you add $2K you lose the entire exclusion.

Will
Will
9 months ago
Reply to  Rick Connor

As anyone who has been thru this kind of ‘screw job’ or ‘antiloophole’ knows, it doesn’t take a tax genius to see that cliff coming if you are the one writing the law. Why do these idiots not avoid the injustice and graduate the limits?!?! And while I am on it, why are limits usually in Dollar amounts instead of per cents? As we all know, the value of a dollar changes a lot over a lifetime.

Tim Butts
Tim Butts
9 months ago
Reply to  Rick Connor

Which begs the question “Why would anyone continue to live in New Jersey?”

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