Dividend and interest income on foreign securities is often subject to tax withholding in the issuer’s jurisdiction of incorporation. Because local paying agents in such markets have little or no visibility through the custody chain to the ultimate beneficial owner, the withholding typically defaults to the highest (statutory) rate applicable in each market. Having been over-withheld, investors may file a reclaim application if entitled to a more favorable tax rate under the terms of a bilateral treaty.
For example, a U.S. resident investor who has an account at broker X makes an investment in Nestle, a Swiss company. The broker typically has an account at a Swiss custodian for non-resident investors, which is all the local paying agent sees and generally has no idea whether these investors are from the U.S., Canada, Russia or anywhere else. The Swiss government’s only opportunity to tax that income is at the time of disbursement. They will levy a tax at the statutory rate of withholding; in Switzerland it happens to be 35% so this investor only receives 65% of the gross dividend. The same income is taxed again at his local tax rate, resulting in double taxation. If you are looking at your investment portfolio to figure out where to get the best performance, being taxed twice on your dividends can really affect the quality of your portfolio’s return.
Governments understand that tax is being assessed twice, but they still want to make their capital markets attractive to foreign investment. In order to mitigate double taxation, pairs of countries enter into tax treaties which may allow investors to reclaim all or part of the over-withheld foreign tax subject to certain conditions. The burden of proof falls to the investor to present evidence of residency, receipt of income and tax withheld. Country-specific applications must be completed, signed and filed along with the above certifications and applicable fees. Beneficial owners, particularly tax-exempt entities and partnerships, must also submit other requested disclosure and supporting documentation. All this must be completed, error-free, within the statute of limitations to avoid forever losing this entitlement.
Tax reclamation is a complex and highly manual process, often done on a dividend by dividend basis. Imagine filing claims on an event by event basis across 20 or 30 markets and communicating with tax authorities in each of those markets, often having to overcome time zone, currency and language differences. Entitlement rates and recovery speeds also vary greatly, depending on numerous factors, including beneficial owner entity type, year of dividend, residency of the investor and country of investment. The administrative procedures involve a complex network of custodians, withholding agents, brokers, depositaries, central securities depositories and in-country agent banks. Tax treaties, tax laws and filing requirements vary from market to market, and are subject to frequent change. Errors can be costly, as the smallest mistake may result in a claim being rejected.
Recovery “Sweet Spot”
There are geographical sweet spots for developed tax reclamation processes. Western European countries, for example, have mature double taxation treaty features and recovery processes. There are also a growing number of reclaim opportunities in the Asia-Pacific markets. In particular, one important market people should be aware of is Japan where, as of January 1st 2014, the withholding rate has just been raised from 7.147% to 15.315%. Since the U.S.-Japan treaty provides for a 10% withholding tax rate on dividends for taxable investors, there is now a reclaim opportunity for all U.S.-based investors. U.S. pensions remain exempt and will still be able to reclaim the entire withholding.
Should I engage in tax reclamation?
Most investors, including many institutional investors, do not have the knowledge or processing infrastructure required to identify entitlements and successfully reclaim over-withheld tax on their own. Generally speaking, this must be done in cooperation with the investor’s custodian, many of which do not offer reclaim support services, The absence of such offerings is particularly pronounced among prime brokers and certain large broker/dealers, especially in the retail space. Due to the complexity described above and the difficulty in managing these processes, much of this money goes unclaimed and is essentially forfeited to foreign governments
One common misconception is that an investor can simply take a tax credit for the excess withholding. However, according to the U.S. Internal Revenue Code and the published instructions on the IRS Form 1116 – Foreign Tax Credits: “You cannot take a credit for the following foreign taxes. 1. Taxes paid to a foreign country that you do not legally owe, including amounts eligible for refund by the foreign country. If you do not exercise your available remedies to reduce the amount of foreign tax to what you legally owe, a credit for the excess amount is not allowed.” The portion of withholding that can be reclaimed, whether acted upon or not, is not eligible as a credit or deduction for tax purposes. Tax-exempt investors generally do not pay taxes in the U.S. and so would not have an opportunity to take a credit for foreign tax paid anyway.
A unique benefit for investors engaging in tax reclamation for the first time is that they often receive a significant windfall, based on excess withholdings from prior years that are still within the statute of limitations to claim. If, however, the beneficial owner does not take action to reclaim these funds within the statute of limitations period, the unclaimed entitled benefit is forfeited. Statutes of limitations vary by market but generally range between two and six years.
Tax reclamation serves as a powerful tool for enhancing portfolio performance, yet, due to the complexities described here, many investors’ entitlements expire unclaimed. While investors are not generally able to manage this sort of process on their own, one solution is to seek a third-party firm that can monitor income data for entitlement opportunities and manage the certification and claim filing processes required to recover all legal entitlements. In addition to maximizing total return, and attracting and maintaining investments, recovering an investor’s legal entitlements can serve to satisfy concepts of good corporate governance and fiduciary duty/standard of care.
For additional information on this topic or to receive a free recovery analysis, please contact GlobeTax at email@example.com or +1-212-747-9100.