I’m often asked why 1099 reporting doesn’t just include US income paid to US persons. I’m always glad to be asked this because its been one of my favourite topics for some time.

Most financial institutions that allow US customers to open accounts outside the US understand that this decision exposes them to 1099 reporting and, if they do any backup withholding, then form 945 reporting is required too.  The financial institution typically just adds up any US income paid to their US client and reports it on 1099-X where “X” represents the type of income. For most financial institutions, this will be a 1099-DIV or a1099-INT for dividends and interest respectively.

Now, on a 1099-DIV, a financial institution would typically use boxes 1a and 1b to report ordinary and qualified US dividends. However, the 1099-DIV also has box 7. This box is used to report non-US (or “foreign”) tax paid. So, while box1 a could be used to report Tesla, Microsoft and SpaceX dividends paid to a US person, if that same person also held shares in Nestle (a Swiss company), they would have received a Swiss dividend taxed at 35%. So, in this instance box 7 would contain the total of the Swiss tax withheld. This causes a problem for the financial institution because most US investors maintain a portfolio of cross border investments. So a financial institution will have to add up all the non-US tax paid on dividends from each market to its US customer, convert that to US dollars and put that in Box 7 – a 1099-DIV for each market in which foreign tax was paid.

Now, there are a couple of quirks here. First, as we all know, the US investor has an obligation to report any foreign bank account. This is the Foreign Bank Account Report or FBAR. So, if a US investor is holding a portfolio at a non-US bank, the financial institution will have a reporting obligation under FATCA. So, those two dots should join up and, if the US person is reporting his or her foreign accounts and the financial institution also reports those accounts, the IRS is happy(ish). But FATCA and FBAR are generally about account balances at year end, not income. That’s where the 1099 comes in. The financial institution should be reporting US income and foreign tax paid by its US client on the 1099.

The second quirk is the common practice by many US investors to claim their entire foreign tax paid (reported in box 7), as a credit against their domestic tax liability and thus avoid any double taxation. The problem is that this is not how it works. The rule, which is very clear, is that a US investor can only claim a tax credit against the unrecoverable portion of foreign tax paid. This rule explained on US form 1116 which is how an individual claims a tax credit.

Foreign Taxes Not Eligible for a Credit. Taxes paid to a foreign country that you don’t legally owe, including amounts eligible for refund by the foreign country. If you don’t exercise your available remedies to reduce the amount of foreign tax to what you legally owe, a credit for the excess amount isn’t allowed. The amount of tax actually withheld by a foreign country isn’t necessarily 100% creditable. See Regulations section 1.901-2(e)(2)(i). Example. Country X withholds $25 of tax from a payment made to you. Under the income tax treaty between the United States and Country X, you owe only $15 and can claim a refund from Country X for the other $10. Only $15 is eligible for the foreign tax credit (whether or not you apply for a refund).

Extract from page 3 of instructions for form 1116 [author’s highlighting]

So, in our Swiss example, the US investor would have 35% of his or her dividend withheld, which would be the amount reported in Box 7 of form 1099-DIV. However, there is a double tax treaty between the US and Switzerland with a treaty rate of 15%. So, of the 35% in the hands of the Swiss tax authority, 20% is recoverable under the DTT, if you know the forms and procedures to claim the refund. 15% is not recoverable because ist the agreed tax treaty rate – so that’s the amount that the US investor can claim as a tax credit, NOT the 35% foreign tax paid as reported in box 7. There are firms out there that can help US investors to reclaim these over-withheld foreign taxes (for a fee), but this model holds for all jurisdictions where the statutory tax rate on dividends is higher than the treaty rate. The problem for the financial institutions producing the 1099s is that it must be able to gather data from all markets in which to which the US investor is exposed and add all that up to convert it to US dollars in order to be able to complete the 1099s properly. Calculating the US dividends is the easy bit.

And if the US investor doesn’t claim the over-withheld tax back from the foreign government – well that’s their problem. They’ll either be committing tax evasion by trying to claim a credit where one is not available, or, if they do claim the credit correctly, potentially losing out on the tax reclaim that they could have filed.

The overlap with FATCA can also be confusing. The 1099-DIV also contains Box 11. This box is used if the 1099 is being used instead of reporting the account in FATCA. In other words, if a financial institution had 100 US clients and 30 of them received US dividends, those thirty could be reported on 1099-DIV with Box 11 checked, meaning that the account of this US person would not be included in a FATCA report by the issuing financial institution. The other 70 accounts would not receive a 1099 and would therefore need to be reported in FATCA. Most financial institutions do not want the operational headache of dealing with this bifurcation, so they report all US accounts in FATCA then also report Us income paid those accounts on 1099-DIV. Does this mean that there is level of double reporting, sure it does. The financial institution doesn’t care as long as it met is regulatory obligation. The US investor doesn’t care, as long as they aren’t investigated by the IRS (and they can claim their tax credit and file reclaims to optimise their portfolio value). The IRS? Well the IRS is under-funded and has not yet demonstrated conclusively that it has the budget or the manpower to analyse the lakes of data they are being sent by financial institutions and IGA partner tax administrations.

The industry has been lobbying the IRS for many years to introduce boxes 7a and 7b where foreign tax could be separately reported as recoverable and non-recoverable, this making an easy connection to any tax credit claim filed on form 1116. To date, this appears to be falling on deaf ears.

While it may seem a rather anachronistic example, the US is an investor-oriented society in ways that Europe and Asia have yet to equal. So, the number of Americans with foreign portfolios is likely to be very large. The unaware US investor should be very careful and make sure they get expert tax advice on how to handle their foreign portfolios from a tax perspective. The impact of doing this portfolio optimisation has been widely estimated at around 150 basis points.