How to manage tax on foreign trades

Working out how much UK tax to pay on dividends from foreign stocks can be a real headache. Cris Sholto Heaton explains everything you need to know about managing tax on foreign trades.

It makes sense to look beyond Britain's borders when you invest. The cost of trading foreign stocks is falling all the time. And if you're after high-quality global companies that pay decent dividends the sort of stocks we favour you can spread your currency risk by investing in European, American and even Asian blue-chips too.

But just be aware of the tax implications. Most British residents need to pay UK tax on dividends from foreign shares, whether or not you bring the money back into Britain. The complication is that some countries will already have taken tax from this income. This is known as withholding tax', and means you can end up being taxed twice on the same income. Obviously, this would be unfair even by tax standards. So Britain has double taxation agreements' (DTAs) with most countries to stop this happening. The DTA limits the maximum withholding tax that can be taken from dividends paid to British residents: it's usually 15%. This can then be offset against any UK tax due.

So how much UK tax is then due on this income? In most cases, foreign dividends are treated the same as British ones, which leads to a slightly roundabout calculation. UK dividends come with a notional tax credit of 10%. Years ago, this related to the amount of corporation tax that had been paid before the dividend was disbursed, and could even be reclaimed, but it's largely theoretical today.

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So the dividend comes with this 10% credit and basic-rate taxpayers have a theoretical 10% income-tax liability on dividends. These cancel out, and they pay no more tax. Higher-rate taxpayers are liable to 32.5% tax on dividends, so after offsetting the credit they need to pay 25% more tax. Top-rate taxpayers are liable to 42.5% on dividends, so after offsetting the credit they pay 36.1% more.

Since 2009, the tax office has also given the tax credit to most foreign dividends. So you calculate the tax due by adding the credit to the gross dividend (ie, before withholding tax is deducted), then multiplying that by your full dividend income-tax rate. You then subtract the withholding tax already deducted by the foreign government, and also the tax credit, to get the UK tax due.

So say you get a US dividend of $9. Add a ninth to get $10 (so you're now including the notional 10% tax credit). As a higher-rate taxpayer, multiply by 32.5%, which gives $3.25. The US has already taken 15% of the original $9 ($1.35), and the tax credit is worth $1. So you now owe $0.90 to the UK tax office.

The result is that the maximum combined British and foreign tax you should pay on your foreign dividends is the higher of i) the withholding tax rate specified in the DTA or ii) the actual tax you'd pay on an equivalent UK dividend after allowing for the theoretical tax credit. Under most DTAs, basic rate taxpayers will end up paying the first (typically 15%, sometimes less), because it's higher than the remaining 0% liability on UK dividends. Higher and top-rate taxpayers will end up paying the second (25% or 36.1%).

However, there's a slight snag. Many countries withhold more tax than permitted under the DTA and expect you to reclaim it. America has one of the few tax authorities that allows you to register to receive dividends with only the treaty rate of tax deducted. If you complete a W-8BEN form most brokers will ask you to do this you will be able to get your dividends with only 15% deducted.

However, America is an exception. In most cases, you will have to reclaim any extra tax charged, and you can't rely on your broker to help. The exact process varies for each country, but you will need a statement from your local tax office that you are UK resident and proof that you received the dividend after withholding tax had been deducted. This is simple if you receive a tax voucher for the shares, otherwise you'll need to ask your broker or the paying agent for confirmation.

Whether this is worth doing will depend on how much tax was deducted and how easy the reclamation process is. For example, if you hold Swiss shares, it may be worth considering: withholding tax is 35%, while the treaty rate is 15%. But shares in Spanish bank Santander would be more questionable: the extra rebate is just 4% and the process is bureaucratic, with forms only available in Spanish.

Finally, what happens if you hold foreign shares in an individual savings account (Isa) or a self-invested personal pension (Sipp)? For an Isa, you won't pay any UK tax, but you will have to pay the withholding tax (DTAs don't recognise the Isa as anything special). The situation for Sipps is more complex. A few DTAs allow for no, or reduced, withholding tax on dividends paid into a pension; examples include Switzerland and the US. Most brokers are not set up to take advantage, but some can arrange for US dividends to be paid with zero tax deducted.

What you'll pay

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Hong Kong0%0%
* Except franked dividends, which have no withholding tax.
** The treaty provides for 15% withholding tax, but Singapore currently imposes none.

This article was originally published in MoneyWeek magazine issue number 559 on 14 October 2011, and was available exclusively to magazine subscribers. To

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Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.