Some investors who do not have experience with international investing may be puzzled by foreign withholding taxes and the Foreign Tax Credit. Below is a review of these taxes. In addition, there is an example that shows that the federal income tax paid directly by a taxable U.S. international fund shareholder may be less than expected due to the benefit of the Foreign Tax Credit. Vito Fronda, Lord Abbett's Director of Taxation, answers some frequently asked questions.

Q: What exactly is a foreign withholding tax?
A: Generally, income is taxed in the jurisdiction in which it is earned. In the international equity arena, dividends paid by a foreign corporation are sourced to the foreign corporations country. When a foreign corporation (e.g., Canon, Inc.) pays a dividend to a nonresident, such as a fund, a portion of the dividend is withheld (in this example, by Japan). The withholding works similarly to your payroll taxes. Instead of your employer withholding money for taxes and submitting it to the government, the funds custodian withholds a certain amount of the dividends paid and submits it to the foreign country. Withholding rates are generally 30% unless the United States has an active treaty with the country. Most treaties reduce the amount of withholding on dividends to 015%.

Q: How does the foreign tax credit work?
A: The Foreign Tax Credit was created to prevent a shareholder from being taxed twice for the same income: once in the foreign country and again in the United States. There is currently a similar credit in the United States at the state level. You may be familiar with it if you work in one state and live in another. For example, I work in New Jersey but live in New York. Assume the New Jersey income tax rate is 6% and New Yorks income tax rate is 10%. I do not pay 16% in state income taxes. Instead, I pay 6% to New Jersey because I earned the income in that state, and 4% to New York because I live in New York. Mechanically, the way that it works is when I complete my New York tax return, I am able to take a tax credit for the taxes I paid to New Jersey (6%) because it relates to the same income.

The Foreign Tax Credit works the same way. Assume you own a foreign stock that paid a dividend and 10% was withheld. When you prepare your U.S. federal income tax return, you are allowed to take a credit for the taxes you paid to the foreign country. Therefore, if the dividend you received is subject to the 15% tax rate in the United States, you will only need to pay 5% in U.S. federal income taxes because you already paid 10% to the foreign country.

Q: How does this get applied to an international equity mutual fund?
A: What makes a mutual fund unique is that it does not pay taxes on the income it earns if it meets certain requirements. Instead, a fund must distribute all the income that it earns to its shareholders, who are then taxed as if they earned the income directly. Since a mutual fund does not pay income taxes, it cannot take the benefit of the Foreign Tax Credit. Instead, a fund may pass through the ability to take the Foreign Tax Credit to its shareholders.

A shareholder receives Form 1099 every year, which states the amount of dividends and other distributions they received during the year. Box 6 of the 1099 is used if a Foreign Tax Credit is being passed through. The amount in Box 6 represents foreign taxes paid by a fund on behalf of a shareholder. A shareholder will be able to reduce his or her U.S. federal income taxes by the amount of the Foreign Tax Credit. Essentially, a fund paid a portion of the shareholders taxes. The following example illustrates this concept.

The table illustrates the hypothetical federal income tax consequence of a shareholder that invests in two different mutual funds. The first investment is an international fund that passes through the Foreign Tax Credit, and the second is a domestic equity fund with the same level of income dividends, but without the Foreign Tax Credit.