Tax Implications From an IRA With Chinese Stocks

Chinese stocks are available in the U.S. as American depositary receipts.
i Goodshoot/Goodshoot/Getty Images

Individual retirement accounts provide tax benefits to investors and savers. Traditional and Roth IRAs shield your investment income from current taxes, and you can deduct your contributions to a traditional IRA. You cannot hold foreign stock directly in a U.S. account, but you can hold American depositary receipts, or ADRs, that are backed by foreign stock. The dividends you receive from Chinese ADRs may be subject to withholding tax, whether or not the ADR resides in an IRA.

American Depositary Receipts

ADRs represent shares of foreign stock. The “sponsorship level” of an ADR determines how you trade it. High-level ADRs trade just like domestic shares on American exchanges, but you must trade ones with lower sponsorship levels through private or over-the-counter transactions. You purchase, sell and receive dividends on ADRs in U.S. dollars. Domestic depositary banks issue ADRs, and foreign custodian banks hold the underlying shares. ADRs can represent partial, single or multiple underlying shares. More than 100 Chinese ADRs trade in the U.S.

U.S.–China Tax Treaty

The tax treaty between the United States and China specifies how to handle tax-related matters between the two countries. The treaty provides for the Chinese government to withhold some of the dividends paid to foreign owners of Chinese securities. China's State Administration of Taxes reports that Chinese corporations paid dividends totaling $65 billion in 2011 to foreigners. Dividend withholding tax on the underlying shares reduces ADR dividends. China withholds 10 percent of dividends paid to American holders of Chinese ADRs. However, the ADRs based on stocks issued in Hong Kong -- the so-called “red chips” -- escape dividend withholding tax.

Foreign Tax Credit

You can file for a foreign tax credit to help compensate for your withheld dividends. You may claim the credit either on Internal Revenue Service Form 1040 or Form 1116. The maximum credit you can claim is a fraction of your total tax liability. The fraction’s numerator is your amount of foreign taxable income, and the denominator is your total taxable income. The credit cannot exceed your tax liability for the year. You may choose to take the credit amount as a deduction instead; you need to figure your taxes both ways to determine the better alternative.

Individual Retirement Accounts

IRAs block you from two potential benefits of foreign stock dividends. First, the foreign tax credit is not available for withheld dividends on stocks you hold in an IRA. Secondly, you do not benefit from the tax break on qualified dividends paid by the stocks you hold in an IRA. ADR dividends frequently qualify for taxation at the capital gains rate; qualification requires that the ADR be easily traded in the U.S. The tax on qualified dividends may be 20 percent, 15 percent or zero, depending on your tax bracket. You pay taxes on unqualified dividends at your marginal rate. IRAs shield you from paying current taxes on dividends: You’ll pay your marginal rate on all distributions from a traditional IRA, but qualified distributions from Roth IRAs are tax free. Before purchasing ADRs, you should probably determine your potential tax liability from ADRs held in and out of an IRA to see which alternative results in greater after-tax income.

the nest

×