An ETF, or exchange-traded fund, enables individual investors to combine various investment options (stocks, shares etc) within one package.
They are somewhat similar to mutual funds – although you can trade ETFs anytime during the day on the stock market, just like a regular stock.
Most ETFs are designed to follow the performance of a specific group of companies, called an index—like the S&P 500, which includes 500 large U.S. companies. These are called passive ETFs. Meanwhile, others are actively managed, meaning professionals try to pick investments they think will do better than the overall market.
Global investors are increasingly turning to U.S. ETFs to diversify their portfolios and gain exposure to the U.S. market.
However, many are unaware that they may be overpaying U.S. tax on the return they receive from these investments – and could be entitled to a refund.
Are you taxed on ETF dividends and why might you be due a refund on U.S. ETF investments?
Typically, brokers withhold upfront up to 30% in U.S. Dividend Withholding Tax (DWT) on the entire distribution from U.S. ETFs.
But this distribution can often include income types that are generally tax-exempt for nonresident investors, such as:
- Qualified interest income (QII)
- Short-term capital gains (STCG)
Despite being tax-exempt under U.S. tax law for nonresidents, these are still commonly taxed at the dividend rate which can result in a refund opportunity for international investors.
The 1042-S form: Showcasing a refund opportunity
Form 1042-S is the key document required in order to understand whether there has been excess withholding tax applied to U.S. ETF distributions.
If there has been a U.S. ETF distribution which was made up of interest income, short-term capital gains as well as dividends, you will usually receive multiple 1042-S forms reflecting the various income types and the tax withheld on each.
Here’s one example which showcases the portion of a U.S. ETF distribution that was comprised of interest income, yet was taxed at the dividend rate instead of being tax exempt:
- Box 1 – Income code “01” reflects interest income (outlining the part of the U.S. ETF distribution made up of interest income)
- Box 3a – Exemption code “02” shows that the income is “exempt under IRC” i.e. is exempt from tax!
- Box 7a – Shows the federal tax withheld, which is often at the dividend rate of 30% or a reduced treaty rate (e.g., 10% in this case for China). If there was any tax reported here, then this tax could likely be reclaimed, since there should not have been U.S. tax applied to this 1042-S form given the exemption code “02” indicates that this income is “exempt under IRC”.
- Box 9 – Over withheld tax repaid to a recipient pursuant to adjustment procedures: If the tax from 7a has been reported here also, then it means the over-withheld tax has been repaid to you due to the withholding agent re-adjusting their reporting. However, if this box is empty, then this presents an opportunity to reclaim the tax that was withheld from box 7a, given that this income is exempt under IRC and has not been repaid back in an adjustment procedure.
ETF sponsors (e.g. Charles Schwab) will generally report their U.S. ETF with a breakdown of whether it comprises of QII or Short-Term Capital Gains on their website – including the percentage of each U.S. ETF that comprises of this income.
As an example, one U.S. ETF might show that 90% of the U.S. ETF distribution is comprised of QII or STCG, however, this can result in the entire amount of the distribution being taxed as a dividend.
The result? It opens the door for a refund claim.
DWT reclaim with Sprintax Dividends
Calculating and reclaiming your overpaid tax is easy with Sprintax Dividends.
- Upload your 1042-S form
- Complete a short Sprintax questionnaire
- Sprintax calculates your refund and prepares your Form 1040NR
- Need a U.S. tax number (ITIN)? Sprintax will also prepare your Form W-7
- Submit your claim to the IRS – refunds are issued by check or to a U.S. bank account
- Optional post-filing support – if the IRS sends you a notice, our team will help
Get started today with Sprintax Dividends
Many international investors leave money on the table without realizing it.
If you received a 1042-S form from your U.S. financial institution, upload it to Sprintax Dividends today and see if you qualify for a refund.
