With all the interest in dividend-paying stocks, it's only natural that investors have started looking beyond the borders of the U.S. to find promising ways to add to their income-producing portfolios. But before you start counting on reaping some of the juicy yields that foreign stocks offer, you need to understand how some fairly complicated tax provisions could have a big impact on your after-tax returns.

Understanding foreign taxes
Investing in U.S. companies is simple from a tax standpoint. Each year, you receive dividends from the stocks you own, and if you own them in a regular taxable account, then you have to include those dividends on your tax return and pay income tax on them. If you receive dividends on stocks you hold within a tax-favored account like an IRA, then you don't have to pay any tax on them, and you don't have to report that income on your tax return.

Owning foreign stocks is a bit more complicated. Technically, when you receive dividends from a foreign corporation, you earn income that's potentially subject to tax by the country in which that corporation is located. So theoretically, you could end up having to file separate tax returns in each of the countries that you receive income from.

Tax authorities around the world know that expecting investors to comply with such a requirement would be unrealistic. Therefore, in order to ensure that they get their fair share of tax revenue, governments require companies and financial institutions to cooperate to withhold tax from the dividends they pay to foreign shareholders.

The rates on withholding tax differ from country to country, and they also depend on whether the U.S. has a special tax treaty with the particular country. In many cases, tax treaties reduce the rate that would otherwise apply.

Feeling the pain
But even with tax treaties, withholding tax can take a reasonably big bite out of your dividend income. To come up with some good examples, I took a look at the highest-yielding foreign stocks that have stock listings on major U.S. exchanges in several different countries. I then looked up the withholding tax rate for that country and applied it to the current yield. Below, you can see the impact it has on after-tax yield.

Stock

Country

Current Yield

Withholding Tax Rate

After-Tax Yield

Westpac Banking (NYSE: WBK)

Australia

6.5%

15%

5.5%

BCE (NYSE: BCE)

Canada

5.5%

15%

4.7%

Nokia (NYSE: NOK)

Finland

5%

15%

4.3%

France Telecom (NYSE: FTE)

France

8.6%

15%

7.3%

Telefonos de Mexico (NYSE: TMX)

Mexico

4.9%

0%*

4.9%

Philippines Long Distance (NYSE: PHI)

Philippines

8.7%

25%

6.5%

Credit Suisse (NYSE: CS)

Switzerland

4.6%

15%

3.9%

Source: Capital IQ, a division of Standard and Poor's. Withholding tax rates taken from Deloitte International Tax Source
*10% withholding tax typically applies to Mexico, but Telmex reports that shareholders aren't subject to withholding tax.

As you can see, even with treaties reducing the ordinary levels of withholding tax, the reduction in yields can be quite substantial in some cases.

Get it back
But the good news is that in many cases, you can get all or part of your money back. Under U.S. tax law, taxpayers are entitled to a foreign tax credit for taxes they pay on their overseas income. The form that many taxpayers are required to file to claim a foreign tax credit is extremely complicated. But if you haven't had much foreign tax withheld -- less than $300 for single taxpayers or $600 for joint filers -- then you can often claim a credit without filing the long form.

A further complication, though, is that you're not allowed to claim a foreign tax credit for taxes withheld on stocks held in IRAs. Although some countries have special provisions in their tax treaties that eliminate withholding taxes for stocks held in tax-favored accounts, many do not. As a result, you may end up paying foreign tax on IRA income even while it's tax-deferred for U.S. tax purposes.

The value of diversification
Even with the complications of foreign taxes, you shouldn't let them stop you from investing in dividend stocks overseas. Some of the best investing opportunities are outside the U.S., and if you let tax fears stop you from grabbing them, you'll miss out on some excellent prospects.

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Fool contributor Dan Caplinger is freakish in his interest in taxes. He doesn't own shares of the companies mentioned in this article. France Telecom and Philippine Long Distance Telephone are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never withholds anything from you.