Americans in the UK Need to Avoid this Catch-22 Investment Trap By David Kuenzi, Thun Financial Advisors, Copyright 2015 2015 Summary The U.S. Passive Foreign Investment Company (PFIC) tax regime raises high hurdles for Americans in the United Kingdom to invest wisely and tax efficiently. This is because the United Kingdom has a parallel system of punitive taxation of non-uk funds. This investment Catch-22 can be successfully navigated by investing in efficient U.S. exchange traded funds that are also so-called UK reporting funds. Most importantly, the new U.S. FATCA legislation makes this once easily ignored tax issue critical for all American investors living in the United Kingdom. Introduction to PFICs The United States, almost uniquely in the world, taxes not only on the basis of residence, but also on the basis of citizenship. As a result, U.S. Thun Financial Advisors, L.L.C. is a U.S.-based, fee-only, Registered Investment Advisor that provides investment management and financial planning services to Americans residing in the U.S. and overseas. We maximize long-term wealth accumulation for our clients by combining an index allocation investment model with strategic tax, currency, retirement and estate planning. We guard our clients wealth as though it was our own by emphasizing prudent diversification with a focus on wealth preservation and growth. Thun Financial Advisors 3310 University Ave Madison, WI 53705 608-237-1318 Skype: thunfinancial thunfinancial.com 1
citizens (and U.S. permanent residents) are taxed by the United States, as well as their country of residence, no matter where they live or how long they have lived outside the United States. While there are special provisions in the U.S. tax code and bilateral tax treaties that generally protect U.S. citizens from double taxation, navigating the complexities of cross-border taxation still requires diligent tax planning. Furthermore, when it comes to long-term wealth management planning, it is critically important that a sound investment strategy not be forfeited to achieve purely tax or compliance objectives. Thun Financial Advisors specializes in implementing investment strategies that are tax efficient and compliant, yet still sound from the point of view of strategic investment objectives. In this note, we address a Catch- 22 investment tax issue that affects Americans who reside in the United Kingdom. After describing the problem, we present a series of solutions and rank them in terms of their tax/compliance efficiency as well as their soundness as investment strategies. hedge funds, certain insurance products, etc.) should be avoided because such investments are treated under the U.S. tax code as Passive Foreign Investment Companies (PFICs). PFICs are subject to special, highly punitive tax treatment by the U.S. tax code. Not only will the tax rate applied to these investments be much higher than the tax rate applied to a similar or identical U.S. registered investments, but the cost of required accounting/record-keeping for reporting PFIC investments on IRS Form 8621 can easily run into the thousands of dollars per investment each year. The increased tax and high compliance burden is so severe, it is essentially impossible to justify from an investment management perspective owning a PFIC. This is especially true where an identical investment can be made through U.S. registered securities that are not PFICs. Thus, an American expat taxpayer living in the United Kingdom (or anywhere for that matter) should never choose to invest through mutual funds or other pooled investments that are not registered in the United States. The Problem Special Tax Regimes in the UK and the U.S. for Offshore Funds U.S. PFIC Taxation For investors subject to U.S. taxation, Thun Financial Advisors broadly recommends that all non-u.s. pooled investments products (i.e. mutual funds, ETFs, The Catch-22: UK taxation of off-shore funds For U.S. taxpayers living in the United Kingdom, the solution to the PFIC problem is complicated by the UK tax system. The United Kingdom applies special, punitive tax rates on non-uk registered investment funds. 2
For investors subject to UK taxes (generally anyone resident in the UK) most U.S. registered funds are deemed non-reporting funds (that is, they do not report to UK accounting standards). Non-reporting funds are penalized by the UK tax system because capital gains in nonreporting funds are taxed at regular tax rates, not the lower capital gains rates. The Catch-22, therefore, is that American taxpayers who reside in the United Kingdom run afoul either of the PFIC tax rules (if they buy a UK registered fund) or the non-reporting fund rules (if they buy a U.S. fund). Welcome to the tax hell of your typical American expat trying to save and invest for their future! PFIC Solutions: Good, Better and Best Fortunately, there are several solutions to avoid the worst possible implications of this Catch-22. Here we describe three possible strategies to mitigate the impact of this UK/U.S. investment tax nightmare. We grade each strategy on two criteria: 1) tax and compliance costs and 2) the soundness of the underlying investment approach. 1) Good Do not invest in funds. Both the PFIC rules and the non-reporting fund rules apply only to pooled investment funds. An investment portfolio constructed completely of individual stocks, bonds and other investments that are not pooled avoids all of the problems described above in both the United States and the United Kingdom. Owning a portfolio of individual stocks and bonds can create other, less severe reporting problems but in general these problems are manageable. We give this strategy a grade of B+ from the point of view of tax and compliance. From the point of view of the soundness of the investments, however, we give this approach only a D grade. Generally, an investment portfolio of at least $10 million dollars is required to achieve the economies of scale necessary to invest efficiently without the use of pooled investments such as mutual funds, ETFs or hedge funds. Thorough diversification and investment cost management are the bedrock of successful longterm investing. These rules of sound investment management will be violated when investing in individual securities except where the total value of the investment portfolio is very large (and even then there are significant limitations). 2) Better Accept the lesser of two evils. The details of PFIC taxation are complex and as a result we do not delve into the details in this note other than to report that the tax is highly punitive. The UK taxation of non-reporting funds is substantially less complex and substantially less punitive than is PFIC taxation. Furthermore, for American expats who employ sound long-term investments strategies AND who do not expect to reside in the United Kingdom permanently, tax 3
inefficiencies arising from owning non-reporting funds can be almost wholly avoided by not realizing net capital gains through the sale of the funds while resident in the United Kingdom. Therefore, one solution is to simply keep investments in U.S. registered funds and manage them in a way to minimize capital gains realization while resident in the United Kingdom. This strategy will not work for Americans expecting to stay permanently or retire in the United Kingdom because eventually the funds will probably be sold, the gains realized and the punitive UK tax rate on the capital gain paid. On the other hand, paying the regular UK tax rates on capital gains from a non-reporting fund is still a preferred outcome to the U.S. tax and compliance costs arising from owning a PFIC. So, the lesser of two evils approach boils down to taking the tax hit in the United Kingdom, rather than the in the United States, if one taxing jurisdiction must be chosen. For Americans living in the United Kingdom for a limited time, the lesser of two evils strategy garners a B grade for tax and compliance. For Americans expecting to live a long time or permanently in the United Kingdom it gets no more than a D grade, for reasons described above. From the investment soundness point of view, this strategy gets an A grade because it allows an investor to choose from the vast number of investment fund options in the United States. From this broad pool of investment funds, low-cost and tax efficient funds can be selected. These select funds can be combined to build a strategically sound and thoroughly diversified portfolio consisting of global stocks, bonds and alternative investments. 3) Best We save the best solution for last. American expats should thread the needle of U.S. and UK compliance by investing in U.S. registered funds with UK reporting fund status. Fortunately, the UK government allows non-uk registered investment funds to apply for reporting fund status. Until recently, the list of non-u.k registered funds with reporting status was made up almost exclusively of funds registered in places other than the United States. While such funds might be tax efficient for most UK residents, they are not good choices for U.S. citizens resident in the United Kingdom because they are still PFICs. However, over the last couple of years, a core of U.S. registered mutual funds and ETFs have been granted UK reporting fund status. For the U.S. taxpayer resident in the United Kingdom, therefore, these U.S. registered funds with UK reporting fund status represent an elegant solution to the Catch-22 of U.S. and UK investment taxation: they both avoid the PFIC trap in the United States and the non-reporting fund trap in the United Kingdom. Most importantly, although the list of U.S. funds with UK reporting status is not extensive, it does now include a core of excellent, efficient ETFs (mostly from the U.S. fund company Vanguard). From these funds a fully diversified, global investment 4
portfolio of stocks, bonds, commodities and real estate can be constructed, just as Thun Financial builds for its global clients not hemmed in by the restrictive tax systems of the U.S. and the UK. However, the new FATCA (Foreign Account Tax Compliance Act) Law of 2010 completely changes all this. (The new U.S. FATCA LAW: What U.S. Expats Need to Know, Thun Financial Advisors, 2012) Going forward, UK financial institutions will be reporting directly to the IRS about holding of clients deemed likely to be U.S. citizens. Furthermore, the FATCA law specifically stiffened aspects of the PFIC rules and made them subject to reporting not only on the existing IRS Form 8621, but also on the new IRS Form 8938. Clearly, Congress intends one of the effects of the new FATCA law to be enforcement of the PFIC rules. FATCA: Why This Obscure Tax Issue is Now Critical for U.S. Citizens in the UK Many U.S. investors living in the United Kingdom may protest the implications of this note by referencing the fact that they have ignored the PFIC rules for years and have never gotten in trouble with the IRS. Further, they have never heard of any other Americans getting in trouble for failure to properly report non-u.s. funds as PFICs. Indeed, enforcement of the PFIC tax regime on investments held outside the United States by persons subject to U.S. taxation has been close to non-existent, even though the PFIC tax rules have been around since the 1980s. That is because enforcement relied entirely on self-reporting. The IRS has had no independent way to verify the nature of off-shore investments held by Americans and therefore was severely limited in its ability to enforce PFIC reporting. A Note on PFIC or Non-Reporting Funds Held Within a Qualified Retirement Plan Many Americans resident in the United Kingdom will be wondering how this affects investments held in either U.S. or UK retirement accounts, such U.S. IRAs or 401ks or UK SIPPs. Fortunately, the United States and the United Kingdom have a double taxation treaty that provides for the mutual recognition of each other s system of tax deferred retirement accounts and pension plans. Because assets in these accounts are subject to a separate set of tax rules in both the United States and the United Kingdom, none of the rules regarding either PFICs or non-reporting funds apply if the funds in question are held inside a qualified retirement account. Therefore, a U.S. citizen building up a retirement nest egg through a UK employer provided pension plan does not have to be concerned that the investments in the plan are PFICs. Likewise, if the same U.S. investor is contributing to a U.S. 401k, he or she does not have to worry that the investments in the 401k, or an old inactive 401k are non-reporting funds. It does not matter. All those rules are overridden by the rules regarding taxation of withdrawals from these specific kinds of retirement accounts. 5
Conclusion FATCA is changing the landscape for American investors living abroad. Implementing sound investment strategies without being ensnarled in a cross-border tax trap has never been harder. The case of U.S. PFIC and UK reporting fund rules discussed here is a primary example of the dilemma in the case of U.S. investors living in the United Kingdom. However, proper financial planning can provide solutions that allow Americans abroad to get on with the task of building wealth over a lifetime through wise long-term investing without fear of hidden tax traps. Contact Us David Kuenzi Thun Financial Advisors 3310 University Ave Madison, WI 53705 608-237-1318 Visit us on the web at www.thunfinancial.com Please visit Thun Research Articles for American Expat Investors to find more related information on investing while living abroad. Copyright 2015 Thun Financial Advisors DISCLAIMER FOR THUN FINANCIAL ADVISORS, L.L.C., THE INVESTMENT ADVISOR Thun Financial Advisors L.L.C. (the Advisor ) is an investment adviser licensed with the State of Wisconsin, Department of Financial Institutions, Division of Securities. Such licensure does not imply that the State of Wisconsin has sponsored, recommended or approved of the Advisor. Information contained in this brochure is for informational purposes only, does not constitute investment advice, and is not an advertisement or an offer of investment advisory services or a solicitation to become a client of the Advisor. The information is obtained from sources believed to be reliable, however, accuracy and completeness are not guaranteed by the Advisor. The representations herein reflect model performance and are therefore not a record of any actual investment result. Past performance does not guarantee future performance will be similar. Future results may be affected by changing market circumstances, economic and business conditions, fees, taxes, and other factors. Investors should not make any investment decision based solely on this presentation. Actual investor results may vary. Similar investments may result in a loss of in investment capital. 6