There are many issues investors need help with such as: asset allocation, diversification, asset location, fees and expenses, rebalancing, and asset turnover. But for Americans living abroad, there are even more things to worry about: dual taxation, taxable foreign exchange gains, future liabilities in foreign jurisdictions which will require foreign currencies, and an array of reporting and disclosure requirements.
For the US Expatriate living in the UK, one of the more difficult issues is the treatment by US and UK laws of “collective investment vehicles” more commonly called, investment funds, mutual funds, UCITS etc.
ISSUE –AMERICANS LIVING IN THE UK MUST INVEST CAREFULLY
US taxpayers living in the UK are caught between two sets of rules with similar goals. In the US there are rules relating to Passive Foreign Investment Companies (PFICs) which aim to ensure that such funds are not used to avoid, evade, reduce or defer tax payable to the US Government. In the UK there are Reporting Fund Status rules which aim to ensure UK taxpayers do not avoid, evade, reduce, or defer taxes payable to the UK Government.
First, we’ll look at the US PFIC rules.
PFIC stands for Passive Foreign Investment Company. A PFIC is defined under US law as a foreign corporation (non-US) that meets either of the following tests:
- Income test: 75% or more of the corporation’s gross income for its taxable year is passive income.
- Asset test: At least 50% of the average percentage of assets held by the corporation during the taxable year are assets that produce passive income or are held for the production of passive income.
While the definition of passive income in the US tax code is lengthy, it is clear that buying shares of companies for normal investment purposes will meet the second test of assets held for the production of passive income. The first test will also often be met by such investment companies, as they undertake no activities to ‘earn income’ (such as manufacturing), therefore the passive income from their investing activities will comprise more than 75% of their gross income.
It is likely that any non-US investment fund (offshore mutual funds, offshore hedge fund, UK investment trust, etc.) will be a PFIC. Why does this matter? PFICs are subject to disadvantageous tax treatment for US taxpayers. If you own a PFIC you can receive three different forms of tax treatment:
- If the fund is willing to provide the necessary reporting information (Annual Information Statement) to you, you can file a Qualifying Electing Fund election (QEF) for each PFIC you own. Importantly you have to file a QEF election for each PFIC owned by a PFIC you own. This is similar to the fund providing a 1099 to the IRS. A QEF election allows the investment to be treated similarly to a US fund. However, most offshore and non-US funds do not compile the information necessary to create the Annual Information Statement, so this option is rarely open to US taxpayers.
- You can make a Mark-To-Market (MTM) election each year and treat the year-on-year change as if you had sold and repurchased the fund each year at the end of your tax year.
- If you don’t make a QEF election and if you don’t make an MTM election and pay tax on the implied capital gain and income each year, you will build up capital gains and income inside the fund. The capital gains and income in the PFIC will eventually be taxed as if you have sold the fund each year, recognized the gains, reinvested the full amount, and NOT paid the tax. This is a serious problem because the non-payment of the tax will attract interest and such interest will compound for each year the PFIC was held. This can cause the tax liability to exceed 100% of the value of the investment in the PFIC!
Even if you don’t get into the tax treatment you have an obligation to report your ownership of a PFIC on Form 8621. This short 4-page report filing is also required for any PFIC owned by a PFIC you own.
Conclusion: As a US Expat you don’t want to invest in a PFIC. But the problem doesn’t end there…
The second set of rules are the UK’s Reporting Fund Status rules to discourage UK taxpayers from investing in offshore or non-UK funds.
An offshore or non-UK fund can apply to obtain Reporting Fund Status from the UK tax authorities, Her Majesty’s Revenue and Customs (HMRC). As a Reporting Fund, the fund must provide to both the fund investors and HMRC, details of the fund’s income to both its UK resident investors and to HMRC. This is similar to a 1099 received from a US investment manager. The Reporting Fund will report on income even if it is not distributed. Gains from a Reporting fund are taxable as they arise but are taxable at the capital gains tax rate. By contrast, a non-reporting fund (the default state of a non-UK fund) only creates a tax liability for a UK resident when gains are distributed (and for remittance-based taxpayers only when the distribution is actually remitted to the UK). However, these gains are taxed as income at the much higher income tax rate.
Conclusion: As a UK resident you don’t want to invest in a fund that does not have Reporting Fund Status.
IN WHAT CAN AMERICANS LIVING IN THE UK INVEST?
As a US taxpayer resident in the UK, you must avoid both PFICs and funds that do not have Reporting Fund Status. You, therefore, have only two realistic options.
- Only buy directly the individual stocks and bonds of companies in which you wish to invest. For example, you might buy 100 shares of an American company listed on an American stock exchange directly and buy 100 shares of a UK public limited company from a UK stock exchange directly. Neither of these operating businesses are funds or investment companies so PFIC rules and Reporting Fund status requirements do not apply. It is difficult, time-consuming and much more expensive to create a diversified portfolio of investments buying individual stocks and bonds one at a time.
- Find and invest in funds that are not PFICs and that have UK Reporting Fund Status. While many funds do not comply, there are an increasing number that do.
Hibernian Financial Planning can help
Hibernian Financial Planning, LLC provides US expats with fee-only fiduciary financial advice covering all of their financial matters.
Please contact us to discuss your personal situation.