HOW BEST TO INVEST AS A US CITIZEN OVERSEAS?
FATCA, PFICs, AIFMD – what does it all mean for me?
As you are probably already aware, in recent years there has been a heightened level of scrutiny placed on US tax filers who are based outside the US or have assets outside the US. Various pieces of legislation including; the Hire Act, FATCA and AIFMD, to name but a few, has led to mean that any American living outside the US must now contend with an alphabet soup of reporting requirements. With it comes understandable confusion over where they can and can’t invest.
The US tax system means that Americans are taxed on a worldwide basis regardless of where they live. On the face of it this does not seem like a major issue for Americans living in the UK as there are significant tax treaties with the US to ensure that there is not double taxation for these individuals. However it is the treatment of the investment medium itself, together with the products commonly used in the UK that cause the issues.
What about my US investments?
On top of this Americans must also consider any investments they have chosen to keep domestically in the US as UK and US legislation also take this into consideration.
In addition to the problems seen at an individual level, Americans living overseas are coming into difficulty with the very institutions they go to for help. The complexities associated with managing US wealth has caused many of the Wealth Managers and Banks in the UK to make a commercial decision to close their doors to anyone with a US reporting requirement. If this is not bad enough, AIFMD has meant that an increasing number of US brokers and banks are now no longer able to look after the assets of Americans living outside the US.
The paper below focuses on some of the most common issues faced by Americans living in the UK from an investment and financial planning perspective. It is not designed to provide tax or legal advice.
What are the most common issues?
For Americans living in the UK, the areas to consider can be broken down to 3 main categories
In the UK the most common form of investment used is ‘funds’ or ‘collective investments’ that are usually either structured as OEICs or Unit trusts. These types of investments however, if not structured in a US friendly manner, are extremely tax disadvantageous for Americans as they are regarded as PFICs (Passive Foreign Investments Companies) by the IRS and as such are taxed in a much more punitive manner than they would be for a non-US tax reporter.
In certain circumstances this can mean that the level of tax paid can completely wipe out any gain the investment makes.
It is not just the UK investments that require care. For those Americans who have passed through the 7 out of 9 tax year in the UK rule, or those who have gone past 15 out of 20 tax years after April 2017, are now taxed on an arising basis, they are now also subject to worldwide income and capital gains tax from a UK perspective. This means that the UK will look at any investments that are held in the US.
In much the same way as in the UK, the US investment industry is dominated by Mutual funds, Index funds and more recently ETFs. Unless these have ‘reporting status’ in the UK they fall under the UK offshore fund rules which results in any proceeds being taxed at UK income tax as opposed to potentially more favorable capital gains or dividend tax.
Much like investments there are some very common products used in the UK that American’s must handle with care.
ISAs (Individuals Savings Accounts) – For UK savers these are very popular for tax efficient investing. The government will allow an individual over 18 to invest £15,240 per year, rising to £20,000 in 2017/18 of after-tax money into an ISA.
This money will grow free of all tax while it is invested and - on top of this - the proceeds can be withdrawn at any point, also without being taxed. The IRS on the other hand does not recognize these products. This means that they are viewed for tax purposes in the US like any other general investment account.
The different treatment of these products by the UK and US is a common cause of mistakes. Many UK ISA providers will only allow the underlying investment to go in funds, so the individual will automatically be investing in PFICs.
Such is the level of ambiguity on this topic a separate paper could be written on pensions alone. In brief, the US and the UK have a pension treaty that means that any employer-sponsored pensions are considered by both jurisdiction in the manner they are treated in their home country. This means that any investments within them are immune from any of the negative tax treatment discussed previously.
However, the water has been muddied since the dawn of private pensions and more specifically SIPPS (self-invested personal pensions), as there is no specific reference made to these in the US/UK pension treaty. SIPPs are commonly set up at trusts and so could potentially fall under the ‘Foreign Grantor Trust’ rules in the US
This means they are need to file additional reporting information and to be transparent from the IRS perspective. This transparency would mean the underlying investment again must be reviewed, because, much like the ISA, the most common investment available within these products would fall foul of the PFIC rules.
This may not be the most commonly reviewed area but where the investments are and how they are structured can be just as important as where they are invested. For Americans who come to the UK, they often arrive on the premise of staying for a few years and then returning to the US without ever needing or wanting to bring money from the US into the UK.
Should this be the case and they do not trigger the 7 out of 9 year residency rules in the UK, then their US investments are safe from the eyes of HMRC.
However, like many things in life the initial plan does not always stay the same. For those who end up deciding to stay in the UK for longer periods of time or want to invest money in the UK the structure of their offshore assets becomes extremely important. If a US individual wants to bring money into the UK from abroad and there has not been a clear separation of the original clean (tax paid) capital from the rest, the UK will view the monies as ‘mixed’. This mixed capital can be subject to income tax on remittance to the UK and so causing potential double taxation.
Are there any solutions?
For each of these major issues there are solutions, from an investment and financial planning perspective that mean these pitfalls can be avoided.
Being selective is vitally important. Although most funds outside the US fall foul of the PFIC rules, there are a handful that have made an election to be treated as a qualifying fund for US purposes. These are few and far between but are available. Ensuring that the fund maintains this status is imperative.
There is a similar solution for the UK offshore fund rules. There are a (small) number of US mutual funds and ETFs that have obtained ‘UK reporting status’ meaning they report the necessary information to the UK to ensure they are taxed in the same way as ordinary UK funds.
Both these options require an investor to choose from a limited pool and leave little option for sophisticated investment planning. Another option is to invest in individual stocks and bonds. These individual assets are taxed under the normal regimes in both jurisdictions and give broader investment selection. There is also the potential to buy individual stocks that qualify for advantageous tax treatments on their dividends.
ISAs – There is a common misunderstanding that because the IRS does not recognize the ISA wrapper, they ‘do not work’ for Americans. This is not the case. While US tax rates remain, for the most part, higher than the UK tax rates, an American living in the UK should take advantage of the ISA allowance before investing in a standard general investment account.
The investments within the wrapper are not subject to the higher UK tax rates but instead to the more favorable US tax rates. Although the difference in the tax rates may be small it still makes sense to take advantage of this difference while it is around.
Once this is understood it is just a case of ensuring that the actual investments within the wrapper are not tax disadvantageous. This is achieved by ensuring the ISA wrapper selected allows for investments such as those discussed in the previous paragraph.
Given the ambiguity in this area from a tax perspective it is difficult to provide a hard and fast ‘solution’. We like to find the path of ‘least regret’. Should the IRS decide that SIPPs are in fact foreign grantor trusts, then ensuring the money is not invested in assets that are taxed punitively is key. This prudent approach ensures that whichever the IRS decides, there will not be a negative tax surprise further down the line.
This is the most commonly overlooked issue but has the potential to cause enormous headaches. Given that it is difficult to plan for events that may or may not happen, finding an approach that maintains the most flexibility is often the best answer. The solution to this problem may sound simple enough, but it is easier said than done.
Assets that are offshore from a UK perspective should be set up in such a way that ‘Capital’ is separated from ‘Income’: This means that any income/interest/dividend that gets distributed from the assets needs to be ‘swept’ (within 24 hours) to a separate account. This process ensures that the original clean (tax paid) capital is clearly separated from the income.
Should the individual want to remit money in to the UK then this original ‘Clean Capital’ can be brought in to the UK without tax. Quite often the mechanism for doing this is more difficult than it sounds as many of the investments do not allow for this or custodians are not geared up to do it. Ensuring that the investment manager and the custodian bank are able to execute this is fundamental.
Like all these things, this should be done as soon as possible after being resident in the UK but it does require re-organizing offshore assets in most instances. This often means people end up doing it after much of the damage has already been done.
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