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″ (UK funds are taxed punitively by the U.S.; U.S.-based funds can be taxed punitively by the UK) 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 and Americans moving to the UK.
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. 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 tax or compliance objectives alone.
Creative Planning International 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.
The Problem – Special Tax Regimes in the UK and the U.S. for “Off-Shore” Funds
U.S. PFIC taxation
For investors subject to U.S. taxation, Creative Planning International broadly recommends that all non-U.S. “pooled” investments products (i.e. mutual funds, ETFs, 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 owning a PFIC from an investment management perspective. 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 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. 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 non-reporting 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 could 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.
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 long-term 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).
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 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 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.
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 residing 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 now includes a core of excellent, efficient ETFs (mostly from the U.S. fund company Vanguard). From these funds a fully diversified, global investment portfolio of stocks, bonds, commodities and real estate can be constructed, just as Creative Planning International builds for its global clients elsewhere in the world.
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 (even British citizens in the U.S.) 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.
However, the FATCA (Foreign Account Tax Compliance Act) of 2010 completely changes all this (see: What is FATCA? What Do American Investors Need to Know?). 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.
A Note on PFIC or Non-Reporting Funds Held Within a Qualified Retirement Plan
Many Americans residing in the United Kingdom may wonder 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 needn’t be concerned that the investments in the plan are PFICs.
Likewise, if the same U.S. investor is contributing to a U.S. 401k, s/he does not have to worry that the investments in the 401k, (or an 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.
In 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, British citizens living in the U.S. and Americans thinking about moving to the UK. 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.