The intricate landscape of the U.S. passive foreign investment company (PFIC) tax regime raises high hurdles for Americans residing in the U.K. who are trying to make tax-optimal investment decisions. This complexity arises due to the coexistence of a parallel tax regime within the U.K., which imposes punitive taxation on non-U.K. funds. These laws create a catch-22 situation, as U.K. funds are taxed punitively by the U.S. while U.S.-based funds can suffer from the same punitive tax treatment from the U.K.
However, this complex landscape can be successfully navigated by strategically directing investments toward efficient U.S. exchange-traded funds that are also categorized by HMRC as U.K. reporting funds. Most importantly, the 2010 Foreign Account Tax Compliance Act (FATCA) elevates the significance of this previously overlooked tax issue, rendering it critical for all U.S. citizens living in — or moving to — the U.K.
Passive Foreign Investment Companies (PFICs)
Setting itself apart from the rest of the world, the U.S. enforces a system based not only on residency but also on the grounds of citizenship. As a result of citizenship-based taxation, U.S. citizens and permanent residents face taxation from both the U.S. and their country of residence, no matter their location or the duration of their stay outside the U.S. While there are special provisions in the U.S. tax code, and bilateral tax treaties exist to mitigate dual taxation of U.S. citizens, navigating the complexities of cross-border taxation demands diligent tax planning.
Moreover, when orchestrating long-term wealth management planning, it’s imperative that a sound investment strategy not be forfeited to achieve tax or compliance objectives alone. Creative Planning International specializes in implementing investment strategies that harmonize tax efficiency and compliance without compromising the integrity of strategic investment objectives. It’s within this context that we address a catch-22 investment tax conundrum affecting U.S. residents in the U.K. By shedding light on the intricacies of the matter and subsequently presenting an array of solutions, we assess these solutions based on their effectiveness in addressing tax and compliance intricacies along with their alignment with sound investment principles.
The Problem – Special Tax Frameworks in the U.K. and the U.S. for Offshore Funds
U.S. PFIC Taxation
For investors subject to U.S. taxation, Creative Planning International strongly advises against investing in non-U.S. “pooled” investment products. These investments fall under the classification of passive foreign investment companies (PFICs) as defined by the U.S. tax code. These PFICs are subject to a distinct and highly punitive tax treatment by the Internal Revenue Code (IRC). Not only are these investments subject to significantly higher tax rates compared to similar or identical counterparts registered within the U.S. but the associated expenses required for accounting and record-keeping to comply with the IRS Form 8621 reporting requirements can easily accumulate, amounting to thousands of dollars per investment each year.
The increased tax coupled with the high compliance obligations are so severe that it becomes nearly impossible to justify owning a PFIC from an investment management perspective. This is particularly evident when considering that an identical investment can be made through U.S. registered securities that aren’t categorized as PFICs. Thus, an American expat taxpayer living in the U.K. (or anywhere else, for that matter) generally should never opt for mutual funds or other pooled investments that aren’t registered in the U.S.
The Catch-22: U.K. Taxation of Offshore Funds
For U.S. taxpayers living in the U.K., finding a solution to the PFIC problem becomes complex due to the intricate U.K. tax framework. The U.K. employs punitive tax rates on investment funds not registered within its borders. For investors subject to U.K. taxation (typically U.K. residents), most U.S. registered funds are deemed non-reporting funds, meaning they don’t adhere to U.K. accounting standards. Consequently, non-reporting funds are penalized within the U.K. tax system, as capital gains within these funds are subject to standard tax rates rather than the most favorable capital gains rates.
This catch-22 scenario leaves American taxpayers who reside in the U.K. in a vulnerable position, facing the risk of potentially infringing upon either PFIC tax regulations (by investing in a U.K. registered fund) or the regulations governing non-reporting funds (by investing in a U.S. fund). Welcome to the tax nightmare 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. In the following sections, I outline three possible strategies designed to alleviate the impact of this investment nightmare between the U.K. and the U.S. Each strategy is evaluated based on two criteria: the extent of tax and compliance costs and the soundness of the underlying investment approach.
Strategy 1: Good – Focus on Individual Securities
To sidestep the intricacies of both PFIC and reporting fund rules, consider abstaining from investing in pooled investment funds. An investment portfolio composed solely of individual stocks, bonds and other non-pooled investments effectively avoids all the problems described above, both in the U.S. and the U.K. While holding a portfolio of individual stocks and bonds can create other, less severe reporting concerns, these issues are generally manageable. From a tax and compliance aspect, we give this strategy a B+ grade.
However, from the point of view of investment soundness, this strategy receives a more modest D grade. Generally, an investment portfolio exceeding $10 million dollars is required to achieve the economies of scale necessary to invest efficiently without the use of “pooled” investment vehicles, such as mutual funds, ETFs or hedge funds. Thorough diversification and investment cost management are the bedrock for successful long-term investing. These principles of sound investment management can be compromised when investing in individual securities except when the total value of the investment portfolio is substantial (and even then, there are significant limitations).
Strategy 2: Better – The Lesser of Two Evils
This strategy involves confronting the situation with a pragmatic approach by selecting the lesser of two challenging alternatives. We emphasize the highly punitive nature of PFIC taxation. In comparison, the U.K. taxation of non-reporting funds is substantially less complex and punitive than the taxation associated with PFICs. For American expats employing sound long-term investments strategies who don’t expect permanent residency in the U.K., tax inefficiencies arising from owning non-reporting funds can be largely avoided by refraining from realizing net capital gains through the sale of funds while residing in the U.K. Therefore, a viable solution is to keep investments in U.S. registered funds and manage them in a way to minimize capital gains realization while a resident in the U.K. This strategy won’t work for Americans expecting to stay permanently or retire in the U.K., as eventually the fund sales and capital gains realization might trigger the punitive U.K. tax rate on the capital gains.
On the other hand, paying standard U.K. tax rates on capital gains from a non-reporting fund prevails as the preferable outcome in contrast to the substantial U.S. tax and compliance costs arising from PFIC ownership. This lesser of two evils approach boils down to taking the tax hit in the U.K. rather than in the U.S.
For Americans living in the U.K. for a limited time, this strategy attains a B grade in terms of tax and compliance. Conversely, for Americans expecting an extended or permanent U.K. residence, this approach earns no more than a D grade for the reasons described above. In terms of investment soundness, this strategy gets an A grade due to its capacity to leverage the vast number of investment fund choices in the U.S. From this broad pool of investment funds, one can cherry-pick low cost, tax-efficient funds and integrate them into a well-structured and thoroughly diversified portfolio of global stocks, bonds and alternative investments.
Strategy 3: Best Solution – U.S. Registered Funds With U.K. Reporting Fund Status
Now for an optimal solution for American expats. By investing in U.S. registered funds granted U.K. reporting fund status, U.S. citizens living in the U.K. can skillfully navigate both U.S. and U.K. compliance hurdles. The encouraging aspect is that the U.K. government permits non-U.K. registered investment funds to apply for the coveted reporting fund status. This selection used to be dominated by funds registered outside the U.S. that were unsuitable for U.S. citizens resident in the U.K. due to their PFIC classification, even though these funds might be tax-efficient for most U.K. residents.
Fortunately, a significant shift has taken place in recent years, as a core selection of U.S.-registered mutual funds and ETFs have been granted reporting fund status by the U.K. This development represents an elegant solution to the catch-22 faced by U.S. citizens residing in the U.K., enabling them to avoid both the PFIC trap in the U.S. and the non-reporting fund trap in the U.K.
Most importantly, although the list of U.S. funds with U.K. reporting fund status is not extensive, it now includes a core of efficient ETFs, primarily from the prominent U.S. fund company Vanguard. This assortment of funds is a fully diversified, global investment portfolio composed of stocks, bonds, commodities and real estate, all of which can be constructed. This approach mirrors the approach taken by Creative Planning International for its global clients across various corners of the world.
FATCA: Why This Obscure Tax Issue Is Now Critical for U.S. Citizens in the U.K.
The intricacies of PFIC rules may have been ignored by many U.S. investors living in the U.K. (and even British citizens in the U.S.). In their defense, the IRS has shown inconsistent enforcement of consequences over the span of decades, despite the PFIC tax rules being in existence since the 1980s. This discrepancy in enforcement can largely be attributed to the reliance on self-reporting. The IRS has largely depended on individuals to voluntarily disclose their investment status, and its ability to enforce PFIC reporting has been hindered by the absence of an independent mechanism to verify the nature of offshore investments held by American citizens. Consequently, the IRS has been severely limited in its ability to uphold compliance with PFIC reporting.
However, FATCA completely changed this. Since its introduction in 2010, U.K. financial institutions have been disclosing directly to the IRS their holding of clients deemed likely to be U.S. citizens. Moreover, FATCA reinforced certain elements of the PFIC rules, extending their scope to necessitate reporting not only on the existing IRS Form 8621 but also on the recently introduced IRS Form 8938. Evidently, one of the intentions behind FATCA, as set by Congress, is to bolster the enforcement of PFIC rules.
A Note on PFIC or Non-Reporting Funds Held Within a Qualified Retirement Plan
For many Americans residing in the U.K., questions may arise concerning the implications for investments held within U.S. or U.K. retirement accounts, including U.S. IRAs, U.S. 401k plans and U.K. self-invested personal pensions (SIPPs). Fortunately, the U.S. and the U.K. have a bilateral taxation treaty in place, which provides for the mutual recognition of each country’s tax-deferred retirement accounts and pension plans. Because assets within these accounts are subject to distinct tax rules in both nations, 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 U.K. employer-provided pension plan need not be concerned that the investments in the plan might qualify as PFICs. Likewise, if the U.S. investor is also making contributions to a U.S. 401k plan, there’s no need to worry about the investments held in the 401k plan, even if the account is inactive. These regulations are superseded by the rules regarding taxation of withdrawals from these specific categories of retirement accounts.
In conclusion, FATCA is changing the landscape for American investors living outside the U.S. Implementing sound investment strategies without becoming entangled in cross-border tax complexities has never been more difficult. The case of U.S. PFICs and U.K. reporting fund rules discussed here is a primary example of the dilemma confronting U.S. investors living in the U.K., British citizens living in the U.S. and Americans thinking about moving to the U.K. However, proper financial planning can provide solutions empowering Americans abroad to pursue the journey of building wealth over a lifetime through wise long-term investments without fear of hidden tax pitfalls.
