Investment funds are a seemingly straightforward component of the average investor’s portfolio. And yet countless American expatriates – and the financial advisers who look after them – have ended up making costly, and easily avoidable errors, by investing or advising on the investment in funds that are uniquely unsuitable for Americans.
Here, Peggy and Chad Creveling, the principals of the Bangkok-based, fee-only firm Creveling & Creveling Private Wealth Advisory explain why this is; what “PFICs” are; and how costly US tax mistakes can be avoided…
With the advent of the US Foreign Account Tax Compliance Act (FATCA) over the past few years, most offshore financial intermediaries and expat Americans at last realise, if they didn’t before, that trying to avoid US tax by investing offshore doesn’t work.
These days, American citizens and Green Card holders are well known around the world for being subject to US tax on their global income, even when they live outside of the US.
And for some, the complications don’t stop there: such other factors as an American expat’s current country of tax residence, their source and type of income, and any other tax jurisdictions that may be come into play in their life – for example, if they happen to be dual-nationality Americans, or live in a multi-nationality household – can also affect the way the US Internal Revenue Service (IRS) views these individuals, their income and their wealth.
This article outlines some of the basics that offshore advisers need to be aware of for their clients who are subject to US tax.
Why non-US domiciled investment
schemes cause tax problems for Americans
Where Americans invest their savings matters – a lot.
Unfortunately, as an increasing number of Americans are living and working overseas, many have unwittingly subjected themselves to the IRS’s punitive Passive Foreign Investment Company (PFIC) rules.
A “PFIC” could be any kind of mutual fund, hedge fund, or other similar type of pooled investment product originating and domiciled outside of the US.
Less obviously, even investing in domestic local mutual funds or local tax-deferred vehicles in the country in which the American currently lives may subject him or her to the IRS’s punitive PFIC consequences.
What’s more, investing in offshore investment schemes that involve an insurance wrapper usually doesn’t help.
That’s because these types of financial products normally include an insurance structure that’s defined under the laws of an offshore jurisdiction only.
And while such insurance wrappers may offer tax benefits in some tax jurisdictions, they almost never qualify for US tax-deferred benefits from the IRS.
What is a PFIC?
The rules surrounding PFICs are complicated, but essentially, any non-US incorporated investment fund that derives 75% or more of its income from passive activities is classified as a PFIC. This covers virtually all mutual funds, exchange traded funds (ETFs) and hedge funds that have been incorporated outside the US and distributed by foreign financial institutions.
The intent of the PFIC rule is to discourage Americans from investing in financial products and through financial institutions that cannot easily be monitored by the IRS.
In theory, a foreign fund manager could structure payouts and reporting on his fund to qualify for US tax treatment similar to US domestic funds – and some do.
The reality, though, is that most offshore funds have few US investors. Also, their managers may be unaware of the US tax consequences to their American clients. Or it may simply not be economical for certain funds to be structured in such a way as to meet US rules.
Until very recently, many Americans who’ve invested in PFICs have been unaware of their different treatment, and have tended to report and pay tax on their foreign investments in the same manner as they would an investment in a US domestic fund.
Since this is not the correct way to handle PFICs for US tax purposes, they could, and often do, end up facing significant penalties, back taxes and interest when they try to rectify the situation at a later date.
better for Americans’
While the intent of the PFIC rules may be to discourage Americans from investing in products and through institutions that cannot easily be monitored by the IRS, the result is that they effectively deter American citizens from investing in funds that are not US domiciled.
Why, after all, buy a non-US mutual fund that charges an expense ratio of 2% per year or more, and a 5% to 7% front-end load; offers no tax deferral; and sees any gains taxed at the investor’s marginal tax rate in the best case, and in the worst case, sees them subject to the top marginal tax rate, as well as a penalty interest rate?
While investing in PFICs can still make sense in specific, limited cases, it’s important to compare the after-tax, after-fee return with comparable investment options first.
In most cases, Americans will find that they can gain the same economic exposure using a US investment vehicle – with far lower fees and commissions, lower overall taxes, few tax filing issues, and stronger regulatory consumer protections.
When offshore investments
can actually make sense
There are some cases in which owning an offshore fund or PFIC can, however, make sense. Here are two examples:
• Foreign Pension Plans – US citizens may find it beneficial to sign up to a foreign pension plan, even if it involves PFICs, in cases where an employer is making matching pension contributions.
They should seek professional tax advice before doing so – in some cases, tax treaties may allow for preferential tax treatment and filing; in other cases, a foreign pension plan may be considered an “employee benefit trust”, with different filing and tax requirements.
They should also be careful of tax residency implications – for example, a US citizen with a UK pension plan may not be able to claim US-UK treaty benefits if the American is a tax resident of Singapore.
If Form 8621 and PFIC rules do apply, they should consider the “mark-to-market” election, to minimise the US tax and filing impact.
• Funds that Provide Local Tax Benefits – Some countries have incentive programs that provide local tax deductions for fund contributions – for example, Thailand’s Retirement Mutual Funds (RMFs) and Long Term Equity Funds (LTFs).
Even though the IRS will not recognise the local tax deduction for US tax purposes, and the fund is a PFIC, contributing to such funds still can make sense in some cases.
For example, for Americans who can exclude from US taxes all foreign- earned income under the Foreign Earned Income Exclusion (FEIE, equal to $101,300 in 2016) and housing deduction, making locally tax-deductible contributions from salary income to a foreign fund, may cut local taxes and save on their total annual tax burden.
Even though the investment earnings may be reported annually under PFIC rules, the overall tax savings could still make this a worthwhile trade-off – especially if the mark-to-market election is made.
Each case is different, so the client or their tax adviser would need to do the maths, to make sure there is a net tax savings.
Conclusion: American expats
need qualified advice
One thing American expatriates need to understand from the outset is that they cannot expect an insurance or asset management company that is seeking to offer them their latest offshore investment scheme to be relied upon to inform them, or their financial adviser, of the US tax consequences of the proposed investment.
This is because, as mentioned, these product providers may, in fact, be unaware or uninformed about the rules.
And for that matter, expatriate Americans should not be allowed or encouraged to expect that Turbo Tax or a hometown tax preparer back in the States will be up to speed on such matters either.
The parts of the US tax code that apply to American expats are obscure and, until recently, were rarely enforced. With the arrival of FATCA, though, and certain other relatively new regulations, the days of benign neglect by the US tax authorities have come to an end.
Luckily, there are still many ways that American expats can minimise their US taxes, while diversifying their investments globally. But before they buy any type of investment or insurance product from a foreign financial institution or offshore broker, a tax adviser who is experienced in working with American expats must always be consulted.
Because the tax penalties that may result from failing to do so are just not worth it.
Chad and Peggy Creveling are the co-owners and founders of Bangkok-based Creveling & Creveling Private Wealth Advisory, a fee-only advisory firm which specialises in providing cross-border financial planning and investment advice to expatriates and multi-nationality households. This article is intended for general information only, and is not intended as specific advice.
This article appeared in the February 2017 issue of International Investment magazine.