One thing is clear to anyone who has ever sought to fill out a tax return for an American who is living abroad: The US tax code was not designed with American expats foremost in mind.
Indeed, some would say it seems to go out of its way to actively punish those who have chosen to make their home outside of the US.
Here, Mary Beth Lougen, (pictured), who founded and heads up Virginia Beach, Virginia-based American Expat Tax Services, considers some of the issues that those who are attempting to file a US tax return for an American expat before the 2016 deadline of 15 June cannot afford not to take into account.
The basic principle every financial adviser must abide by is, of course, to always put the interests of their clients first. It is a simple concept that serves as the basis for every advisory code of ethics you’ll ever see.
To put it another way, it means that advisers must always ensure that the investment strategy they develop for their clients is unique to each individual client, and tailored to make the most of that client’s specific situation.
This, as it happens, is necessarily true for advisers of US citizens and green card holders, because complex and detailed tax considerations need to be considered from the outset, to ensure that any investment gain the client eventually realises is not totally negated by the US tax code.
The difficulties begin to mount, though, when those US citizens and green card holders begin living outside of the US, and having to file their tax returns from abroad.
This is because the archaic US tax system is based on residency and citizenship – and this citizenship, as growing numbers of American expats have been discovering the last few years, lasts until a person formally “renounces”, which is a complex, time-consuming and increasingly expensive process that few expats are keen to embrace, at least at first.
The central feature of citizenship-based taxation (which the US is the only major country in the world to practice) is that the country’s citizens are taxed on their worldwide income, even if they have never lived or worked in that country, for their entire lives.
One result of this is that what might be a perfectly brilliant investment strategy for an adviser’s British or South African clients, who are taxed on the basis of where they legally reside, is likely to be the equivalent of tax poison for an American one.
This is because, in the eyes of the US tax code, income and investments can change character when they are earned in another country. Therefore, when making client recommendations, care must be taken to understand the tax treatment of any income or deduction in both the country of residence and the US.
Another consideration is the fact that the US tax system is unnecessarily complicated. For example, the timing of income inclusions, and the character of the income, are different; sometimes the individual’s income is only taxable in one country but not the other. The possibilities for confusion are endless.
‘No ISAs for us, we’re Americans’
Then there’s the Individual Savings Account (ISA), an extremely popular British investment product that is also a great example of how the US tax system seems almost to go out of its way to make life more difficult than it has to be for its citizens when they live outside of the US.
The ISA is designed to encourage British citizens to save for their future, by enabling them to accumulate their investment earnings in a tax-free wrapper. They only have to pay tax on the income when they begin to cash in the savings account – by which point, it is assumed, they are likely to be retired, and therefore paying tax at a lower rate than when the money was being accumulated in the account. The ISA would, therefore, seem a natural to include in the investment portfolio of almost anyone living in the UK who happened to have a bit of extra money to put aside.
Unless, of course, that client were an American. Because the IRS chooses not to recognise the tax-free status of ISA accounts, and stubbornly insists on seeing ISA gains as taxable income realised in the year in which it is added to the individual’s account.
As a result, a US citizen with ISA income is taxed on all of their ISA income as if it had been earned in a regular investment account.(So much for encouraging people to save for their retirements…)
But that is only the first level of complication. The IRS may also view an ISA account as a “foreign trust”, under Internal Revenue Code §671-679. At the moment there is an ongoing debate among international tax professionals about whether an account like an ISA is deemed by the IRS to be a foreign trust, but, depending on the type of ISA they’ve got, an American expat who has one may wish to seek an opinion from a clued-in US tax professional before filing their tax return. Because if their ISA is in fact considered to be a foreign trust, not only is the income taxable every year, but two extra forms are required to be filed with the IRS each year in connection with such “trusts”.
In the end, given the amount of money an ex-pat American is likely to need to pay a US tax professional to prepare the forms required to own an ISA – not to mention the fact that the IRS won’t allow the annual income to be rolled up tax-free inside of it until some future date – ISAs would seem not to be a terribly clever investment for an expat American living in the UK to own, the product’s popularity among British investors notwithstanding.
(And that’s also not to mention yet another issue that can arise for Americans who have ISAs, which is what happens if the ISA account in question happens to hold non-US mutual funds or exchange traded funds. The IRS tends to regard these as so-called Passive Foreign Investment Companies, or PFICs, which are subject to some of the most complex tax rules found in the entire US tax code.)
With the coming into force in 2013, at last, of the Foreign Account Tax Compliance Act (FATCA), the push by the IRS to find all the reported 8.6 million Americans who live outside the US is on. And for this reason, those who are advising American expats on their investments needs to take the US tax implications of every element of the client’s portfolio from the outset.
Mary Beth Lougen is the founder and head of American Expat Tax Services, an Enrolled Agent, and US Tax Court practitioner.
To test your knowledge of US tax trivia, click here.
To see a list of tax quotations from the IRS’s website – plus a few of International Investment‘s favourite tax quotes – click here.