What Every American Investor Must Know

Many American investors are confused by sales pitches of expat investment advisors who are unfamiliar with United States tax laws. While it is true that no tax may be payable in the fund’s jurisdiction (Isle of Man, Guernsey or the UAE, for instance), significant US taxes are payable by the American owner. Confusion abounds when Americans invest in foreign mutual funds, life policies, savings plans, portfolio bonds and similar fund arrangements as compared to when they invest in US-based funds.

Generally, with a US fund virtually all of the income and the gains are distributed annually to investors and reported directly on their US tax returns. The fund sends both the investor and the IRS a form 1099 detailing the shareholder’s income earned in the fund. Foreign investment vehicles are not subject to this kind of disclosure. The American investor must flounder along and determine the proper US tax treatment of his investment.

The US tax laws are clearly designed to deter US persons from investing in offshore funds, whether the investment is made directly or indirectly (e.g., through a BVI company, non-US trust etc.). They prevent the income or gains from escaping US taxation and, impose harsh sanctions on the US investor eliminating any possible tax deferral.

“Passive Foreign Investment Company”

Generally, such offshore funds are taxed as a so-called “passive foreign investment company” or a “PFIC”. A PFIC includes any non-US corporation if 75% or more of its gross income for the year consists of “passive income”. Passive income generally includes dividends, interest, rents, royalties, most foreign currency and commodity gains, and capital gains from assets that produce such income. Just about all of the income of a fund will usually qualify as passive and so, nearly all foreign funds will qualify as PFICs!

Harsh Tax Results – Compounded Interest, Loss of Capital Gain Treatment

Once a corporation qualifies as a PFIC, very harsh tax consequences can result. In the absence of making a special election, taxation will generally occur when the fund makes a distribution to the investor or, when he disposes of his PFIC shares. When taxation occurs, the amounts will be taxed at the highest ordinary income tax rate for the investor without regard to other income or expenses (currently the highest individual rate is 39.6% with a possible 3.8% Medicare surcharge tacked on for high income earners – updated October 22, 2013). Long-term capital gains treatment does NOT apply. Further, the amounts are treated as if they were earned ‘pro rata’ over the investor’s holding period for his fund shares (in other words, the amounts are “thrown back” evenly over each of the earlier tax years, tax assessed for each year at the highest rate, and interest compounded on the tax deemed due for each year). This is very punitive because compounded interest charges are computed on the ‘deferred tax’ owed; the high rates can quickly eat up the investment by removing the benefit of any tax deferral.

Elections, Returns and Filings

A so-called “Mark-To-Market” election may be possible. If eligible for this election, the investor can “mark gains to market” at the end of each year thus choosing a relatively simple taxation scheme that is less punitive. The fund shares must be “regularly traded” on a registered national securities exchange. A foreign exchange can qualify under certain delineated circumstances.

According to Vince Truong, a U.S. CFP® with Holborn Assets in Dubai, the investment that is most often touted by advisors, and which should cause the most concern for US taxpayers, are regular savings plans marketed as an alternative form of pension. “These are not pensions but rather a contractual form of investing where the client is putting aside monies on a monthly, quarterly or some regular frequency, which then are invested into a variety of mutual funds. It is very difficult to opt for the less punitive “Mark-To-Market” election with these savings plans due to the need to calculate the basis on each regularly invested amount, which is then spread out across a number of funds, and then re-adjust the basis annually for each underlying fund. It is even more difficult if the provider offers mirror funds instead of the actual direct funds because mirror funds are not “regularly traded” and would likely not qualify for the ‘Mark-To-Market’ election.”

A US investor in a PFIC must file various information and tax forms (e.g., Form 8621, Form 8938, FBAR). Record-keeping and preparation time for the Form 8621, alone, is extremely complicated and a separate Form must be filed for each PFIC owned. The IRS estimates that the time required with regard to Form 8621 for each PFIC investment is at 22 hours per year! The tax preparation costs may certainly outdo the value of the investment. To avoid possible penalties, the investor should examine the proper tax treatment and filings with a tax professional.

Just in case a taxpayer thinks of ‘ignoring’ the rules regarding self-reporting on PFICs, please note that under new tax legislation commonly referred to as FATCA, commencing 2014, ”foreign financial institutions” will be required to report directly to the IRS about assets held by US persons with that institution. The FATCA rules will make it very easy for the IRS to cross-reference the information provided by the foreign financial institution with the taxpayer’s Form 8621 to determine whether taxes and reporting on the foreign fund have been properly undertaken.

Given the significant tax complexities, Americans must be well advised before investing in the offshore fund market.

In accordance with Circular 230 Disclosure