In recent years there has been heightened scrutiny of US tax filers based outside the country.
Various pieces of legislation, including Hiring Incentives to Restore Employment, the Foreign Account Tax Compliance Act (FATCA) and Alternative Investment Fund Managers Directive mean that any American living outside the US now has to contend with a plethora of reporting requirements and significant confusion over their investment options.
Under the US tax system, Americans are taxed on a worldwide basis regardless of where they live, which, on the face of it, seems straightforward. However, both the choice of investments and commonly used UK tax wrappers can create problems.
At the same time, Americans must also consider how the UK may treat any of their investments retained in the US.
Obtaining the right investment advice and execution is becoming increasingly problematic, with many institutions closing their doors to anyone with a US reporting requirement and an increasing number of US brokers and banks offering limited services to overseas Americans.
For Americans living in the UK, there are three main areas to consider:
Underlying investments
In the UK the most common form of investment medium is collective funds, either OEICs or unit trusts. If these are not structured in a US-friendly manner, they are extremely tax-disadvantageous for Americans as they are often regarded as passive foreign investments companies (PFICs) by the Internal Revenue Service (IRS) and taxed punitively. In certain circumstances, the level of tax paid can negate any gain made on the investment.
Those Americans resident in the UK for seven out of nine tax years become deemed domicile for UK income and capital gains tax purposes, and are now taxed in the UK on an arising basis (unless they are willing to pay the annual remittance basis charge) on any worldwide income and capital gains.
This means all investments held outside the UK that do not have UK reporting status will fall under the UK offshore fund rules, with any proceeds subject to UK income tax rather than the largely more favourable taxes such as dividend and capital gains.
Investment products
There are some common products used in the UK that Americans must handle with care. The IRS does not recognise ISAs, for example.
This means they are viewed for tax purposes in the US like any other general investment account and taxed accordingly. US individuals must be aware of how the US authorities treat the underlying holdings, as with any other investment account.
For pensions, there is significant ambiguity: the US and the UK have a pension treaty that means employer-sponsored pensions are considered by both jurisdictions in the manner they are treated in their home country. This means any investments within them are immune from the negative tax treatment discussed previously.
The water has been muddied since the dawn of private pensions and more specifically SIPPs, as there is no specific reference made to these in the US/UK pension treaty. SIPPs could potentially fall under the foreign grantor trust rules in the US, which would mean they are required to file additional reporting information and are transparent from the IRS perspective.
Structure
Where the investments are and how they are structured can be just as important as the underlying investments.
For Americans who come to the UK, they often arrive on the premise of staying for a few years and then returning to the US without ever needing or wanting to bring money from the US into the UK. Should this be the case and they do not trigger the ‘seven out of nine year’ residency rules in the UK, their US investments are safe from the HM Revenue & Customs.
However, for those who decide to stay in the UK for longer periods or want to invest money in the UK, the structure of their offshore assets is extremely important.
If a US individual wants to remit offshore monies into the UK and there has not been clear separation of original clean (tax paid) capital and income/interest paid by those investments then the
UK will view the monies as mixed. This mixed capital can be subject to income tax on remittance to the UK regardless of whether or not tax has been paid previously elsewhere.
In search of a solution
As far as investment is concerned, being selective is fundamental when investing for US/UK individuals. Although most funds outside the US fall foul of the PFIC rules, there are a handful that have made an election to be treated as a qualifying fund for US purposes. For the UK offshore fund rules, there are a number of US mutual funds and ETFs that have obtained UK reporting status, meaning they report the necessary information to the UK to ensure they are taxed as ordinary UK funds.
Both these options require an investor to choose from a limited pool and do not leave a great deal of potential for sophisticated investment planning.
Another option is to invest in individual stocks and bonds. These individual assets are generally taxed under the normal regimes in both jurisdictions and allow for a much larger universe. There is also the potential to buy individual stocks that qualify for advantageous tax treatment.
For ISAs, there is a common misunderstanding that because the IRS does not recognise the ISA wrapper, they do not work for Americans. This is not the case. An American living in the UK should take advantage of the ISA allowance before investing in a standard general investment account.
The investments within this wrapper will not be subject to the higher UK tax rates but instead to (usually more favourable) US tax rates. The difference in the tax rates may be small but it still makes sense to take advantage of this difference. Once this is understood, it is just a case of ensuring the actual investments within the wrapper are not tax-disadvantageous.
Given the ambiguity in the pensions arena from a tax perspective, it is difficult to provide a hard and fast solution. Should the IRS decide SIPPs are in fact foreign grantor trusts, then ensuring the money is not invested in assets that are taxed punitively is key. This prudent approach ensures that whichever way these pensions are treated from an IRS perspective, there will not be a negative tax surprise further down the line.
A flexible approach
Given that it is difficult to plan for events that might not happen, flexibility is often the best option. Assets that are offshore from a UK perspective should be structured to separate capital from income, with any income/interest/dividends swept to a separate account.
Should the individual want to remit money into the UK then this original ‘clean’ capital can be brought into the UK without tax. Ensuring the investment manager and the custodian bank are able to execute this is fundamental. This should be done as soon as possible after being resident in the UK to reduce the potential difficulties and cost of restructuring.
There is increasing complexity for US tax filers, and taking legal and tax advice alongside the stated planning and investment solutions is key. Given all this it is easy to see why wealth managers on both sides of the Atlantic are backing away from advising Americans based offshore.
However, there are solutions to the problems posed by this increased regulatory burden but any manager must be able to incorporate financial planning, investment expertise and an awareness of the tax environment to build a robust solution for clients.