The Importance of U.S.-Listed and U.K. Reporting Funds for U.S. Taxpayers in the United Kingdom

U.S. taxpayers living in the United Kingdom must carefully understand the impact of U.S. and U.K. tax laws on their investment portfolio. From a U.S. tax perspective, it is essential to invest using U.S. listed investments to avoid the complicated and tax-costly U.S. passive foreign investment companies (PFIC) tax regime. On the U.K. tax side, the HM Revenue & Customs (HMRC) reporting fund regulations further restricts tax-efficient options for U.S. taxpayers who are also U.K. tax residents.

Not understanding both sides of the equation and using the wrong investment vehicles may lead to permanent double taxation. It is vital for American expats living in the United Kingdom, British nationals returning home after obtaining U.S. citizenship/green cards, and other individuals subject to both U.S./U.K. tax regimes to organize their balance sheet efficiently to ensure optimal after-tax returns.

Why U.S.-Listed Investments Are Essential for U.S. Taxpayers in the United Kingdom

A common investment-related income tax issue encountered by U.S. taxpayers living abroad is ownership of foreign investment funds. Non-U.S.-listed investment funds are classified as PFICs by the Internal Revenue Service (IRS). The PFIC tax regime aims to discourage U.S. persons from shifting income out of U.S. taxation. Funds classified as PFICs require complicated U.S. tax reporting and are often subject to higher U.S. tax rates than U.S.-domiciled funds.

Almost any non-U.S. registered investment product, other than direct ownership of stocks and bonds, is likely classified as a PFIC by the IRS. PFICs are simply “pooled investments” registered outside of the United States. Pooled investments include foreign mutual funds, exchange-traded funds (ETFs), money market funds, hedge funds and investments within non-U.S. insurance products.

Understanding PFIC tax rules is essential for U.S. expats, green card holders and other U.S. taxable persons. The IRS, through the Foreign Account Tax Compliance Act, is receiving more information on foreign accounts owned by U.S. citizens, which may start to include information about unreported PFICs held by Americans living in the United Kingdom. Thus, it is becoming increasingly important for U.S. taxpayers to ensure all foreign investments are reported properly on a U.S. tax return to avoid unnecessary fines and penalties later.

An important aspect of the U.S. PFIC regulations for U.K. investors is that investments held within tax qualified retirement accounts (under the U.S.-U.K. double tax treaty) such as a U.K. company pension or U.S. 401(k) do not require PFIC reporting. However, some U.K.-based savings schemes such as individual savings accounts (ISAs) do not enjoy tax-deferred status in the eyes of the IRS, as they are not qualified foreign pension accounts. If investing in mutual funds or ETFs in a U.K. ISA, there may be PFIC reporting requirements, which may negate any perceived benefit to using an ISA in the first place to obtain U.K. tax relief.

Avoiding PFICs Is Great, but Not All U.S. Investments Are U.K. Tax-Optimized: What Are HMRC Reporting Funds?

In a similar fashion to the U.S. PFIC rules, the United Kingdom has its own set of tax rules aimed at discouraging the use of opaque offshore funds by U.K. tax residents to defer income. The HMRC offshore funds regulations impose extra taxation on U.K. tax residents who own certain, non-U.K.-listed offshore funds. Navigating these HMRC offshore reporting funds rules is essential for long-term U.K. resident investors to benefit from tax-optimal returns.

The difference in taxation may be quite significant between U.K. reporting and non-reporting funds. If an investor is a U.K. tax resident and owns an investment that is classified as a non-reporting fund, any gain upon sale will be taxed as offshore income gains (OIG) rather than a capital gain by the HMRC. The offshore income gain rate may be as high as 45% for some U.K. taxpayers. When possible, investing through funds that are not subject to OIG is ideal.

To obtain a more favorable U.K. tax rate, investors should use registered U.K. reporting funds. When selling an offshore fund classified as an HMRC reporting fund, any gain upon sale will be subject to tax as a capital gain (10% or 20%) rather than income. Most U.S. mutual funds and ETFs are without U.K. reporting fund status and subject to the highest tax rates upon sale.

Which U.S. Listed Funds Are HMRC Reporting Funds?

Fortunately, there are many suitable U.S.-based funds that comply with the HMRC reporting fund regulations that are efficient for U.S. taxpayers living in the United Kingdom to own. The HMRC maintains a list of approved offshore reporting funds. However, cross-border investors must remain selective with their investments as most funds on the HMRC reporting fund list would be considered PFICs by the IRS and lead to punitive taxation.

In general, there is a limited selection of mostly ETFs that investors will want to use when building a long-term U.S. taxpayer-compliant investment portfolio. The good news is that most major asset classes may be efficiently owned through U.S. ETFs classified as U.K. HMRC reporting funds. Exposure to asset classes not available through a U.K. reporting fund may be obtained through retirement accounts such as IRAs, Roth IRAs, 401(k)s and U.K. pensions. As these tax-advantaged accounts are not taxed on an ongoing basis, the HMRC is not concerned about the fund status and compliance with income distributions rules. Tax will be owed when cash leaves the pension wrapper.

To add another wrinkle to the U.S. taxpayer investment dilemma, recent European Union restrictions on packaged retail and insurance-based investment products (PRIIPs) further curtails available investment options in the European Union and United Kingdom. PRIIPs regulations came into effect in January 2018 and impose special requirements on investment products across the European Union. Investment funds purchased before the EU PRIIPs regulation came into effect can be kept and sold, but EU residents can generally no longer buy new shares of these funds after PRIIPS (2018). Even though the United Kingdom is leaving the EU, a similar PRIIPs rule has been adopted that continues to limit the available investment options through U.S. and U.K. investment custodians.

Lastly, note that that there are no adverse tax consequences to owning individual stocks or bonds. U.S., U.K. or even stocks listed on another foreign stock exchange present no complex reporting requirements with the IRS or HMRC. However, there are certainly some challenges to implementing a portfolio compromised of only individual securities such as achieving optimal diversification to different asset classes.

Structuring an Investment Portfolio to Be U.S./U.K. Compliant

To remain U.S. and U.K. tax compliant, U.S. taxable investors should focus on building a portfolio with U.S. registered funds (not PFICs) that have U.K. reporting fund status. Advanced planning is the best solution to structuring a U.S./U.K.-compliant investment portfolio. Individuals moving to the United Kingdom should review their investment holdings beforehand for compliance with HMRC reporting fund regulations. Restructuring a portfolio to minimize taxes is usually most efficient prior to moving to the United Kingdom.

However, liquidating all investments before a move and often realizing significant capital gains may not always be the best decision before U.K. immigration. For U.S. citizens not planning to reside in the United Kingdom permanently, the U.K. tax inefficiencies from non-reporting fund investments may largely be avoided by not selling these funds while taxable in the United Kingdom. In contrast to the U.S. PFIC tax regime, the United Kingdom does not assess an annual tax charge on non-reporting funds. If an investor is happy with their portfolio, they may just keep it. Additional investments that are U.K.-compliant may be integrated into the portfolio to give options down the road (sales subject to U.K. capital gains tax).

For individuals who can no longer avoid U.K. taxation, a different analysis must occur. In most cases, acting sooner than later is the best course of action to maximize long-term wealth accumulation before the taxation becomes a larger problem (assuming positive investment returns). This is especially true for British nationals who may be moving back to the United Kingdom for retirement (unable to employ resident, nondomiciled remittance basis of taxation) and likely requiring an investment portfolio to support their standard of living.

Regardless of the situation, a careful analysis of current tax liabilities and goals is required. There are many nuances and strategies that must be considered to avoid adverse taxation and ensure the best investment results.

The next section reviews several important considerations when structuring an investment portfolio to be U.S./U.K. tax-compliant.

What Is the Arising Basis vs. Remittance Basis of U.K. Taxation?

The United Kingdom has a preferential tax regime that may be very advantageous for non-U.K.-domiciled individuals moving to the United Kingdom. A U.K. resident investor may have the option of being taxed on all worldwide income and gains (called the “arising basis”) or only be taxed on U.K. source income and gains and certain assets brought into the United Kingdom (called the “remittance basis”). Understanding these tax regimes is important for U.S./U.K. investors looking to minimize their net global tax exposure.

Many Americans living in the United Kingdom elect to pay tax on an arising basis and incur U.K. taxation on their global portfolios. In this case, it is important to ensure that investment funds are approved HMRC reporting funds. Any transaction or investment strategy must consider both U.S. and U.K. tax consequences to be efficient.

Electing the remittance basis of U.K. taxation may be very beneficial for certain U.S./U.K. investors. This means that for an annual remittance fee, investors are only taxed on income and gains that they bring into the United Kingdom (remittance of funds). The remittance basis has no charge for the first seven years and then costs between £30,000–£60,000 (2020–2021) per year between years 8–15. Paying this remittance charge to shelter non-U.K. funds from taxation allows U.S./U.K. investors to focus almost exclusively on the U.S. tax efficiency of their portfolio.

Is There a Difference Between USD and GBP gains?

Transactions must be examined closely under both tax systems as currency movements may have a dramatic impact on the net taxes an investor pays. These exchange rate swings may be particularly acute with U.S. fixed income and other U.S.-focused investments given the current strength of the U.S. dollar (USD). The below example demonstrates the tax consequences of large currency movements:

Purchased on June 27, 2014:

U.S. Treasury Bond	USD	FX Rate	GBP
Purchased on June 27, 2014	$100,000	0.588235	£58,823.53
Matured/Sold March 8, 2019	$100,000	0.769231	£76,923.08
U.K. Capital Gain	£18,099.55

The investor appears to have no gain in USD, but the actual Great Britain pound (GBP) gain is quite significant. This analysis must be completed with all transactions to ensure optimal U.S./U.K. tax efficiency and is particularly important when restructuring a portfolio into U.K. reporting funds. Commonly, managed accounts or active trading strategies with a focus on only one tax jurisdiction may create large tax bills when reconciled at year-end.

What to Do With Alternative or Private Investments?

More sophisticated investors may own interests in private equity, hedge funds or other nonpublic investments. From a U.S. tax perspective, these investments tend to be relatively tax-inefficient and complicated to start with. Bringing the U.K. tax system into the mix will compound this tax complexity greatly.

With different private fund investment structures, there may be timing differences between the realization and distribution of income to investors. These timing differences may lead to double taxation for a U.S. taxpayer who is taxable in the United Kingdom on the arising basis. A U.S. private equity fund may structure itself to be compliant with the HMRC for reporting fund status. However, this option may only be available to larger investors and pursuing it could come at considerable cost to the fund. Other planning structures exist that may make these investments more U.S./U.K. tax-friendly and expert tax advice is required from the beginning.

Donating Non-U.K. Reporting Funds to Charity

For charitably inclined investors, an easy and tax-efficient way to remove non-U.K. reporting funds from an investment portfolio is to make a charitable donation. Non-U.K. reporting funds may be gifted to charities or U.S./U.K. dual-qualified donor advised funds. In both the United States and the United Kingdom, no gain will be recognized on a gift to a charity and the fair market value may be used to offset other tax liabilities. Careful attention must be paid to the organization that the donation is made to ensure qualified tax treatment in both the U.S. and U.K. tax systems. Fortunately, there are special U.S./U.K. dual-qualified donor advised funds that can make a gift tax-efficient and easy to accomplish in both jurisdictions.

U.S./U.K. Share Matching: What Is Deemed to Be Sold?

The U.S. tax code offers investors several different options for deciding which exact shares or tax lots of a security are sold. This includes using a specific identification method that gives greater certainty and control for investors to optimize capital gains by selecting the most tax-optimal shares.

The United Kingdom has different ordering rules that specify which tax lots of an investment are sold. Generally, an average share pool is used to calculate capital gains. This can create incongruencies between what the United States views as sold and the United Kingdom views as sold. Cross-border investors must be certain on the tax reporting method to avoid surprises at tax time.

Tax-Efficient Investing for U.S. Citizens Who Become a Long-Term Resident in the United Kingdom

Understanding both the HMRC and IRS rules related to U.S./U.K. investment funds is essential, but only one part of building a comprehensive cross-border financial plan. As some of the examples illustrate, failing to take both U.S. and U.K. laws into account may have dramatic financial planning ramifications. Other important U.S./U.K. financial planning issues include:

• U.K. inheritance tax / U.S. estate tax
• Long-term currency management
• Management of clean capital accounts
• Offshore trust management (excludes property trusts and other U.S./U.K. structures)
• Cross-border life insurance

Being cognizant of these key situations and seeking the right advice at the right time, can save U.S. expat investors taxes and accountancy bills down the road. Cerity Partners specializes in implementing investment strategies that are tax-efficient and compliant for U.S.-U.K. investors and helping clients navigate the many other financial planning issues that can arise when U.S. citizens live abroad.

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