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December 1, 2022
Whether you are a young executive planning your first move overseas or a high-net-worth individual retiring in another country, there are many financial matters to consider when moving abroad. No matter how many years someone has spent outside the United States, a U.S. citizen or a current green card holder is still required to file a U.S. tax return. The requirement to file U.S. taxes has a substantial impact on choosing a long-term investment strategy.
A common investment-related income tax issue encountered by U.S. citizens living abroad or U.S. permanent residents (green card holders) is owning foreign investment funds. These foreign investment funds are classified as passive foreign investment companies (PFICs). The PFIC tax regime aims to discourage U.S. persons from forming a foreign corporation to shift income out of U.S. taxation. PFICs require complicated U.S. tax reporting and are often subject to higher U.S. tax rates. A superior solution for U.S. taxable persons is to avoid PFIC funds and focus on building a global investment portfolio through U.S.-based investment options. This is certainly the best way for Americans living abroad to invest to avoid PFIC reporting complications and additional tax costs.
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. Almost any foreign investment product other than direct ownership of stocks and bonds is likely classified as a PFIC by the Internal Revenue Service (IRS).A common place where many investors own PFICs is in a foreign pension plan. If the foreign pension plan is not qualified under a U.S. double tax treaty, the underlying PFIC investments must be reported individually and PFIC tax rates apply. This can be incredibly burdensome for U.S. taxpayers, and it may make sense to steer clear of voluntary contribution pension plans not covered by a tax treaty to avoid PFIC problems when filing U.S. tax returns.
U.S. taxpayers who own PFICs face increased tax rates and complicated U.S. tax reporting requirements. There are several different PFIC tax reporting methods. Ultimately, PFIC tax rates can reach near or above 50% when considering penalties and interest. Furthermore, no deferral of gains is allowed. This means gains on a PFIC investment must be realized at a high tax rate each year (deducting losses is also limited on these investments). Over time, the IRS always wins and the PFIC tax drag will significantly erode investment returns.
Additionally, PFICs must be reported on a special tax form (IRS Form 8621). The IRS estimates that it takes approximately 22 hours to properly fill out Form 8621. Each individual PFIC must be reported on a separate form. An investment portfolio of 10–15 PFIC investments will take considerable accounting time and cost. This is another major reason why American expat investors should avoid building a portfolio of non-U.S. mutual funds.
U.S. taxable investors should focus on building a globally diversified investment portfolio through U.S. registered funds. For example, a U.S.-based fund that invests in emerging markets may benefit from a 15% long-term capital gains rate. If the U.S. investor buys the identical fund, but listed on a foreign exchange, they may have to realize gains annually at a tax rate close to 50%! Furthermore, many foreign investment products have much higher management fees and lower liquidity than similar options available through U.S. financial markets. A U.S. taxable person (often American expats or green card holders) owning a PFIC will likely be best off financially if they sell the foreign mutual fund as soon as possible.
Many other countries have similar rules to the U.S. PFIC regime. For example, investors who are a taxable resident and domiciled in the United Kingdom must be mindful of the “reporting funds regime” administered by the HM Revenue and Customs (HMRC)—the U.K.’s tax authority. Offshore funds not on an approved list by the HMRC will not be eligible for U.K. capital gains treatment. Germany, Austria, Australia and New Zealand also have similar rules aimed to discourage the ownership of nontransparent offshore funds.
Understanding the PFIC rules is essential for U.S. expats, green card holders and other U.S. taxable persons. Due to the Foreign Account Tax Compliance Act, it is becoming increasingly important for U.S. taxpayers to ensure all foreign investments are reported properly. The IRS is receiving more information on foreign accounts owned by U.S. citizens, which may include information about unreported PFICs.
Many foreign financial advisors do not understand that the investments they are selling, likely foreign funds classified as PFICs, can be tax-inefficient for an American taxpayer. American citizens living abroad should use U.S. investment funds and work with an American expat financial advisor who is an expert in cross-border matters. Green card holders and foreign nationals should consider selling PFICs they purchased before moving to the United States. Ultimately, this will be the most cost-effective and tax-efficient way to build wealth over time for a global family.
Cerity Partners understands these vital cross-border investment issues. Whether you are an American expat, a current green card holder or foreign national moving to the United States, contact one of our experienced international financial advisors to review your situation.
Cerity Partners LLC (“Cerity Partners”) is an SEC-registered investment adviser with office locations throughout the United States. Registration of an Investment Advisor does not imply any level of skill or training. The foregoing is limited to general information about Cerity Partners’ financial market outlook. You should not construe the information contained herein as personalized investment, tax, or legal advice. There is no guarantee that the views and opinions expressed in this commentary will come to pass. The information presented is subject to change without notice and should not be considered as an offer to sell or a solicitation of an offer to buy any security. Material economic conditions and/or events may affect future results. Before making any decision or taking any action that may affect your finances or your company’s finances, you should consult a qualified professional adviser. For information pertaining to the registration status of Cerity Partners, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). For additional information about Cerity Partners, including fees, conflicts of interest, and services, send for our disclosure statement as set forth on Form CRS and ADV Part 2 using the contact information herein. Please read the disclosure statement carefully before you invest or send money.
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Frederic Behrens is a Partner in the New York office, where he provides investment management and financial advisory services for high-net-worth individuals and international families....
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