U.S. taxpayers living in the United Kingdom must carefully understand the impact of U.S. and UK 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 company (PFIC) tax regime. On the UK tax side, the HMRC reporting fund regulations further restricts tax-efficient options for U.S. taxpayers who are also UK tax residents.
Not understanding both sides of the equation and using the wrong investment vehicle may lead to permanent double taxation. It is vital for American expats living in the UK, British nationals returning home after obtaining U.S. citizenship/green cards, and other individuals subject to both U.S./UK tax regimes to organize their balance sheet efficiently to ensure optimal after-tax returns. Remember, it is not what you make, but what you keep!
Understanding Why U.S. Listed Investments are Essential for U.S. Taxpayers in the UK
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 passive foreign investment companies (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 (FATCA), is receiving more information on foreign accounts owned by U.S. citizens and and this may start to include information about unreported PFICs held by Americans living in the UK. 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 UK investors is that investments held within tax qualified retirement accounts (under the U.S.-UK double tax treaty) such as UK company pension or U.S. 401k do not require PFIC reporting. However, some UK-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 UK ISA, there may be PFIC reporting requirements which may negate any perceived benefit to using an ISA in the first place to obtain UK tax relief.
Avoiding PFICs is Great, but not all U.S. Investments are UK Tax Optimized: What are HMRC Reporting Funds?
In a similar fashion to the U.S. PFIC rules, the UK has their own set of tax rules aimed at discouraging the use of opaque offshore funds by UK tax residents to defer income. The HMRC offshore funds regulations impose extra taxation on UK tax residents who own certain, non-UK listed offshore funds. Navigating these HMRC offshore reporting funds rules is essential for long-term UK resident investors to benefit from tax optimal returns.
The difference in taxation may be quite significant between UK reporting and non-reporting funds. If an investor is a UK 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 UK taxpayers. When possible, investing through funds that do not face OIG is ideal.
To obtain a more favorable UK tax rate, investors should use registered UK 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% UK CGT rate) rather than income. Most U.S. mutual funds and ETFs are without UK 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 UK 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 exchange trades funds (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 UK HMRC reporting funds. Exposure to asset classes not available through a UK reporting fund may be obtained through retirement accounts such as IRAs, Roth IRAs, 401ks, and UK 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 Retailed Investment Products (PRIIPs) further curtails available investment options in the EU and UK. PRIIPs regulations came into effect in January 2018 and impose special requirements on investment products across the EU. 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 UK is leaving the EU, a similar PRIIPs rule has been adopted which continues to limit the available investment options through U.S. and UK investment custodians.
Lastly, note that that there are no adverse tax consequences to owning individual stocks or bonds. U.S., UK, 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./UK Compliant
To remain U.S. and UK tax compliant, U.S. taxable investors should focus on building a portfolio with U.S. registered funds (not PFICs) that have UK reporting fund status. Advanced planning is the best solution to structuring a U.S./UK compliant investment portfolio. Individuals moving to the UK should review their investment holdings beforehand for compliance with HMRC reporting fund regulations. Restructuring a portfolio is usually most efficient prior to moving to the UK to minimize taxes.
However, liquidating all investments before a move and often realizing significant capital gains may not always be the best decision before UK immigration. For U.S. citizens not planning to reside in the United Kingdom permanently, the UK 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 UK 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 UK compliant may be integrated into the portfolio to give options down the road (sales subject to UK CGT).
For individuals, who can no longer avoid UK 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 UK for retirement (unable to employ resident, non-domiciled 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./UK tax compliant.
What is the Arising Basis vs. Remittance Basis of UK Taxation?
The UK has a preferential tax regime that may be very advantageous for non-UK domiciled individuals moving to the UK. A UK resident investor may have the option of being taxed on all worldwide income and gains (called the Arising Basis) or only be taxed on UK source income and gains and certain assets brought into the UK (called the Remittance Basis). Understanding these tax regimes is important for U.S./UK investors looking to minimize their net global tax exposure.
Many Americans living in the UK elect to pay tax on an arising basis and incur UK taxation on their global portfolios. In this case, it is important to ensure that investments funds are approved HMRC reporting funds. Any transaction or investment strategy must consider both U.S. and UK tax consequences to be efficient.
Electing the remittance basis of UK taxation may be very beneficial for certain U.S.-UK investors. This means that for an annual remittance fee, investors are only taxed on income and gains that they bring into the UK (remittance of funds). The remittance basis has no charge for the first 7 years and then costs between £30,000-£60,000 (2020-2021) per year between years 8-15. Paying this remittance charge to shelter non-UK funds from taxation allows U.S/UK 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 current USD strength. The below example demonstrates the tax consequences of large currency movements:
The investor appears to have no gain in USD, but the actual GBP gain is quite significant. This analysis must be completed with all transactions to ensure optimal U.S./UK tax efficiency and is particularly important when restructuring a portfolio into UK 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 non-public investments. From a U.S. tax perspective, these investments tend to be relatively tax inefficient and complicated to start with. Bringing the UK 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 UK on the arising basis. A U.S. private equity fund may structure itself to be compliant with the HMRC for reporting fund status. However, pursuing this option may only be available to larger investors and come at considerable cost to the fund. Other planning structures exist that may make these investments more U.S./UK tax friendly and expert tax advice is required from the beginning.
Donating Non-UK Reporting Funds to Charity
For charitably inclined investors, an easy and tax efficient way to remove non-UK reporting funds from an investment portfolio is to make a charitable donation. Non-UK reporting funds may be gifted to charities or U.S./UK dual-qualified donor advised funds. In both the U.S. and the UK, 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 U.S. and UK tax systems. Fortunately, there are special U.S./UK dual qualified donor advised funds that can make a gift tax efficient and easy to accomplish in both jurisdictions.
U.S./UK Share matching: What is Deemed to be Sold?
The United States tax code offers investors several different options for deciding which exact shares or tax lots of a security are sold. This includes using the specific identification method. This gives great certainty and control for investors to optimize capital gains by selecting the most tax optimal shares.
The UK has different ordering rules which 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 U.S. views as sold and the UK views as sold. Cross-border investors must be certain on the tax reporting method to avoid surprises at tax time.
Conclusion: Tax-Efficient Investing for U.S. Citizens Long-Term Resident in the UK
Understanding both the HMRC and IRS rules related to U.S./UK investment funds is essential, but only one part of a building a comprehensive cross-border financial plan. As some of the examples illustrate, failing to take both U.S./UK laws into account may have dramatic financial planning ramifications. Other important U.S./UK financial planning issues include:
- UK IHT/ U.S. Estate Tax
- Long-term currency management
- Management of clean capital accounts
- Offshore trust management (Excluded property trusts and other U.S./UK 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. Round Table Wealth Management specializes in implementing investment strategies that are tax efficient and compliant for U.S.-UK investors and helping clients navigate the many other financial planning issues that can arise when U.S. citizens live abroad.