Investment Issues
Americans abroad often run into difficulties with their financial investments. This most often happens when investing in foriegn mutual funds or foriegn pensions that are taxed as PFICs or Passive Foriegn Investment Companies. Currency flucuations also present an issue for US citizens who may need and want to invest in products offered in their country of residence. Currency flucuations can cause "phantom gains," gains resulting solely from the change in value of the US dollar (required for filing US taxes) against the currency in the country where an individual lives. This presents serious issues for individuals who have used a foriegn currency for their foreign transactions and have not patriated US dollars.
The enactment of recent tax evasion legislation; the Foreign Account Tax Complinace Act (FATCA) legislation, the increased enforcement of Foreign Bank Account Report (FBAR), the Patriot Act, and foreign government tax legislation such as the European Alternative Investment Fund Managers Directive (AIFMD), has in some cases, resulted in the denial and/or closure of both retail and investment financial accounts, both domestic and foriegn-based, for Americans resident overseas.
Some Foreign Financial Institution (FFIs), as a reaction to FATCA and FBAR compliance (given fear of penalty application) are denying and closing accounts for US citizen clients. The Patriot Act, which recommends application of stricter guidance for banks “Know Your Client” requirements, is also having an effect on US citizen’s ability to maintain financial accounts State-side when they are no longer resident in the United States. Foreign legislation such as the European, Alternative Investment Fund Managers Directive (AIFMD), which does not allow some US mutual funds to be sold or managed for US clients resident outside the United States, is also complicating the situation.
General Investing
Common and widely popular investments, Exchange Traded Funds and Mutual Funds, are not accessible to Americans abroad due to foreign regulations. Having little incentive to comply with foreign laws, ETFs and Mutual Funds are simply not available. Even after finding a US brokerage firm that will support them, expats will see error messages upon trying to purchase them. This effectively turns everyday Americans abroad into individual stock pickers.
Because of the investing difficulties, taxpayers are forced to either become individual stock pickers or look for the foreign accessible equivalent. The foreign equivalent, known commonly as “PFICs” (Passive Foreign Investment Companies) can trigger tax filings with punitive tax rates of well over 50%, even when there is no cash inflow to the taxpayer.
The Pitfalls of Passive Foreign Investment Companies
PFIC taxes prevent U.S. taxpayers from transferring profits to foreign investment corporations and later claiming the income as a capital gain (while paying the lower capital gains rates) by taxing gains on foreign passive investments at ordinary income tax rates, and charging punitive interest for the time the money was invested.
A PFIC is any foreign corporation meeting one of two conditions: 1) 75% or more of its gross income for the taxable year consists of passive income, or 2) 50% or more of the average value of its assets consist of assets that produce, or are held for the production of, passive income.2 Passive income includes dividends, royalties, rents, annuities, capital gains, foreign currency gains, and the like.3 Income derived from active banking activities, insurance, rents from relatives, and export trade is excluded from the definition of passive income for PFICs.4
For the first year, income generated by a PFIC is taxed as ordinary income at the highest marginal rate.5 In subsequent years, increases in distributions from PFICs are penalized as “excess distributions” if the increase exceeds 125% of the average income of the previous three years, or the holding period if less than three years.6 The penalty is the same as the underpayment rate7, which is the Federal short-term rate plus 3 percentage points.8
Taxpayers can avoid PFIC treatment if the company is a qualified electing fund or if the stock is marked to market.9 For the former, the taxpayer must establish fair market value as of the day the company becomes a qualified electing fund and pay the appropriate taxes.10 If a taxpayer does not make this election, the taxpayer remains subject to PFIC rates. A taxpayer may make the qualified electing fund election only if the holding company meets the requirement to determine the ordinary earnings of its net capital gain.11 Mark to market election requires the taxpayer to determine the fair market value of the taxpayer’s holdings annually and pay tax on the gains, with some adjustments for past gains and losses.12
Obviously, investing in Passive Foreign Investment Companies has consequences for the American taxpayer. In addition to paying the fees, the taxpayer must fill out Form 8621 to calculate and report those fees, which the IRS itself estimates will take more than 48 hours.13 Americans living abroad are more likely than those who do not to own foreign accounts. And, they may not even know whether that account qualifies as a PFIC under IRS rules.
Consider an American taxpayer living in Taiwan. If the taxpayer is at all familiar with U.S. tax law, he knows to report income to the IRS. But what about the pension fund set up by his employer, a common event in Taiwan? It is likely the taxpayer knows the balance of the pension account, and just as likely that the taxpayer doesn’t know whether the account qualifies as a passive foreign investment company or, perhaps, a foreign trust. Mutual funds available to owners of foreign accounts face the same problem. As noted earlier, there is a penalty for failure to properly calculate earnings in a PFIC, and the same applies to foreign trusts. In fact, failure to report foreign trust earnings on time results in a penalty of $10,000, or 35% of dividends, whichever is higher, and an additional $10,000 for every 30 days the payment is late after the first 90 days.14
American taxpayers generally assume that accumulating funds in a retirement account or a mutual fund is a good idea. For taxpayers living overseas, however, that proposition is not a sure thing given the possible tax consequences. At the least, earnings can be reduced by the time spent calculating taxes and by penalties. At worst, the entire fund could be lost to the IRS.15 The complexities, and penalties, presented by tax rules on foreign accounts present special problems for American citizens living abroad, problems that their U.S.-resident counterparts are unlikely to ever confront, especially by accident.
[2] 26 U.S.C.S. § 1297(a).
[3] 26 U.S.C.S. §§ 1297(b), 954(c).
[4] 26 U.S.C.S. § 1297(b).<
[5] 26 U.S.C.S. §§ 1291(a)(1), 1 et. seq.
[6] 26 U.S.C.S. § 1291(b).
[7] 26 U.S.C.S. § 1291(c)(A).
[8] 26 U.S.C.S. §6621.<<
[9] 26 U.S.C.S. § 1291(d).
[10] 26 U.S.C.S. § 1291(d)(2).
[11] 26 U.S.C.S. § 1295(a).
[12] 26 U.S.C.S. § 475.
[13] https://www.irs.gov/instructions/i8621
[14] 26 U.S.C. § 6677(a).
[15] Id.
Proposal for treatment of foreign pensions
Former ACA Director Jackie Bugnion and Paula Singer of counsel at Vacovec, Mayette & Singer LLP, have published a proposal for the fair US tax treatment of foreign pensions. The non-recognition of foreign pensions as US-qualified is one of the biggest concerns for Americans living and working overseas. See Ms. Bugnion and Ms. Singer’s recommendations are here (Copyright 2016 Tax Analysts; reprinted with permission)
Currency Fluctuation and Phantom Gains
Currency fluctuations can cause taxable events for Americans trying to do normal life transactions such as taking a mortgage to buy a house. Phantom gains on debt forgiveness if the USD appreciates over the term of the mortgage can be virtually impossible for everyday taxpayers to keep track of. Most Americans not trying to speculate on price changes and most are working in their local jurisdiction currency . To complicate the situation phantom gains are taxable however, phantom loses cannot be taken as a tax credit.
US citizens living overseas must use the US dollar as their functional currency U.S. Code § 985 - Functional currency. Currency fluctuation is virtually impossible for expats to plan around. The volatility can cause taxable events for US citizens overseas trying to do normal life transactions such as having a credit card or taking on a mortgage to buy a house.
Currency fluctuations can cause taxable events for US citizens trying to do normal life transactions such as taking a mortgage to buy a house. Phantom gains on debt forgiveness if the USD appreciates over the term of the mortgage can be virtually impossible for everyday taxpayers to keep track of. To complicate the situation phantom gains are taxable however, phantom loses cannot be taken as a tax credit. U.S. Code § 988 - Treatment of certain foreign currency transactions
For example, if an American buys a house in Europe with a €1 million mortgage while the exchange rate is €1:$1, the expat will also have a $1 million mortgage. If the USD strengthens over time and, over the course of the mortgage, €1 million euros is the same as $900,000, the IRS will say there is $100,000 of debt forgiveness income (the original $1 million minus the $900,000 principal paid). This will result in a large unexpected tax bill at their ordinary tax rate that is not eligible for foreign tax credit relief. Also, had the dollar weakened against the euro, the resulting loss (paying more than $1 million in principal) would not be allowed.