U.S. individuals living overseas and foreign nationals who move to the United States frequently will maintain at least part of their wealth in non-U.S. financial accounts. These individuals face a much more complicated set of issues than their peers who do not have any cross-border investments. In addition to various investment-related concerns, they must also keep a careful watch on tax-inefficient investments, complex international information reporting requirements, and significant U.S. tax compliance costs. Proper planning can eliminate unnecessary taxes help avoid substantial penalties related to U.S. tax noncompliance, and reduce time, effort, and professional fees spent on U.S. tax compliance services.
1. Shun heavily-taxed foreign investments
U.S. citizens and income tax residents are taxable in the United States each year on their worldwide income. This means that income earned from non-U.S. investments will be taxable in the U.S. each year, even if it is not taxed in the foreign jurisdiction. If the foreign jurisdiction does tax the income in the current year, then the U.S. tax liability may be reduced by the amount of foreign taxes paid. However, in some cases in which the foreign jurisdiction may not tax an investment, or will tax the income at a later date, there is a potential for double taxation of income. This may occur with certain foreign accounts or pension plans that are tax-advantaged in the foreign jurisdiction but not in the U.S.
In addition, certain investments held by U.S. investors abroad will incur significantly higher U.S. income taxes than similar investments held in the U.S. One example is purchasing stock in companies from countries that do not have an income tax treaty with the United States. Dividends from these companies will be considered “non-qualified” dividends, which are taxed as ordinary income at marginal tax rates up to 39.6% rather than the lower 15% rate for qualified dividends from companies located in the U.S. or treaty-partner countries.
Possibly the worst investments for U.S. taxpayers are so-called “Passive Foreign Investment Companies,” (“PFICs”) the most common example of which are foreign-registered mutual funds. Because foreign mutual funds generally are not required to distribute income annually as U.S. funds are required to do, Congress passed legislation containing special rules intended to make the taxation of foreign funds and U.S. funds similar.
Unless certain elections are made when a PFIC is purchased, a U.S. taxpayer who owns a PFIC is generally subject to tax at the highest marginal rate in the U.S. (currently 39.6%), regardless of their own personal marginal tax rate, on any income earned from a PFIC (including capital gains). In addition, the income must be allocated across the holding period in the fund and charged interest to the date of the income or capital gain. Capital losses on the sale of PFICs are generally not recognized. The punitive nature of the PFIC tax regime may result in tax and interest totaling over 100% of the income earned!
U.S. taxpayers with international investments should seek professional investment and tax advice to ensure that they invest in a tax-efficient manner to increase after-tax returns. Some possibilities include investing in the United States, or for foreign investments, purchasing only individual securities as opposed to PFICs.
2. Make sure you comply with all U.S. tax and information reporting requirements
In addition to owing U.S. income tax on their worldwide income, U.S. taxpayers are also subject to certain information reporting requirements related to their foreign assets and income. Although most of the forms are for information purposes only and do not create an additional tax liability, the penalties for failing to file the forms can be extremely punitive. Many forms carry an annual penalty of $10,000 or more for failing to file. The most severe penalties come from failing to file a Foreign Bank Account Report (described below), which can be charged up to the greater of $100,000 or 50% of the maximum account balance per year!
Some of the most common IRS international information reporting forms include the following:
- The Foreign Bank Account Report (FBAR) – to report foreign financial accounts  that in aggregate exceed $10,000 at any time during the year
- Form 3520 – to report an interest in a foreign trust (including certain foreign pension plans) or the receipt of a gift or inheritance over $100,000
- Forms 5471 and 8865 – to report an interest in certain foreign corporations and partnerships that have significant U.S. ownership
- Form 8621 – to report an interest in foreign mutual funds and other PFICs
- Form 8938 – to report foreign financial accounts and entities (may overlap with the above forms)
Due to the extremely severe penalties associated with the failure to properly meet all IRS foreign information reporting requirements, it is imperative that a U.S. taxpayer with foreign financial assets obtain qualified U.S. tax advice.
Those taxpayers who have failed to meet all of their foreign information reporting requirements in the past may be able to take advantage of certain IRS programs to reduce or eliminate their penalties. One of the best options for many taxpayers is the IRS’ Streamlined Program, which can reduce the penalty to 5% for certain taxpayers who live in the United States, and to 0% (no penalty) for qualifying taxpayers who live abroad. Qualifying taxpayers will need to file 3 years of U.S. tax returns and 6 years of FBARs, in addition to a certification that their noncompliance was non-willful.
3. Structure your foreign investments to minimize U.S. tax compliance costs
Many taxpayers with cross-border investments know that due to the complexity of their U.S. tax situation (including but not limited to the information reporting described above), the professional fees for providing accurate advice and properly preparing U.S. tax returns can be substantial. The simplest way to minimize these costs would be to keep all investments in the United States, which will avoid the burdensome foreign information reporting requirements.
If an individual wants or needs to maintain investments outside the U.S., then certain filing requirements and therefore related professional fees cannot be avoided. For example, most foreign financial institutions do not report income to account holders or investors under U.S. tax principles (long-term vs. short-term capital gains, qualified vs. non-qualified dividends, etc.). They will not provide a Form 1099 equivalent to match the reporting done under IRS rules by U.S. financial institutions. It may be necessary to convert income to a calendar year basis or into U.S. Dollars. These various complications will increase tax preparation fees and/or the taxpayer’s time and effort required to prepare an accurate U.S.tax return.
While certain complications may be unavoidable, there are ways to reduce the time, effort, and tax compliance costs of investing abroad in some situations. U.S. taxpayers who invest abroad should do so in as streamlined a manner as possible. Having many small foreign financial accounts as opposed to a few larger accounts will necessarily drive up the time and fees required to prepare necessary tax and reporting forms. Likewise, certain taxpayers may benefit from consolidating multiple foreign personal pension plans into one plan (if possible) to reduce the number of foreign information reports that are required. Unless there is a specific, legitimate purpose for investing through a foreign company, trust, or other entity, U.S. taxpayers should avoid doing so as this will unnecessarily increase their U.S. tax compliance burden, often without reducing their U.S. tax liability.Finally, any investments in PFICs will increase U.S. tax compliance costs due to the complex calculations required to properly report them. Investing in many PFICs, and/or actively trading PFICs, can cause U.S. tax compliance costs to skyrocket due to the added complexity.
The easiest way for U.S. investors to avoid high U.S. tax compliance costs related to foreign investments is to bring those investments to the U.S. If they do not wish to, or cannot, do so, then they should obtain proper advice to simplify their foreign investments to the extent possible.