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Tax efficient investments

Investments can become tax inefficient in cross-border situations, and there may be other surprises.

Most individuals with spare funds to invest will at some time have been involved in tax planning.

Without doubt, this will have been done with the view to avoiding unnecessary taxes. Nevertheless, the activity in question will have taken place with acceptance by, and even encouragement from, the authorities in the country where the investor was living at the time.

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Investments can become tax inefficient in cross-border situations, and there may be other surprises

Most individuals with spare funds to invest will at some time have been involved in tax planning. Without doubt, this will have been done with the view to avoiding unnecessary taxes. Nevertheless, the activity in question will have taken place with acceptance by, and even encouragement from, the authorities in the country where the investor was living at the time.

Governments take decisions about activities that they want to encourage for political or economic reasons. Then it is often the case that a tax incentive will be attached as a ‘nudge’ factor to encourage the public to take that direction of travel.

An obvious example of such a policy is the Individual Savings Account (ISA) in the UK. Successive Governments have taken the view that regular saving is an activity to be encouraged. ISAs provide all savers with an attractive environment in which to save, although the real target audience is small savers. Hence there is an annual limit on contributions to an ISA. The real target audience is unlikely to want to save regular amounts in excess of that limit. Furthermore, it was much simpler to give all savers eligibility to a limited amount of tax saving than try to create an investment vehicle that was only available to small savers

A good tax result at home is unlikely to be replicated when moving to another country

Under any such tax-favoured saving regime, all is well and good so long as the individual investor continues to reside in the ‘home’ country. However, an international move (e.g., in connection with employment) should be a trigger for the investor to take immediate advice in two respects:

  • Consult a tax professional on how the investment portfolio will be taxed in the new country of residence
  • Consult with an investment advisor on whether that new tax environment requires a realignment of the portfolio

A simple rule of thumb in these circumstances is that what the home country provides by way of tax incentives is unlikely to be replicated in the new host country. Even when the governments in both countries have a policy of encouraging the same type of activity, the mechanics those two countries have put in place to nudge their populations in the desired direction will differ. Someone moving from the UK to a host country which also has tax incentives to encourage small savers, is highly unlikely to find that their ISA gets any favourable treatment there. Much more likely is that all income and gains arising within the ISA will be liable to host country taxation.

It makes sense to consult an investment advisor

Consultation with an investment advisor is recommended in these ‘tax change’ situations because the economics of a particular investment may have changed fundamentally. This can be illustrated by the case of an individual who has invested in US Municipal Bonds while they were resident in the USA, as Interest on Municipal Bonds is exempt from US Federal Income Tax. However, on moving to another country, that interest income is likely to be subject to host country taxation.

Because there have been defaults in the past, interest rates on Municipal Bonds will vary according to the credit rating of the municipality which issued the bonds. Given this variation in interest rates, there is not a ‘one size fits all’ answer for the investor who moves from the US to another country.

In the case of a hypothetical AAA-rated municipality, the traditional way in which interest rates were set at the time of a bond offering followed this pattern:

  1. Recognition that the minimum level of investment required meant that investors would be individuals paying the highest rate of US Federal Income Tax
  2. Computation of the after-tax income such a top rate taxpayer would get from a AAA-rated debt instrument paying taxable interest at the current market rate
  3. Offer an interest rate on the ‘tax free’ Municipal Bond which delivered a better cash flow to the investor than the after-tax result at Step 2 above
    – Obviously, the actual ‘premium’ offered over that after-tax amount was determined by other market forces

If the Municipal Bond interest becomes exposed to host country taxation, it is obvious that the full rationale behind the original investment decision needs to be revisited and a ‘continued fit-for-purpose’ test applied.

Another point to discuss with an investment advisor is the situation where continuing with an existing investment will give rise to statutory information reporting requirements in the host country. Some countries take a particular interest in knowing about investments which their residents have in other jurisdictions.

If that statutory information reporting is such that a third-party professional will need to be paid to assist, the associated professional fees should be looked at as being a cost of holding that investment. The extent to which such a cost tarnishes the appeal of a particular investment will vary from case to case.

Examples of the interaction of UK and US tax rules

It is beyond the scope of this short article to provide an exhaustive set of country-to-country comparisons.

  • Therefore, for illustrative purposes, the issues arising from moves between the UK and the US are set out below:
    Other than the fact that US citizens and ‘green card’ holders continue to be taxed by their ‘home’ country, even when living elsewhere; similar issues to those illustrated below should be considered in any country-to-country move
  • The illustrations are not presented as an exhaustive list of things to consider, but merely the more obvious ones. There is no substitute for engaging a tax professional to advise on all the cross-border tax issues which will arise in relation to a particular individual’s facts and circumstances

1. US Individual Moves to the UK

Existing investment in US Municipal Bonds

  • Interest will be UK taxable.
  • Not an issue if a remittance basis taxpayer in the UK and none of the Municipal Bond interest is either remitted to the UK or applied offshore in a way that constitutes a constructive (e. deemed) remittance for UK tax purposes.

Advice required by a remittance basis taxpayer if some of the interest is to be remitted to the UK.

  • Individuals taxed in the UK on the arising basis should be having discussions with their investment advisor.

Making UK tax efficient investments such as putting money into an ISA

  • The advantageous UK tax treatment is not replicated for US Federal Income Tax purposes.
  • That does not necessarily mean that it is a ‘bad’ investment for a US person living in the UK. The evaluation against alternative, UK taxable, investments will depend on the individual’s own facts and circumstances.

2. UK Individual Moves to the US and Becomes Tax Resident There

Existing investment in UK Unit Trusts

  • Bad news for the US individual
  • For US tax purposes, a Unit Trust is a Passive Foreign Investment Company, or PFIC (pronounced pee-fik)
  • The PFIC rules were to make non-US mutual funds unattractive to US domestic investors
  • The result is that PFICs get both an unpleasant US tax treatment and burdensome reporting requirements

Existing investment in an ISA

  • Income and gains arising within the ISA will be liable to US tax

Making small amounts of capital gains that would be exempt from UK Capital Gains Tax

  • No such exemption in the US
  • The ‘cost’ of an investment acquired other than by paying for it in $US, is computed by reference to the historic $US exchange rate in force at the time of acquisition
  • Depending on foreign exchange movements, this might result in a more substantial US $ gain (i.e. what is US taxable) than is apparent by simply looking at the £ sterling numbers

Selling the former UK home after becoming a tax resident in the US

  • If a move to the US will occasion the sale of a former UK main residence, it may not be possible to complete that sale prior to becoming US tax resident
    NOTE: For US tax purposes the key date is completion of the sale, not the date on which contracts are exchanged
  • For US Federal Income Tax purposes, there is only a limited exemption for the gain arising on a former main residence
  • In certain circumstances, a separate item of US taxable income can arise when a UK mortgage on the property is repaid

Funds in a UK pension scheme other than an employer’s occupational scheme

  • The issue here is not something becoming US taxable (at least not at the Federal level), but compliance with mandatory US information reporting requirements
  • Membership of a UK registered pension scheme carries no privileges under US domestic tax law. However, the US/UK Tax Treaty (the Treaty) comes to the rescue. The negotiators of the Treaty were keen that the trans-Atlantic mobility of labour was not deterred by cross-border tax issues arising from pension plan membership. Consequently, the Treaty contains a number of provisions to eliminate such issues
  • What the Treaty does not do, is modify any of the mandatory information reporting requirements contained in US domestic law
  • Only membership of a UK occupational scheme satisfies one of the exemptions available under US domestic law. Other UK pension arrangements such as a self-invested personal pension (SIPP) do require annual information reporting to the US internal Revenue Service
  • There is a substantial penalty for failure to make information returns within the designated time period

Would you like to know more?

If you would like to discuss how the above may affect your business, please get in touch with your usual Blick Rothenberg contact or John Havard using the form below.

Personal tax is one of the most complex areas of wealth management and can significantly erode your wealth over time

Blick Rothenberg is considered to be market leaders in the taxation of non-UK domiciled individuals and offshore trusts, as well as cross-border personal taxation.

We have a strong base of clients in the UK and a broad and longstanding international focus too, acting for a large number of non-UK domiciled individuals and international families. So, we understand the complexities that US citizens face when living, working and operating businesses in the UK.

Whether you are a start-up entrepreneur, a wealthy family with complex affairs, or a business executive, our dual-qualified team of tax advisers will look after your US UK personal tax affairs as well as those of your business.

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