US Insights

Tax efficient investments

Governments decide 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 example of such a policy is the Individual Savings Account (ISA) in the UK. Successive Governments maintain the view that regular saving is to be encouraged for individuals. 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 ISA. Small savers are unlikely to want to save regular amounts in excess of this limit. Furthermore, it is simpler to give all savers eligibility to a limited amount of tax saving, than to create an investment vehicle that is 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:

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

Typically, in these circumstances, 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 encourage the same type of activity for a population, the methods they employ to achieve this 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. Realistically, all income and gains arising within the ISA are likely to be liable to host country taxation.

Investment advisors should be consulted in these ‘tax change’ situations, as the economics of a particular investment may have changed fundamentally. For example, in the case of an individual who has invested in US Municipal Bonds while they were resident in the USA. The interest on the 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.

Due to past defaults, 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 no ‘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:

Recognition that the minimum level of investment required meant that investors would be individuals paying the highest rate of US Federal Income Tax
Computation of the after-tax income a top rate taxpayer would get from a AAA-rated debt instrument, paying taxable interest at the current market rate
Offering of 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
– The actual ‘premium’ offered over the ‘after-tax’ amount was determined by other market forces

If the Municipal Bond interest becomes exposed to host country taxation, the full rationale behind the original investment decision should be revised, and a ‘continued fit-for-purpose’ test applied.

Another point to discuss with an investment advisor, is a 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 a paid, third-party professional is required to assist with statutory information reporting, the associated professional fees should be considered 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

This short article does not 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 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.
There is no issue if the individual is 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.

A remittance basis taxpayer will require advice if some of the interest is to be remitted to the UK.

Individuals taxed in the UK on the arising basis should have 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 designed to make non-US mutual funds unattractive to US domestic investors
This results in an unpleasant US tax treatment, as well as 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 in any other currency than $US, is computed using the historic $US exchange rate 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 rather 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 Treaty negotiators were intent on keeping the trans-Atlantic mobility of labour undeterred by cross-border tax issues arising from pension plan membership. Consequently, the Treaty contains several provisions to eliminate such issues.
The Treaty does not 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
Failure to make information returns within the designated time period incur substantial penalties.

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 one of the team using the form below.

Our expert team

Partner, Head of Private Client

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

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