The ongoing saga of Brexit is causing economic repercussions throughout the UK. From business uncertainty to concerns about trade and product availability, one of the biggest impacts so far is the sharp decline in the pound’s value.
And when it comes to US expats living and working in the UK, the repercussions are twofold. First, there is the obvious implications changing local currency value have on exchange rates. But more importantly, and more subtly, there is also a specific tax opportunity regarding UK investments for US tax purposes.
This covers UK investments that are considered to be passive foreign investment companies (PFICs), and their affect on US income tax.
Why PFIC strategies are necessary for US expats
The rules and regulations surrounding PFICs are intricate and can be difficult to grasp. However, US expats that hold foreign investments must have a broad understanding of these rules, as the tax implications can be severe.
As a general rule of thumb, the majority of foreign mutual funds fall under the PFIC banner. This is the case even if they are held through a savings account set up as tax deferred.
This is because a PFIC is strictly defined as a non-US corporation that covers one of the following:
- At least three-quarters of the corporation’s income is defined as ‘passive’. This can be interest or dividends, for example. Or
- At least half of the corporation’s assets are considered passive income producing. These could be cash, loans or stock, for example. Foreign mutual funds, whether they are held indirectly or directly, usually come under this category.
What are the tax implications of PFICs for US expats?
If a US expat has any percentage interest in a PFIC then they come under the rules governing the tax implications. This applies even if they hold a tiny percentage.
The default rules say that any income made from investing in a PFIC in the form of distributions, and anything earned following the sale of a PFIC could come under strict US federal tax rates. The highest rate of tax can in theory be imposed by the US Government on the US taxpayer. This currently stands at 37% tax, and this remains true even if lower capital gains rates would usually apply.
There is also a significant penalty for interest charged, which will compound on a regular basis as long as the US expat taxpayer holds the PFIC. Additionally, in many cases no foreign tax credit is available.
Two main PFIC strategies for US expats
There are two avenues for US expats to reduce the tax implications that are present under the default rules. The first is a Qualified Electing Fund (QEF). This would allow shareholders to include the pro rata earnings shared from the QEF in their gross income. The pro rate share of net capital gain from the PFIC would then be considered long-term capital gain. If this is done, then there are no harsh tax rates and interest charges.
To make this election, the US expat shareholder must hold a PFIC Annual Information Statement from the PFIC itself. This can cause problems, as it is often difficult or impossible to get hold of this statement e.g. the fund may not produce one.
The second option is a Mark-to-Market (MTM) election. This would mean shareholders can include the excess of the market value of their PFIC as ordinary income every year. This applies as at the close of the tax year over the purchase price. In this case, there are no punitive tax or interest charges. This option is usually available only to marketable securities. And as PFIC investments generally consist of these, this is an easier route than the QEF election.
A US expat PFIC holder must make an MTM election for the first 12 months of ownership. This will allow them to skip the default regulations entirely. However, most US expat investors only find out there is an issue with their PFIC a number of years into the investment cycle.
It is possible for the holder to change from the default tax regime to the MTM regime by electing for the current year. However, this will mean that the default rules will continue to apply for the first 12 months of the MTM election. The MTM rules will then come into play the year after.
In both cases, there are still challenges to overcome, this is because the US tax will arise year on year, but UK tax may not be due until the investment is actually sold. Absent great care this can result in lower US tax rates but double taxation on the eventual sale when UK tax is due.
How does the value of the pound against the dollar affect US expats?
In terms of the value of the pound and dollar, all US citizens are considered for US tax purposes as using the dollar as their main currency. This includes US expats and means that for all transactions, including foreign investments, the US dollar is the ‘functional currency’ for tax purposes.
This means that, even if the PFIC’s value has gone up over the years, because of the declining value of the pound, then the US dollar value might have either decreased or incurred insignificant increases e.g. you have made a gain in GBP on the investment which is reduced by an FX loss when converted to USD.
Under the circumstances, US expats with any UK investments should consider whether there is any opportunity within the current economic environment to limit any negative implications for PFICs. This will then make ownership of PFICs less of a tax liability in the future.
For advice and assistance on all aspects of US expat taxes, including PFICs and any foreign investments, contact the team at Ingleton Partners. We have the expertise and experience to work through all US and UK tax affairs to ensure compliance and to work on the best strategies to mitigate any implications, penalties or problems.