U.S. taxpayers with foreign investments should be proactive
Taxpayers and their advisors should closely examine how multiple layers of international tax law and new U.S. requirements could affect taxpayers’ investments and tax liabilities
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
In the Greek myth of Theseus and the labyrinth, Theseus is sent into a maze designed to prevent anyone from escaping. A minotaur stalks the hallways of the labyrinth. But Theseus comes prepared with a ball of string. He unravels it as he makes his way through the labyrinth, slays the minotaur, and follows the string back to his ultimate escape (it was a very long ball of string).
Although we don’t send people into labyrinths, the same principle applies for U.S. taxpayers considering participating in foreign transactions: Ultimate success is favored by preparation.
When it comes to foreign investments, multiple sets of tax laws can apply. Taxpayers will encounter taxation from U.S. and foreign governments on federal, state, and local levels. Added to this mixture are new IRS tax rules coming into effect under the Foreign Account Tax Compliance Act (FATCA).
Taxpayers and their advisors should be prepared to complete some extra planning and possibly legwork to properly navigate the rules for ultimate success.
The benefits and disadvantages of foreign transactions
Many of us have heard whether through friends or media, that diversification is key to investing success. Phrases such as “don’t put all your eggs in one basket,” “emerging markets,” and “foreign mutual funds” make it seem like higher income is only a mouse click away.
Without a doubt, there are tremendous benefits in using foreign investments to build wealth. This includes investments such as foreign educational saving plans for children, foreign pension arrangements, foreign mutual funds, fast-growing foreign stock markets, and so on.
But what many taxpayers forget is the third component of the three constants of life: death, the speed of light, and taxes.
The taxes depend on the investment
The U.S. government taxes income based on a worldwide system. This means that if a taxpayer is a U.S. citizen or green card holder, that taxpayer will be reporting worldwide income whether or not he or she lives in the U.S.
Many taxpayers think that foreign investments have much higher returns than domestic ventures, and that the benefits outweigh any costs. Taxpayers also commonly think that the U.S. must tax foreign investments in the same way it taxes domestic investments. The truth, as taxpayers will encounter frequently in international tax law, is: It depends.
If a U.S. taxpayer is buying and selling stocks on foreign stock markets, the gain will be treated the same as if the taxpayer were buying and selling on U.S. stock markets.
But once we move away from stocks, the picture becomes much more complex. Here is an example involving foreign education savings plans.
U.S. Qualified Tuition Plans (QTPs), also called 529 plans, allow parents to save tax-free money for their children’s education. Foreign education savings plans, however, don’t get the same tax treatment.
For example, Canada offers a Registered Education Savings Plan (RESP). Let’s suppose that the RESP gets higher returns than a U.S. QTP. On the surface, the foreign RESP is better for the parents, compared with the domestic QTP.
Then, taxes come into play. In the U.S., the parents’ RESP will be treated as a foreign trust. The parents will be required to file Forms 3520 and 3520-A every year, and report all of their contributions and earnings every year as taxable income on their Form 1040. Both forms require extensive information, including RESP account details, and are complicated by differing exchange rates and conflicting tax years. Domestic QTPs, on the other hand, are not reported as trusts, and earnings are not taxed until distributions begin.
In this case, even though Canada is highly aligned with the U.S. on taxation and has a comprehensive income tax treaty with the U.S., earnings from Canadian RESPs are still taxable to the U.S. as they occur, and there is complexity involved in reporting this foreign investment.
The important thing to remember is that taxpayers with foreign investments and their advisors should thoroughly examine the tax regimes of all countries involved in the taxpayer’s investments to determine whether the benefits of higher returns outweigh potentially increased taxation.
The Foreign Account Tax Compliance Act is also changing the landscape
Several new aspects of foreign investments are emerging as a result of FATCA, which was introduced in 2010 and has been coming into effect incrementally since then. FATCA was designed to ensure that U.S. taxpayers, regardless of whether they live in the U.S., are complying with U.S. tax laws by reporting all of their worldwide financial assets.
Under FATCA, foreign financial institutions (FFIs) are required to report to the IRS certain information on the accounts of any U.S. persons. To enforce this rule for any FFIs that do not comply, the IRS requires 30 percent tax withholding on any payments of U.S. source income to the FFIs.
Some FFIs are unable or unwilling to comply with the FATCA regulations, and, as a result, some U.S. taxpayers are finding that their accounts are being closed or that they cannot open an account at all.
This situation can lead to premature recognition of taxable income and a higher than expected U.S. tax burden. For example, if a taxpayer has a foreign retirement plan similar to a U.S. employer’s 401(k), and the FFI closes the account, the income from that account would be distributed and, as a result, taxable to the U.S. in the same year.
Taxpayers whose foreign retirement accounts are being closed or whose U.S. tax liabilities are being affected because of FATCA may be looking for methods to defer U.S. taxes on their retirement account earnings until they reach retirement age and begin distributions.
Withdraw funds. Under current U.S. tax law, rolling over foreign retirement plans into a U.S. retirement plan is not allowed. Rollovers are allowed only from one qualified U.S. plan to another qualified U.S. plan. If taxpayers with foreign retirement plans simply withdraw the funds from the plan, the 10 percent penalty for early withdrawal will not apply on these taxpayers’ U.S. returns, because that penalty applies only to domestic U.S. retirement plans. However, the earnings on the foreign retirement plan will be taxable to the U.S. as ordinary income, and there may be tax consequences in the foreign nation.
Transfer income. Another possible option for taxpayers whose accounts have been closed is transferring the foreign retirement income to another FATCA-compliant FFI in the same nation. Transferring the funds could eliminate U.S. recognition of income until the taxpayer actually takes distributions of the amounts. For example, this has been allowed under Article 18(1) of the U.K. tax treaty, which has been interpreted as allowing a tax-free transfer from one U.K. pension scheme to another U.K. pension scheme.
Taxpayers and their advisors should look closely at the tax treaty between the foreign country and the U.S. to see what options, if any, are available to them. They should also look into the foreign tax credit to determine whether it can alleviate double taxation that may occur.
Find a compliant FFI. The best course of action for taxpayers with foreign investments is to find an FFI that is complying with FATCA regulations and is willing to open and maintain accounts for U.S. taxpayers. At the very least, taxpayers with foreign accounts should look for information from their FFI or check directly with the institution on the details of the FFI’s compliance with FATCA. Taxpayers should proactively discuss the new law with their FFIs and determine what effects, if any, the law will have on their account.
Taxpayers armed with knowledge of how these rules apply to their specific situation may find ways to navigate the labyrinth of foreign and U.S. tax laws in a better way than those who did not bring their ball of string.