Thun Financial Advisors, Copyright © 2015
Designing and implementing an effective long-term wealth management strategy is a complex undertaking. Changing market conditions, shifting tax and compliance rules, and evolving family circumstances must all be considered. For cross-border families, many additional complexities must also be factored into the investment equation. These include home country and country of residence taxation, compliance (FATCA), currency considerations, and international estate planning. When some or all family members become U.S. citizens or permanent residents, U.S. taxation becomes a permanent feature of the investment decision equation even if the family leaves the United States.
What is a “Cross-Border” Family?
We use the term “cross-border” broadly to refer to any investment planning circumstance that involves families of mix-nationality and/or whose financial affairs extend across borders. Cross-border families include Americans living abroad, U.S. residents of foreign origin, and non-U.S. residents who are investing within the United States. Such families commonly have a mix of citizenships and/or immigration statuses. Cross-border families typically hold a range of financial assets and business interests that are subject to taxation in more than one national jurisdiction.
In the following pages, we present an introduction to the investment and tax issues that are unique to cross-border families residing in the United States (Thun Financial Advisors publishes extensive research on investment topics related more specifically to U.S.-connected families living outside the United States; see www.thunfinancial.com). These topics include:
- Investing for long-term wealth and the case for making investments in securities;
- U.S. citizenship-based taxation and the new FATCA law;
- Foreign financial assets – taxation of non-U.S. investment and retirement accounts, and non-U.S. financial products;
- Strategic use of U.S. retirement accounts and regular investment accounts;
- Cross border estate planning considerations; and
- Investment strategies for maximizing wealth in a cross-border financial planning environment.
Our goal is to help cross-border families implement effective investment strategies to maximize their long-term, after-tax wealth potential whether they remain in America, move abroad, or maintain something in between.
The Case for Building Wealth by Investing in Stocks, Bonds and Other Financial Instruments
Newcomers to investing are often skeptical that real wealth can be effectively built through steady consistent investing in brokerage or retirement accounts.
Empirical analysis of historical data, however, firmly demonstrates that investing in a well-diversified portfolio of publicly traded securities (stocks and bonds) offers superior long-term returns. Furthermore, portfolio investments offer high levels of security against fraud and, when managed properly over long periods of time, have almost no risk of losing value.
This presentation does not afford space for a full treatment of the case for building wealth through portfolio investing, but the graph below clearly shows the very attractive returns that have been achieved historically through investing in U.S. markets. Similar rates of returns have also been achieved by investing in portfolio investments outside the United States.
The first step to successful wealth-building is to recognize that, for most of us, portfolio investing represents the most advantageous way to systematically build wealth over a lifetime.
Source: Ibbotson Associates
Defining U.S. Tax Status
For U.S. tax purposes, an alien (not a U.S. citizen) falls into one of two categories: non-resident alien (NRA) or resident alien (RA). Non-U.S. citizens are automatically considered non-resident aliens, unless they meet a substantial presence test or hold a green card. Non-resident aliens are taxed only on their income effectively connected with a U.S. trade or business and, to a limited extent, investment income from other U.S. sources.
Taxation of resident aliens (green card holders or permanent residents) is essentially the same as it is for U.S. citizens. This includes worldwide income taxation. Long-term permanent residents that hold a Green Card for 8 of the last 15 years become permanently subject to U.S. taxation of their worldwide income, even if they leave the United States. Only by “expatriating” (renounce citizenship or permanent residence) and potentially paying an expatriation tax according to the same rules that govern expatriating U.S. citizens can long-term permanent residents eliminate U.S. taxation of their worldwide income when they leave the United States.
Given these considerations, we will refer to U.S. citizens and U.S. permanent residents collectively as “U.S. taxable persons” because they are treated the same for U.S. tax purposes. When reference is made to citizenship-based taxation, it should be understood that the same rules apply to U.S. permanent residents.
U.S. Citizenship-Based Taxation and FATCA
Formulating an investment strategy for cross-border families is complicated by two unique aspects of the U.S. tax system: 1) Citizenship-based taxation of worldwide income and; 2) the Foreign Account Tax Compliance Act (FATCA).
The United States, like most other countries, imposes individual income taxes based on residency status. If you live in that country, you are expected to pay tax in that country. In almost all countries, including the United States, residency based taxation extends to the resident’s worldwide income. The United States, however, goes one step farther in that it also imposes worldwide income tax on the basis of citizenship whether or not the taxpayer (or permanent resident) resides in the United States. This creates tax complications for U.S. taxable persons who leave the United States.
Citizenship-based taxation has long been a feature of the U.S. tax code. The recent rollout of FATCA, however, makes the actual impact of citizenship-based taxation a far more serious matter than it was before. FATCA dramatically alters the tax landscape for U.S. taxable persons with foreign investment assets, as is common among foreigners in America as well as U.S. citizens living abroad.
FATCA, passed in 2010, requires all foreign financial institutions to report on all financial assets owned by U.S. taxable persons. These foreign financial institutions include all banks, brokerage firms, mutual fund and other investment companies, insurance providers, pension managers, etc. located outside the United States.
Before FATCA, cross-border families faced very little risk of IRS sanction if they failed to report, or reported incompletely, foreign financial assets. The IRS simply could not know what assets were owned abroad by U.S. taxable persons. FATCA radically changes this because the law will eventually provide profound transparency to the IRS for assets held by U.S. taxable person anywhere in the world.
Going forward, U.S. taxable persons must assume that the IRS has full information about their assets both in the United States and outside the United States. Cross-border families with non-U.S. assets and investment income are being compelled to report on these assets with high degrees of precision. Furthermore, these reporting demands will not go away even if the U.S. taxable person eventually leaves the United States permanently (unless they formally expatriate). This new reality has significant implications for investment decision-making.
U.S. Taxation of Non-U.S. Assets
FATCA makes it imperative that all assets and income are reported on a worldwide basis for taxpayers subject to U.S. taxation. If foreign financial assets could be as easily reported as standard U.S. investment assets are, this would not be a particularly burdensome demand for most taxpayers. The problem is, however, that the U.S. tax code imposes very complex reporting rules on financial assets held outside of the United States. Furthermore, non-U.S. financial products are punitively taxed. A few of the most salient examples include:
- Non-U.S. mutual funds, hedge funds, and a broad range of other investment structures. These kinds of investments, when not U.S. registered, are defined by the IRS as Passive Foreign Investment Companies (PFICs). PFIC investments are subject to extremely punitive U.S. tax treatment. An equally pertinent consideration is the technical difficulty of reporting PFICs properly on a U.S. tax return. The IRS estimates reporting annually on a single PFIC investment requires more than 30 hours of record-keeping and tax preparation time.
- Foreign trusts. Many types of assets besides what we commonly think of as trusts are treated as foreign trusts for U.S. tax purposes. This includes almost all non-U.S. registered life insurance policies (except term life insurance); many types of non-U.S. retirement accounts, and of course, actual trusts governed by non-U.S. jurisdictions with U.S. beneficiaries.
- Non-U.S. businesses. Any kind of non-U.S. business venture (partnerships, corporations, joint venture companies, etc.) owned more than 10% by a U.S. taxable person are subject to special U.S. tax treatment. Failure to declare U.S. reportable business income results in very severe penalties. Non-U.S. business enterprises may be a great source of wealth, but they in no way relieve U.S. taxable persons of their U.S. tax obligations.
These are just some of the most common scenarios in which foreign financial assets become a U.S. tax nightmare for unsuspecting foreign families. FATCA substantially increases the risk of the IRS becoming aware of improperly reported assets. It is important to reiterate that all of these issues are relevant to foreigners who come to America and become U.S. taxable, and remain relevant even once they leave the United States if they acquired permanent U.S. resident or U.S. citizen status.
Investment Strategy Response
An obvious implication of the restrictive U.S. tax treatment of foreign assets is that U.S. taxable persons should generally strive to keep their investments in U.S. accounts. It is important to not misconstrue this statement to imply that U.S. taxable persons must keep their investment confined to U.S. assets. U.S. accounts and holding structures can be used to own virtually any kind of investment from anywhere in the world. When held through U.S. accounts, the punitive treatment of foreign investments described above is usually avoided.
Use of U.S. Qualified Retirement Accounts by Foreigners in the United States
While working in the United States, most foreign nationals are able to contribute to workplace and individual retirement plans. Understanding how to properly employ tax-advantaged retirement accounts is particularly vexing for foreign nationals who might be unsure of their ultimate country of residence during retirement. Mistakenly, these plans are often withdrawn when leaving the United States permanently.
Generally, it is advantageous for U.S. tax purposes and hence beneficial to contribute to a retirement plan while working in the United States, even if an investor expects to eventually leave the United States. Qualified retirement plans (IRAs, 401ks, 403b, defined benefit plans, etc.) all have slightly different structures, rules and contributions limits. In general, however, they offer workers the opportunity to defer taxation on their current income until retirement when their tax rates are likely to be lower than they are during peak earning years. Over a lifetime of saving and investing, these accounts can provide enormous benefits not only in terms of tax savings and tax deferral, but also in terms of asset protection and estate planning.
If the investor anticipates residing outside the United States in retirement, careful consideration must be made regarding how these accounts will be taxed after the owner has left the United States. Many factors come into play, including whether the account owner is a U.S. taxable person or becomes a non-resident alien, country of residence tax treatment of foreign retirement accounts and applicable income tax treaties that many countries have with the United States. Absent a special tax treaty provision, distributions from a retirement plan are subject to a 30% U.S. withholding tax if the account holder is a non-resident alien. Fortunately, most income tax treaties provide an exemption from, or a reduction of, U.S. withholding tax on pension and annuity income. The United States maintains tax treaties with approximately seventy foreign countries. As a result, the investor might only be taxed in their home jurisdiction.
It is usually a mistake to withdraw assets from a U.S. qualified retirement plan before age 59 ½, even when the account holder is leaving the United States permanently. Early withdrawals are always subject to income tax and a 10% excise tax (the “penalty”). More tax efficient alternative strategies exist, including leaving the assets in the United States and withdrawing slowly over time throughout retirement. Another option is to take “substantially equal periodic payments” which are annuity-like payments that you must take annually over time. Roth conversions, furthermore, may be a viable strategy in certain cases to efficiently mitigate potentially punitive tax treatment caused by U.S. withholding on retirement accounts owned by non-resident aliens.
Where the tax implications can be effectively managed, the investor is likely to benefit from leaving the assets in a U.S. retirement account. U.S. retirement accounts have access to highly efficient, globally diversified investment options that are typically superior to alternative investment options available for investment if the assets are transferred abroad and invested through non-U.S. financial institutions.
U.S. retirement accounts can be a key component of an effective wealth management strategy even when the investor anticipates leaving the United States. The key to investment success is to anticipate tax issues so that effective strategies can be devised and optimal investments can be chosen.
Taxation of U.S. Brokerage Accounts
U.S. taxation of non-resident aliens’ U.S. brokerage accounts is sufficiently benign so as to make them comparatively attractive and globally competitive. Non-resident aliens are not taxed in the United States on capital gains in their brokerage accounts. They are also not taxed on non-U.S. source income, which includes almost all publicly traded bonds and the stocks of foreign companies. The income which is subject to tax is subject to federal withholding at a standard rate of thirty percent (30%). However, in many of the income tax treaties that the United States has negotiated with approximately seventy foreign countries, the treaty eliminates or provides a lower withholding rate for its tax residents. Even in countries with which the United States does not have such a treaty, the foreign investor may be able to apply a tax credit at home for the amount of tax withheld in the United States.
For U.S. taxable persons residing abroad, the reasons to invest in the United States are quite clear. Because the United States treasury taxes U.S. taxable persons on worldwide income, there is simply never a tax advantage, or at least no legal tax advantage, to invest elsewhere. In fact, given the multitude of onerous tax and reporting requirements specifically applied to foreign financial assets, including:
- the treasury reporting regulations for passive foreign investment companies (PFICs), personal investment companies (PICs) and foreign trusts;
- disclosure of all foreign financial assets through the FBAR/FinCen-114 report; and
- the punitive tax regime that is applied to foreign investment funds and virtually all other PFICs.
U.S. taxable persons are making a fundamental mistake by favoring foreign-domiciled investments over a U.S. brokerage account. Now that FATCA reporting by overseas financial institutions is going into full effect, these mistakes are unlikely to be forgiven or forgotten.
U.S. Estate Planning Issues for Non-Residents
Federal estate and gift tax burdens have greatly diminished over the past decade for Americans (citizens and permanent residents), with the growth of the lifetime combined estate and gift tax exemption to $5.43 million (2015) ($10.86 combined credit for an American couple). However, the estate and gift tax exemption for non-U.S. persons has not followed suit, and remains at a mere $60,000. This can be overcome if the entire estate is left to a U.S. citizen spouse. In other cases, U.S. federal transfer taxes are an important consideration for the foreign investor to mitigate through (1) portfolio design that limits exposure to U.S. transfer taxes; and (2) cross-border estate tax analysis and planning. Otherwise, foreign investors face up to a maximum rate of forty percent (40%) estate tax liability on their taxable U.S. estate.
U.S. Estate Tax Situs Rules
U.S. transfer taxes apply to all “U.S. situs” assets held by non-U.S. persons, whether held inside or outside the United States. The following assets are generally considered to be “U.S. situs” assets:
- Ownership of U.S. real estate (can be outright ownership of a home, condo or office building, or participation in a trust such as a REIT);
- Ownership of U.S. retirement accounts (pension plans, IRAs, 401(k) and 403(b) plans, annuities, etc.);
- Shares of U.S. companies, regardless of whether the stock certificates are held within the United States; and
- Tangible personal property located in the United States (e.g., art or other collectibles, jewels, automobiles, etc.).
Conspicuously absent from this list, and accordingly non-U.S. situs, are most publicly-traded U.S. fixed income, foreign fixed income, and shares of foreign company stock. Indeed, a globally diversified portfolio should include a considerable amount of assets that are not subject to U.S. transfer taxes.
Mitigating the Estate Tax on U.S. Situs Assets
Considerable mitigation of U.S. estate and gift taxes can be derived from the analysis and application of the estate tax treaties and protocols that the United States shares with other nations. For example, the Canadian protocol increases the exemption from $60,000 to over $2 million. While the United States shares income tax treaties with about seventy nations, it only maintains estate tax treaties with eighteen countries. For residents of other countries, primary relief may come from tax credits granted by the home country to offset estate taxes paid in the United States.
Cross-border estate planning may be able to avert or minimize U.S. estate tax liability further through such estate planning devices as trusts (credit shelter, grantor, non-grantor, crummy, QTIP, QDOT – the varieties are quite extensive), non-U.S. companies such as personal investment companies (PICs), or other “offshore” corporate constructs that are not available (or tax toxic) to U.S. tax residents. However, those who attempt to utilize estate planning methods to mitigate their global estate and inheritance tax burdens should proceed with great caution and only with the assistance of legal counsel that fully comprehends the tax implications of the plan both under U.S. law and the law of the investor’s country of domicile. Often, estate planning structures that work well in the United States will prove futile, or even backfire and trigger income and/or estate taxes, in the investor’s home country. This is an area where additional costs for unique cross-border expertise can avoid substantial legal complications.
A Note on Foreign Trusts
Any trust becomes a foreign trust for U.S. tax purpose if the trust is either governed by a non-U.S. legal jurisdiction or if a non-U.S. person has any control over the trust. Control includes the right of a beneficiary to receive a distribution from the trust. It is a very common cross-border planning outcome that a trust that was never expected to become in any way U.S. taxable becomes U.S. taxable when a trustee, grantor or current beneficiaries becomes a U.S. taxable person. At that point, the entire trust may become subject to U.S. tax reporting requirements. Consequently, care must be taken when foreigners become U.S. taxable persons to ensure that U.S. tax time bombs are not inadvertently created.
Investment Response: How to Effectively Build Wealth in a Complex Cross-Border Environment
Given the proceeding discussion, it is clear that U.S. tax rules make effective cross-border wealth accumulation a complex undertaking. The good news is, however, that the United States also affords investors with superior investment opportunities compared to what can be found anywhere else in the world. U.S. markets offer unparalleled access to low-cost investment vehicles such as index funds and exchange-traded funds (ETFs), low commissions on stock and bond transactions, open access to global investment opportunities, and unmatched transparency and liquidity. Furthermore, these advantages do not apply only to U.S. assets. U.S. investment vehicles and financial institutions offer superior opportunities to invest in global assets. For example, we have shown elsewhere that a diversified portfolio of Europeans stocks can be owned more cost efficiently and tax efficiently through U.S. brokerage account than through investment accounts anywhere in Europe (link to currency paper).
This U.S. investment edge outweighs the negative effects of the relatively complex cross-border tax treatment as long as those tax complexities are managed effectively. Creative, strategic investment and tax planning can go a long way to ultimately increase after-tax rates of return. Some common approaches employed by expert cross-border investment advisors include:
- Build a broadly diversified, multi-asset class, multi-currency portfolio. Stocks and bonds and even alternative investments such as REITs (Real Estate Investment Trusts) can be owned tax efficiently through the use of low-cost ETFs held at U.S. financial institutions.
- Where U.S. or even foreign retirement accounts are “qualified” across borders by bilateral income tax treaties, use these accounts to house investments that might otherwise create tax problems in the United States or country of residence if held in a non-qualified, taxable brokerage account. The retirement account “tax wrapper” supersedes the tax treatment of the underlying investments.
- Use different tax statuses within families to plan and mitigate future tax problems. For example, where only one spouse is a U.S. taxable person, concentrate U.S. situs assets in accounts owned by the U.S. person and non-U.S. situs assets in the accounts of the non-U.S. spouse.
- Optimize portfolios to take advantage of the different tax treatment of different kinds of investment income based on different effective tax jurisdictions in multi-jurisdiction households. For example, if one spouse is a U.S. person but the other one not and the couple lives in Switzerland, it makes sense to concentrate current income-producing investments in the U.S. spouse’s accounts and capital-gain-producing investments in the Swiss spouse’s account.
- Apply a disciplined, rule-based approach to periodic portfolio re-balancing that exploits the long-term tendency of non-correlated assets classes to “revert to the mean” over long periods of time.
- Consider the underlying currency exposures within the portfolio and make sure they are appropriate for the family’s long-term needs. In general, families with financial goals not denominated in dollars (e.g. a European retirement will require primarily euros expenditures) should own portfolios with currency exposures tilted toward the currency of their ultimate residence.
- Continue to monitor changes in tax and compliance rules that impact the effectiveness of current investment strategies. Tax and compliance environments are constantly changing and investment strategies must respond.
- Use U.S. Roth retirement accounts and 529 education accounts while residing in the United States to accomplish tax-efficient generational wealth transfer.
Conclusion – Long-Term Wealth is Within Reach
Cross-border planning and investing is complex. But it does not have to be overwhelming. With proper guidance a strategic, long-term investment strategy can be designed and employed effectively. Thun Financial Advisors manages the complexities and invests for its clients so they can enjoy the fruit of disciplined, long-term investing.