|A comparison of the UK and the US tax treatment of investments|
|Friday, 28 August 2009 11:30|
Investors with UK and US exposures need to take particular care in selecting their investments. By Samantha Morgan, Partner, Jay Krause, Partner and Philip Munro, Associate, Withers LLP.
Globalisation has led to many successful families and their interests becoming international in profile. Accordingly, tax and succession planning for many families will now have a cross-border element which can mean that the tax position of family investments needs to be considered from the perspective of more than one tax regime. As different tax systems can treat certain investment types very differently, international families need careful advice to ensure that their investment strategy is tax efficient across the relevant jurisdictions. As a result of historically close ties, many successful families have both UK and US tax exposures requiring them to develop investment strategies that are tax efficient for both tax regimes. We compare below the US and UK tax treatment of certain investment types as an example of the form of cross-jurisdictional tax analysis that may be required for international families.
However, before comparing the US and UK tax treatment of different investment types, it is worth comparing the connecting factors that bring these tax regimes into play. In the UK, only an individual who is resident in the UK for tax purposes is liable for UK capital gains tax (‘CGT’) while an individual who is not UK resident for tax purposes is, in principle, liable to UK income tax only on UK source income (e.g. rental income from UK property). CGT is charged in the UK at a flat rate of 18%; income tax rates presently rise to 40% although for those earning more than £150,000 per annum will rise to 50% from 6 April 2010.
A non-domiciled UK resident is liable to income tax and CGT on all UK source income and gains although he can, per tax year, elect to be taxed on the remittance basis so that he is only liable to UK tax on overseas income/gains which are actually remitted the UK (although a non-domiciled individual who has been UK resident for seven out of the previous nine tax years must now pay an annual UK tax charge of £30,000 to claim the remittance basis). It should be noted that there are UK offshore anti-avoidance provisions that look to assess income and gains in offshore structures (e.g. non-UK trusts and offshore companies) to UK tax in the hands of beneficiaries/beneficial owners but these only apply to individuals who are UK resident for tax purposes.
Residency is, accordingly, the crucial factor for UK tax exposure. The US, by contrast, looks to tax the worldwide income and capital gains of all US citizens, ‘permanent residents of the US’ (so-called ‘green card’ holders) and persons tax resident in the US. This tax applies to citizens and green card holders regardless of where in the world they may live. Further, non-US persons resident in the US, e.g. employees on secondment, are frequently unaware of the US worldwide tax net and tend not to adjust their investment portfolios for US tax issues prior to moving there. As the US has an extensive set of ‘offshore’ anti-avoidance rules which often adversely impact many categories of non-US investments, a failure to enquire into the tax characterization of non-US investments for persons subject to the worldwide US tax net can result in seriously adverse tax consequences.
US federal tax generally applies to ordinary income at marginal rates of up to 35% and gains on assets held for more than one year at 15%. However, where various offshore anti-deferral rules apply, adverse results can quickly follow. Two of the offshore anti-deferral rules apply to investments through trusts and/or holding company structures and one applies based on whether the investment itself may be adversely classified. One example is when gains in investments which are adversely classified are taxed at the highest ordinary income tax rate and suffer an additional interest charge being compounded over the duration of the holding period. Some (few) investors may take comfort in knowing that these tax and interest charges cannot exceed the amount of the gain; (most) other investors will prefer to avoid the application of these rules.
The following sets out a comparison of the UK and US taxation of certain investment types:
1. Interest on cash and cash equivalents
1.1 UK treatment
Interest that is generated from cash holdings is income for UK tax purposes and is subject to income tax. In some instances, cash is held in cash funds which could sometimes constitute an offshore fund for UK purposes (see section 4 below).
1.2 US treatment
Interest on cash holdings will normally be subject to US income tax at ‘ordinary income rates’. Persons subject to the US income tax regime also need to be aware of the possibility of being taxed on exchange rate gains. Typical examples would include a US citizen or green card holder holding Sterling offshore for UK remittance tax purposes and converting such amounts back into dollars at favourable rates as well as paying off Sterling denominated mortgages at favourable rates.
Generally, it should be noted that US persons are required to report a number of financial arrangements to the US Internal Revenue Service (‘IRS’) whether or not those US persons have any US tax exposure. As an example, a US person who has an interest in, or signature (or other) authority over, one or more foreign financial accounts, must, if the aggregate value of all relevant accounts exceeds US$10,000 at any time in the calendar year, file a Form TD F 90-22.1, commonly referred to as a foreign bank account reporting form, or ‘FBAR’. The penalties that can apply where there has been a failure to make an FBAR return can be significant. FBAR reporting obligations apply to a broad range of accounts and investments including foreign bank accounts and any non-US securities or brokerage accounts. Current guidance provides that interests in individually owned stocks and bonds are not subject to reporting under the FBAR. It further provides that the ownership of shares in a mutual fund does constitute a financial account under the FBAR rules. Informally the IRS has indicated that non-US private equity and/or hedge fund interests likewise may constitute ‘financial accounts’ for purposes of the FBAR rules in some instances. US persons must ensure that they have full professional advice as to their tax filing obligations to protect their position.
2.1 UK treatment
Company dividends are subject to income tax for UK purposes. The higher rate of UK income tax on individuals in respect of dividends is presently 32.5% (although this will rise to 42.5% from 6 April 2010 for those with annual earnings in excess of £150,000).
The proceeds of the sale of shares or the liquidation of a company are generally subject to CGT. In contrast to the high rates of income tax, the UK now has a flat rate of CGT of 18%.
It should be noted that shares in any non-UK company (including LLCs) that do not comprise a single position (i.e. are not a direct company holding) can constitute an offshore fund for UK rules (considered at section 4 below). In addition, certain types of entities, such as single members LLCs, will be transparent for US tax but opaque for UK tax purposes.
2.2 US treatment
While dividends have historically been taxed as ordinary income, certain ‘qualified dividends’ are currently being taxed at favourable capital gains rates. This applies to dividends from US companies and certain qualified non-US companies. Dividends from non-US companies eligible for income tax treaty protection under a treaty with sufficient information exchange provisions should be treated as favourable qualified dividends. This treatment is scheduled to expire December 31, 2010 at which time ordinary income tax rates will apply. Accordingly, US taxpayers receiving dividends who are also subject to UK tax on such dividends may find themselves with larger than expected tax bills.
Gains on sales of equities investments (whether US or not) will be taxed at 15% where they are held for more than 12 months or at ordinary income rates if held for 12 months or less. Accordingly, for US tax purposes, longer retention of investments can improve their tax treatment. With the abolition of CGT taper relief in the UK, the rates of UK tax on investments are not generally affected by the duration of the period of ownership other than in relation to the ‘bed and breakfast’ rules which can set aside transactions in relation to the same investments within a 30 day period.
It should be noted that non-US companies can be treated as so called ‘PFICs’ which can result in adverse US tax implications (discussed at section 4.2 below).
3. US mutual funds
As a result of the disadvantageous regime that applies to US persons investing in non-US funds (see section 4 below), US mutual funds are very popular investments for US persons. In practice, mutual funds distribute (via ‘dividends’) their annual income and net capital gains. Due to special US tax rules for mutual funds, investors are entitled to treat these dividends as being comprised of the underlying types of income and gains comprising the dividend. Thus the portion of the dividend comprised of net capital gains can be eligible for favourable 15% rates.
Gains on sales of mutual fund investments will be taxed at 15% where held for more than 12 months or ordinary income rates if held for 12 months or less. US mutual funds will, however, invariably be offshore funds for UK purposes (considered below at section 4). These mutual funds will not qualify for UK distributor (or new ‘electing fund’) status unless the necessary elections are actually filed in the UK.
4. Offshore funds
4.1 UK treatment
The offshore funds regime in the UK applies to any ‘collective investment scheme’ which includes OEICs, unit trusts, SICAVs, ETFs and, in practice, most other collective investment vehicles other than partnerships whether or not the investment management takes place within the UK.
The effect of this regime is, in summary, that where an investor places money with a collective offshore fund without ‘distributor status’, gains ultimately realised will be taxed as income rather than as capital (i.e. 40% rather than 18%). Dividend and/or interest payments received will be treated as income. It is important, therefore, to establish before any investment in an offshore fund is made whether the fund has distributor status. Where there is a choice between two similar offshore funds, one with distributor status will be significantly more tax efficient from a UK perspective.
It should be noted that with effect from 1 December 2009, the UK ‘distributor status’ fund regime is being replaced with a new ‘Reporting Fund’ status: again, offshore funds with Reporting Fund status will offer CGT treatment on gains and so will be more UK tax efficient than non-Reporting Fund status funds.
4.2 US treatment
The Passive Foreign Investment Companies (‘PFICs’) rules can make non-US corporate funds very unattractive investments for US tax purposes. Many offshore funds structured as companies may be within the scope of the US PFIC rules: classification as a PFIC occurs when 75% or more of the company's income is passive or when more than 50% of the company's assets exist in investments earning interest, dividends, and/or capital gains.
Where a US person owns a PFIC directly (or is deemed to have an indirect ownership interest), he must include as ordinary income (i.e. the 35% rate) the allocated gains or excess distributions in its gross income for the taxable years in which the allocations are made. The tax liability is determined at the highest rate of tax in effect for the applicable taxable year. Additionally, the deferred tax liability from the allocations are treated as underpayments of tax, and interest charges are imposed on the deferred taxes on the allocated gains and excess distributions. Where a fund is a PFIC and has significant accumulated income, the effective rate of tax with the interest charges can be very significant although it will (ultimately) be capped at 100% of the amount of returns received.
It can be possible to invest in a corporate fund without such adverse US tax issues if the fund elects to be treated as a partnership for US tax purposes or if the investor makes a qualifying elective fund (QEF) election in which case the investor pays tax on his share of the income and gains in the fund on an annual basis.
5.1 UK treatment
Some types of collective investment scheme (typically private equity fund arrangements) are structured as partnerships which are generally considered to be outside the scope of the UK offshore fund rules. Partnerships are generally ‘look through’ for UK tax purposes and therefore an investor will be liable on an arising basis to all income and capital generated within the partnership whether or not these income and gains are distributed to them.
Partnership investments in which there is no facility to influence how the underlying investments are run and in which there is little access to information are very problematic in UK terms as it may be impossible to separate out the capital and income that is returned in a mixed receipt. This can make tax reporting difficult for UK investors.
5.2 US treatment
The US has a highly sophisticated set of rules dealing with the taxation of partnerships. In their most basic form, like the UK, these rules result in the partners being taxable annually on their share of partnership income and gains. Almost all US hedge and equity funds are structured either as partnerships or limited liability companies which are taxable as partnerships for US tax purposes.
6.1 UK treatment
Interest paid on Government or corporate bonds is subject to income tax in the UK; proceeds of the sale of bonds or their redemption will be a CGT receipt.
Where a bond can be redeemed (either at maturity or upon any earlier date) at more than its initial issue price, it may constitute a deeply discounted bond for UK tax purposes; this will result in the investor incurring a UK income tax charge on the gain.
6.2 US treatment
If the bonds do not bear adequate interest, US rules can reclassify a portion of the return from capital gain (15%) to ordinary income (35%). Zero-coupon bonds would be an example of a portion of the return being reclassified as interest from the US perspective.
Although the UK and the US rates of tax on income and gains are broadly similar presently, the increase in the higher rate of UK income tax to 50% next year will significantly change the position. In any event, the two tax systems do not necessarily attribute the same treatment to the same investment types: although a UK investor in an offshore fund with distributor status will benefit from CGT treatment on their investment, from a US perspective it may be a PFIC and the effective tax rate might easily be 70% - 80%: while the UK/US double tax treaty might provide a credit against double taxation, it will not normally prevent the difference between the two rate being chargeable. By way of another example, a US mutual fund will represent a very tax efficient investment for US investors offering a 15% rate for long-term investors but for UK investors many such funds will be offshore funds without distributor status and so, from April 2009, gains on them will potentially be subject to tax at a 50% rate. To avoid double tax charges and to try to achieve efficient results, investors with UK and US exposures need to take particular care in selecting their investments.
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