Thun Financial Advisors Research ©| 2017

Thun Financial Advisors Research 2017

Thun Financial Advisors 3330 University Ave. Suite 202 Madison WI 53705 www.thunfinancial.com Skype: thunfinancial

Thun Financial Advisors, L.L.C.

is a U.S.-based, fee-only, Regis-

tered Investment Advisor that

provides investment manage-

ment and financial planning

services to Americans residing

in the U.S. and overseas.

We maximize long-term

wealth accumulation for our

clients by combining an index

allocation investment model

with strategic tax, currency,

retirement and estate plan-

ning. We guard our clients’

wealth as though it was our

own by emphasizing prudent

diversification with a focus on

wealth preservation and

growth.

Americans in the UK Need to Avoid this Catch-22

Investment Trap

Executive Summary

This article addresses:

• PFICs: Definitions and their Consequences for American Inves-tors Abroad

• United Kingdom Taxation and Off-shore Funds

• Interaction between U.S. Taxation and UK taxation creates a pos-sible “Catch-22”

• Possible Solutions to these Complications for American Investors

Introduction

The U.S. Passive Foreign Investment Company (PFIC) tax regime raises

high hurdles for Americans in the United Kingdom to invest wisely and

tax efficiently. This is because the United Kingdom has a parallel sys-

tem of punitive taxation of non-UK funds. This investment “Catch-22″

(UK funds are taxed punitively by the U.S.; U.S.-based funds can be taxed

punitively by the UK) can be successfully navigated by investing in effi-

cient U.S. exchange traded funds that are also so-called UK “reporting

funds.” Most importantly, the new U.S. FATCA legislation makes this

once easily ignored tax issue critical for all American investors living in

the United Kingdom.

Thun Financial Advisors Research ©| 2017

Introduction to PFICs

The United States, almost uniquely in the world,

taxes not only on the basis of residence, but also

on the basis of citizenship. As a result, U.S. citizens

(and U.S. permanent residents) are taxed by the

United States, as well as their country of resi-

dence, no matter where they live or how long they

have lived outside the United States. While there

are special provisions in the U.S. tax code and bi-

lateral tax treaties that generally protect U.S. citi-

zens from double taxation, navigating the com-

plexities of cross-border taxation still requires dil-

igent tax planning. Furthermore, when it comes to

long-term wealth management planning, it is criti-

cally important that a sound investment strategy

not be forfeited to achieve tax or compliance ob-

jectives alone.

Thun Financial Advisors specializes in implement-

ing investment strategies that are tax efficient and

compliant, yet still sound from the point of view of

strategic investment objectives. In this note, we

address a Catch-22 investment tax issue that af-

fects Americans who reside in the United King-

dom. After describing the problem, we present a

series of solutions and rank them in terms of their

tax/compliance efficiency as well as their sound-

ness as investment strategies.

The Problem – Special Tax Regimes in the UK and the U.S. for “Off-shore” Funds

U.S. PFIC taxation

For investors subject to U.S. taxation, Thun Finan-

cial Advisors broadly recommends that all non-

U.S. “pooled” investments products (i.e. mutual

funds, ETFs, hedge funds, certain insurance prod-

ucts, etc.) should be avoided because such invest-

ments are treated under the U.S. tax code as Pas-

sive Foreign Investment Companies (PFICs). PFICs

are subject to special, highly punitive tax treat-

ment by the U.S. tax code. Not only will the tax rate

applied to these investments be much higher than

the tax rate applied to a similar or identical U.S.

registered investments, but the cost of required

accounting/record-keeping for reporting PFIC in-

vestments on IRS Form 8621 can easily run into

the thousands of dollars per investment each year.

The increased tax and high compliance burden is

so severe, it is essentially impossible to justify

owning a PFIC from an investment management

perspective. This is especially true where an iden-

tical investment can be made through U.S. regis-

tered securities that are not PFICs. Thus, an Amer-

ican expat taxpayer living in the United Kingdom

(or anywhere for that matter) should never

choose to invest through mutual funds or other

pooled investments that are not registered in the

United States.

The Catch-22: UK taxation of off-shore funds

For U.S. taxpayers living in the United Kingdom,

the solution to the PFIC problem is complicated by

the UK tax system. The United Kingdom applies

special, punitive tax rates on non-UK registered

investment funds. For investors subject to UK tax-

es (generally anyone resident in the UK), most U.S.

registered funds are deemed “non-reporting

funds” (that is, they do not report to UK account-

ing standards). Non-reporting funds are penalized

by the UK tax system because capital gains in non-

reporting funds are taxed at regular tax rates, not

the lower capital gains rates.

The Catch-22, therefore, is that American taxpay-

ers who reside in the United Kingdom could run

afoul either of the PFIC tax rules (if they buy a UK

registered fund) or the “non-reporting fund” rules

(if they buy a U.S. fund). Welcome to the tax hell of

your typical American expat trying to save and in-

vest for their future!

Thun Financial Advisors Research ©| 2017

PFIC Solutions: Good, Better and Best

Fortunately, there are several solutions to avoid

the worst possible implications of this Catch-22.

Here we describe three possible strategies to miti-

gate the impact of this UK/U.S. investment tax

nightmare. We grade each strategy on two crite-

ria: 1) tax and compliance costs and 2) the sound-

ness of the underlying investment approach.

1) Good

Do not invest in “funds.” Both the PFIC rules and

the “non-reporting fund” rules apply only to

pooled investment funds. An investment portfolio

constructed completely of individual stocks, bonds

and other investments that are not “pooled”

avoids all of the problems described above in both

the United States and the United Kingdom. Owning

a portfolio of individual stocks and bonds can cre-

ate other, less severe reporting problems but in

general these problems are manageable. We give

this strategy a grade of B+ from the point of view

of tax and compliance.

From the point of view of the soundness of the in-

vestments, however, we give this approach only a

D grade. Generally, an investment portfolio of at

least $10 million dollars is required to achieve the

economies of scale necessary to invest efficiently

without the use of “pooled” investments such as

mutual funds, ETFs or hedge funds. Thorough di-

versification and investment cost management are

the bedrock of successful long-term investing.

These rules of sound investment management will

be violated when investing in individual securities

except where the total value of the investment

portfolio is very large (and even then there are

significant limitations).

2) Better

Accept the lesser of two evils. The details of PFIC

taxation are complex and as a result we do not

delve into the details in this note other than to re-

port that the tax is highly punitive. The UK taxa-

tion of “non-reporting funds” is substantially less

complex and substantially less punitive than PFIC

taxation. Furthermore, for American expats who

employ sound long-term investments strategies

AND who do not expect to reside in the United

Kingdom permanently, tax inefficiencies arising

Thun Financial Advisors Research ©| 2017

from owning “non-reporting” funds can be almost

wholly avoided by not realizing net capital gains

through the sale of the funds while resident in the

United Kingdom. Therefore, one solution is to

simply keep investments in U.S. registered funds

and manage them in a way to minimize capital

gains realization while resident in the United

Kingdom. This strategy will not work for Ameri-

cans expecting to stay permanently or retire in the

United Kingdom because eventually the funds will

probably be sold, the gains realized and the puni-

tive UK tax rate on the capital gain paid.

On the other hand, paying the regular UK tax rates

on capital gains from a “non-reporting fund” is still

a preferred outcome to the U.S. tax and compli-

ance costs arising from owning a PFIC. So, the less-

er of two evils approach boils down to taking the

tax hit in the United Kingdom, rather than the in

the United States, if one taxing jurisdiction must

be chosen.

For Americans living in the United Kingdom for a

limited time, the “lesser of two evils” strategy gar-

ners a B grade for tax and compliance. For Ameri-

cans expecting to live a long time or permanently

in the United Kingdom it gets no more than a D

grade, for reasons described above. From the in-

vestment soundness point of view, this strategy

gets an A grade because it allows an investor to

choose from the vast number of investment fund

options in the United States. From this broad pool

of investment funds, low-cost and tax efficient

funds can be selected. These select funds can be

combined to build a strategically sound and thor-

oughly diversified portfolio consisting of global

stocks, bonds and alternative investments.

3) Best

We save the best solution for last. American ex-

pats should thread the needle of U.S. and UK com-

pliance by investing in U.S. registered funds with

UK “reporting fund” status. Fortunately, the UK

government allows non-UK registered investment

funds to apply for reporting fund status. Until re-

cently, the list of non-U.K registered funds with

reporting status was made up almost exclusively

of funds registered in places other than the United

States. While such funds might be tax efficient for

most UK residents, they are not good choices for

U.S. citizens resident in the United Kingdom be-

cause they are still PFICs.

However, over the last couple of years, a core of

U.S. registered mutual funds and ETFs have been

granted UK “reporting fund” status. For the U.S.

taxpayer residing in the United Kingdom, there-

fore, these U.S. registered funds with UK

“reporting fund” status represent an elegant solu-

tion to the Catch-22 of U.S. and UK investment tax-

ation: they both avoid the PFIC trap in the United

States and the “non-reporting fund” trap in the

United Kingdom. Most importantly, although the

list of U.S. funds with UK reporting status is not

extensive, it now includes a core of excellent, effi-

cient ETFs (mostly from the U.S. fund company

Vanguard). From these funds a fully diversified,

global investment portfolio of stocks, bonds, com-

modities and real estate can be constructed, just

as Thun Financial builds for its global clients else-

where in the world.

FATCA: Why This Obscure Tax Issue is Now Critical for U.S. Citizens in the UK

Many U.S. investors living in the United Kingdom

may protest the implications of this note by refer-

encing the fact that they have ignored the PFIC

rules for years and have never gotten in trouble

Thun Financial Advisors Research ©| 2017

with the IRS. Further, they have never heard of

any other Americans getting in trouble for failure

to properly report non-U.S. funds as PFICs. Indeed,

enforcement of the PFIC tax regime on invest-

ments held outside the United States by persons

subject to U.S. taxation has been close to non-

existent, even though the PFIC tax rules have been

around since the 1980s. That is because enforce-

ment relied entirely on self-reporting. The IRS has

had no independent way to verify the nature of off

-shore investments held by Americans and there-

fore was severely limited in its ability to enforce

PFIC reporting.

However, the FATCA (Foreign Account Tax Com-

pliance Act) of 2010 completely changes all this.

(see: The U.S. FATCA LAW: What U.S. Expats Need

to Know, Thun Financial Advisors, 2012) Going

forward, UK financial institutions will be reporting

directly to the IRS about holding of clients deemed

likely to be U.S. citizens. Furthermore, the FATCA

law specifically stiffened aspects of the PFIC rules

and made them subject to reporting not only on

the existing IRS Form 8621, but also on the new

IRS Form 8938. Clearly, Congress intends one of

the effects of the new FATCA law to be enforce-

ment of the PFIC rules.

A Note on PFIC or Non-Reporting Funds Held Within a Qualified Retire-ment Plan

Many Americans residing in the United Kingdom

may wonder how this affects investments held in

either U.S. or UK retirement accounts, such U.S.

IRAs or 401ks or UK SIPPs. Fortunately, the United

States and the United Kingdom have a double tax-

ation treaty that provides for the mutual recogni-

tion of each other’s system of tax deferred retire-

ment accounts and pension plans. Because assets

in these accounts are subject to a separate set of

tax rules in both the United States and the United

Kingdom, none of the rules regarding either PFICs

or “non-reporting” funds apply if the funds in

question are held inside a qualified retirement ac-

count. Therefore, a U.S. citizen building up a retire-

ment nest egg through a UK employer provided

pension plan needn’t be concerned that the invest-

ments in the plan are PFICs.

Likewise, if the same U.S. investor is contributing

to a U.S. 401k, s/he does not have to worry that

the investments in the 401k, (or an inactive 401k)

are “non-reporting” funds. It does not matter: All

those rules are overridden by the rules regarding

taxation of withdrawals from these specific kinds

of retirement accounts.

Thun Financial Advisors Research ©| 2017

“Thun Financial Advisors is a Creative Planning, LLC company. Creative Planning, LLC (“Company”) is an SEC registered investment adviser located in Overland Park, Kansas. This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.”

Contact Us Thun Financial Advisors 3330 University Ave Suite 202 Madison, WI 53705 608-237-1318

Visit us on the web at

www.thunfinancial.com

Skype: thunfinancial.com

david.kuenzi@thunfinancial.com

Conclusion

FATCA is changing the landscape for American investors living abroad.

Implementing sound investment strategies without being ensnarled in a

cross-border tax trap has never been harder. The case of U.S. PFIC and

UK reporting fund rules discussed here is a primary example of the di-

lemma in the case of U.S. investors living in the United Kingdom. Howev-

er, proper financial planning can provide solutions that allow Americans

abroad to get on with the task of building wealth over a lifetime through

wise long-term investing without fear of hidden tax traps.

Thun Financial Advisors Research is the leading provider of financial planning research for cross-border and American

expatriate investors. Based in Madison, Wisconsin, David Kuenzi and Thun Financial Advisors’ Research have been featured in

the Wall Street Journal, Emerging Money, Investment News, International Advisor, Financial Planning Magazine and Wealth

Management among other publications.