HMRC Reporting Funds -- Tax on Undistributed Income

For investors outside the US. Personal investments, personal finance, investing news and theory.
Sister forums: Canada, Spain (en español)
---------------
Post Reply
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

I'm working on understanding the tax implications of owning mutual funds as an American citizen living in the UK. I read on this HMRC web page that if one owns an HMRC reporting fund, they have to report and pay income tax on "undistributed income".

This doesn't sounds very nice, but I don't know in practical terms how much of this type of income is typically generated by common ETFs such as VTI generate. This issue isn't mentioned at all on the Bogleheads wiki page on US domiciled UK reporting ETFS, which makes me wonder whether it's not an issue in practice?

I'm curious whether anyone has experience with this.
baron_greenback
Posts: 39
Joined: Mon Jan 24, 2022 5:18 pm
Location: London

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by baron_greenback »

Here's the UK Report to Participants for Vanguard's US-domiciled UK reporting funds. You'll have to scroll for a bit to get to the most recent info, for 2021. (This doesn't seem to be linked to on Vanguard's website anymore?! Oh dear...)

You'll notice that many funds don't have an amount of such excess reportable income which you'll need to include on your taxes - and for those funds which do have ERI the amount is usually fairly minimal, being less than a quarterly/monthly distribution (VBK seems to be a lone exception here).

At tax time, you just add this to the other distributions you receive from during the fund during UK tax year, and pay taxes on it as if it were a dividend (for primarily-equity funds) or interest income (for primarily-fixed income funds).
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

Nice, thanks for the link. Two follow up questions:
  1. The figures in the "Report to Participants" run from January 1 through December 31, whereas the UK tax year runs from April to April. How can this be handled when reporting on a UK return?
  2. Does paying tax on this undistributed income mean that we end up being taxed twice? I'm guessing that if there's undistributed income, the fund manager would use it to buy more assets within the fund, which would increase the net asset value, which would increase the price, which would lead to a capital gain that we would eventually pay tax on. Is that right?
Valuethinker
Posts: 49027
Joined: Fri May 11, 2007 11:07 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by Valuethinker »

rettir wrote: Mon Feb 27, 2023 8:06 am Nice, thanks for the link. Two follow up questions:
  1. The figures in the "Report to Participants" run from January 1 through December 31, whereas the UK tax year runs from April to April. How can this be handled when reporting on a UK return?
A guess. UK levies tax on a cash receipts basis, not an accrual one. Therefore 31st of Dec 2022 is in the 2022/23 tax year. When it is notionally distributed, is when it is taxable. (Even though it's not paid out in cash to you).
[*] Does paying tax on this undistributed income mean that we end up being taxed twice? I'm guessing that if there's undistributed income, the fund manager would use it to buy more assets within the fund, which would increase the net asset value, which would increase the price, which would lead to a capital gain that we would eventually pay tax on. Is that right?
[/list]
It depends as to why undistributed. In my experience fund managers use that to "smooth" the dividend income from the fund. i.e. it gets paid out eventually. But that's what happens with UK funds - not sure re US.

If the money is reinvested then you would pay tax on it again if it gives rise to income or capital gain. But the same would be true if it was paid out to you, and you reinvested it?
TedSwippet
Posts: 5181
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by TedSwippet »

Valuethinker wrote: Mon Feb 27, 2023 8:22 am
rettir wrote: Mon Feb 27, 2023 8:06 am Does paying tax on this undistributed income mean that we end up being taxed twice? ...
...
If the money is reinvested then you would pay tax on it again if it gives rise to income or capital gain. But the same would be true if it was paid out to you, and you reinvested it?
If you reinvested manually then you would add the reinvested amount to your costs for capital gains tax, so that you only pay tax on the income (unreported, or otherwise) once. You do exactly this for 'excess reportable income' too:

Do you owe tax on excess reportable income? - Monevator
You can at least deduct the value of excess reportable income from any declarable capital gains you make in any particular year from selling some or all your fund. (Otherwise you’ll suffer a double tax charge.)
baron_greenback
Posts: 39
Joined: Mon Jan 24, 2022 5:18 pm
Location: London

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by baron_greenback »

rettir wrote: Mon Feb 27, 2023 8:06 am The figures in the "Report to Participants" run from January 1 through December 31, whereas the UK tax year runs from April to April. How can this be handled when reporting on a UK return?
I go through my account transactions and total up all the interest/dividends actually received* from the fund during the UK tax year, then treat the Excess Reportable Income as another (notional) distribution, falling on the Fund Distribution Date given in the Report to Participants (so multiplying the per-share amount by the number of shares held on that date). As valuethinker said, it doesn't matter what period a fund's Report to Participants covers - all that matters to you is when the Fund Distribution Date falls, as that's when you're deemed to have received (and so owe tax on) the ERI.

(* I should probably be less lazy and do this by ex-date instead of when the money hits my account, but since distributions generally occur at month-end, I've yet to be caught out by distributions with an ex-date falling on a different side of the UK tax year boundary from the corresponding payment.)
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

baron_greenback wrote:it doesn't matter what period a fund's Report to Participants covers - all that matters to you is when the Fund Distribution Date falls, as that's when you're deemed to have received (and so owe tax on) the ERI.
Good to know!
TedSwippet wrote:If you reinvested manually then you would add the reinvested amount to your costs for capital gains tax, so that you only pay tax on the income (unreported, or otherwise) once. You do exactly this for 'excess reportable income' too.
Ah ok that makes sense.

This makes me wonder though whether this is a meaningful disadvantage to holding reporting funds instead of non-reporting funds. If I hold a non-reporting fund, I get to keep the “excess reportable income” and let it grow, and when I’m taxed on it it’s at the relatively low capital gains rate, and it’s probably at retirement when my tax bracket is lower.

In contrast if I own reporting funds, I have to give up the money now so it can’t accumulate more gains, and I’m taxed on it at relatively high dividend rates, all while I’m in a high tax bracket because I'm still earning a salary.

I know the general recommendation for Americans in the UK is hold reporting funds, so I wonder what is the standard thinking about these downsides?
TedSwippet
Posts: 5181
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by TedSwippet »

rettir wrote: Tue Feb 28, 2023 2:40 pm If I hold a non-reporting fund, I get to keep the “excess reportable income” and let it grow, and when I’m taxed on it it’s at the relatively low capital gains rate, ...
No. The UK taxes capital gains on non-reporting funds at higher income tax rates.
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

TedSwippet wrote:No. The UK taxes capital gains on non-reporting funds at higher income tax rates.
Right good point, but the other points still stand I think - I don't get to keep that money now and let it grow, and I'm taxed now instead of during retirement.
TedSwippet
Posts: 5181
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by TedSwippet »

rettir wrote: Tue Feb 28, 2023 3:26 pm
TedSwippet wrote:No. The UK taxes capital gains on non-reporting funds at higher income tax rates.
Right good point, but the other points still stand I think - I don't get to keep that money now and let it grow, and I'm taxed now instead of during retirement.
It's true that fully tax-deferred roll-up may eventually overcome a much higher final tax rate, compared to paying partial tax annually and then a low final tax rate. The problem is with the word "eventually". If you run some projections you could well find that break-even comes either too late in life to be useful, or (worse!) after death.

When I did something similar for my own pension, which could grow over the lifetime allowance, it would take me more than 40 years of deferring a final 55% tax rate to offset 33.75% annually on dividends and 20% on capital gains. And this was on some worst-case assumptions, for example that I paid this 20% capital gains tax annually; in practice, I don't, because I don't realise the gains when not needed. Winning at age 95 may be a sort of victory, but it is Pyrrhic.

Have a play with some numbers, to see how it would work out for you. I could be wrong, but my strong suspicion is that you don't win until much too late in the game to be useful.
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

@TedSwippet That makes sense. It sounds like ultimately this undistributed income tax is potentially a meaningful drag on wealth accumulation, but the lesser of the two evils.

I’m 50/50 at this point whether I’ll end up retiring in the UK or the US, so I’m wondering whether it’s better for me to hold non-reporting funds, and to just not sell them until I move back to the US. As far as I understand it that would be fine with HMRC, is that other people’s understanding?

I’m less sure about the following - what if you hold a non-reporting mutual fund (e.g. VTSAX), then convert it to it’s reporting equivalent (e.g. VTI) when you retire and are ready to start withdrawing? Is there a rule against doing that?
TedSwippet
Posts: 5181
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by TedSwippet »

rettir wrote: Wed Mar 01, 2023 11:34 am I’m 50/50 at this point whether I’ll end up retiring in the UK or the US, so I’m wondering whether it’s better for me to hold non-reporting funds, and to just not sell them until I move back to the US. As far as I understand it that would be fine with HMRC, is that other people’s understanding?
Yes. But. I think you'll struggle to find a UK non-reporting fund that meets PFIC regulations but never pays out any dividends or capital gains distributions.

I think that's what you'd need in order to entirely avoid any UK tax until either you sell or you leave the UK. The problem here though is that you (US citizen) can realistically only use US domiciled funds or ETFs, and US domiciled things must, under US regulations, pay out dividends and perhaps also capital gains annually. And once that happens, unless you're a UK non-dom and don't remit the money to the UK, you're then liable for UK tax on these distributions.

If avoiding both PFIC and annual UK tax drag is your aim, your best bet is probably to buy BRKB. As far as the UK is concerned this is a share, and (of course) no entanglements with horrible PFIC tax rules. It's a lot less diversified than a global index fund, but is an example of at least something that ticks the 'avoid annual tax drag' box, not least because it doesn't (currently) pay dividends.
rettir wrote: Wed Mar 01, 2023 11:34 am I’m less sure about the following - what if you hold a non-reporting mutual fund (e.g. VTSAX), then convert it to it’s reporting equivalent (e.g. VTI) when you retire and are ready to start withdrawing? Is there a rule against doing that?
This looks like it would fall under Regulation 48, which covers what happens if a fund that you hold gains reporting status while you hold it:
...Regulation 48 allows a UK investor to elect for a deemed disposal of their interest at the point the fund converted into a reporting fund. This has the effect of crystallising any gains up to the date of conversion as offshore income gains. It also allows later gains to be treated as capital gains (provided that the fund remains a reporting fund up to the date of disposal of the interest).
That is, result as if a sale of the non-reporting fund and a purchase of the reporting one.

... Although, I'm unsure why you'd consider VTSAX rather than just use VTI from the outset. VTSAX distributes dividends and (potentially) capital gains annually, and you'd face UK tax on those when paid out.
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

TedSwippet wrote: This looks like it would fall under Regulation 48…
Ok good to know, I suspected it might be something like that.
TedSwippet wrote: I think you'll struggle to find a UK non-reporting fund that meets PFIC regulations but never pays out any dividends or capital gains distributions.
That makes sense, but I was assuming that I'd need to pay tax on dividends and distributed capital gains no matter what. The thing I was hoping to avoid was the tax on undistributed income. Assuming that I'll pay income on any gains that are actually distributed either way, would it make sense to hold a non-reporting fund now, then only sell it in a few decades once I’m back in the US?
TedSwippet
Posts: 5181
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by TedSwippet »

rettir wrote: Thu Mar 02, 2023 2:05 pm Assuming that I'll pay income on any gains that are actually distributed either way, would it make sense to hold a non-reporting fund now, then only sell it in a few decades once I’m back in the US?
If you can dig out the numbers you can probably take a stab at estimating any advantage. My guess is that unreported income for most funds will be negligible in the grand scheme of things (although, if a fund isn't UK reporting then you may not have any easy way to determine how much unreported income it generated, because it doesn't have to produce that number)

Taking VTI as a (hopefully) typical fund example, if you look through the Vanguard report that baron_greenback linked upthread, you'll see that its unreported income is tiny or zero for the years covered. And because you couldn't add this unreported income to your cost basis, you'd likely face US capital gains tax on it ultimately anyway.

So at best probably a tiny gain. But set against the possibility of a very oversized UK tax charge on this if your 50/50 turns out that you remain in the UK and wind up selling while a UK resident, and having to pay high income tax rates on capital gains. Very asymmetrical then; small possible upside but large potential downside.
Topic Author
rettir
Posts: 16
Joined: Sun Sep 11, 2016 7:15 am

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by rettir »

Thanks @TedSwippet, that makes sense. A follow-up question on that - when you pay UK tax on unreported income, do you add that unreported income to your cost basis for US tax, as well as for UK tax?

In other words, will the IRS honor the fact that I paid tax to the UK on this unreported income, or will they say that they don't recognize that type of tax so my cost basis stays where it was?
TedSwippet
Posts: 5181
Joined: Mon Jun 04, 2007 4:19 pm
Location: UK

Re: HMRC Reporting Funds -- Tax on Undistributed Income

Post by TedSwippet »

rettir wrote: Wed Mar 15, 2023 12:17 pm In other words, will the IRS honor the fact that I paid tax to the UK on this unreported income, or will they say that they don't recognize that type of tax so my cost basis stays where it was?
Not a US citizen or other US 'taxable person', so no direct experience, but I strongly suspect the answer will be the latter, meaning you have to maintain two basis numbers for your holding -- one for the UK, the other for the US. The problem here is a mismatch of income types. The UK taxes "unreported" fund income as if annual dividend; the US will roll it all up as if capital gain on sale. And the offset here, both in income type and in time (there could be years or decades between unreported income and fund sale) creates a strong probability for some element of double-tax.

Annoying, but at least probably fairly minimal, even over time, since unreported income for Vanguard reporting status funds is small to zero. Likely more a paperwork and reporting nightmare than an actual tax cost. There are many areas where US and non-US tax intersect poorly and which create much worse double-tax than this.

Again though, with the disclaimer that I'm a UK resident but not a US citizen, so that for me this is abstract and never real, and I don't have to think about it as deeply as you.
Post Reply