Non-US investor's guide to navigating US tax traps

US tax laws contain multiple traps for unwary non-US investors. In the worst cases they can lead to outcomes such as US income tax rates of 100% on gains, loss of 40% of total assets to US estate taxes, and huge fines for non-disclosure of assets. This page contains a guide for non-US investors planning to use index tracker funds or ETFs, with the aim of helping these investors to avoid falling into US tax traps by navigating around, through, or between them.

Introduction
US tax laws are extensive, complicated, and far-reaching. In common with many countries, the US taxes the worldwide income of its residents. However, it is virtually unique in taxing the foreign income of its citizens and legal permanent residents who live outside the country either temporarily or permanently. It also applies onerous estate taxes to US situated assets held by non US persons (that is, non-US citizens who are also not US residents).

Non US investors susceptible to hidden US tax traps fall into three main categories: All three groups face difficulties with US taxes. By following the guidelines below a non US investor should be able to avoid the worst of the issues presented by US taxes. If you fall into any of these groups, read on.
 * US citizens and green card holders living outside the US
 * Non US persons living temporarily in the US
 * Non US persons living outside the US and holding US investments or assets

Flowchart
This is the flowchart we will be using to navigate around US tax traps. Scroll down to Start to begin the process of following it.



Start
Navigate the flowchart by answering a series of questions and then following the links that apply to you until you reach a result. Most questions have simple yes/no answers.

Often you will need to read external documents to decide which answer to a question is the right one for you. But by following it, this flowchart should help you to determine how best to invest in index funds or ETFs while minimising US tax difficulties.

Go to Question 1 to begin.

Q1. Are you a US citizen?
If yes, go to Question 3. If no, go to Question 2.

You are a US citizen by birthright if you were born in the US or born outside the US to one or more US citizen parents. If not a citizen by birthright, you can become one through a process of naturalization.

Once you are a US citizen the only way you can shed this is by renouncing your US citizenship at a US consulate. To do this you would generally need to have another citizenship besides US.

Q2. Are you a green card holder (US legal permanent resident)?
If yes, go to Question 3. If no, go to Question 3b.

You have the status of US legal permanent resident if you are authorised to live and work in the US by holding a green card.

Q3. Are you a US resident?
If yes and you are a US citizen, go to Result A1. If yes and you are not a US citizen, go to Question 4. If no, go to Result A2.

A US citizen or green card holder can use the physical presence test or the bona fide residency test as a measure of whether or not the US considers them to be resident in the US. US citizens living outside the US get a bit of a break on their US taxes as applied to earned income, but no break against US taxes on unearned income such as dividends or interest.

Q3b. Are you a US tax resident?
If yes, go to Question 5. If no, go to Question 6.

For temporary US residents, such as people on H1B and L1 work visas, the US uses the substantial presence test to determine whether a person is a 'US resident for tax purposes'.

The test involves several potentially fiddly calculations, but as a general rule you can usually assume that if you have not set foot in the US in any given year (or perhaps only been there on vacation) then you are not a 'US resident for tax purposes', and if you have stayed in the US for several months, and especially over six months, then you are a 'US resident for tax purposes'.

Q4. Do you plan to retire in the US?
If yes, go to Result A1. If no, go to Result A3.

For best results, you probably want to hold different investments if you plan to retire in another country compared to if you plan to retire in the US. The problem here is one of continuity of investing. Everything works best if you can leave it alone. If you hold a portfolio of investments that work perfectly well in the US but could turn into a tax nightmare when you move to a different country, you might effectively be forced to sell to cash before moving. This can be disruptive, and potentially also an unwanted and unnecessary tax cost.

If you are unsure, try following both paths to get an idea of the challenges of each.

Q5. Do you plan to get a green card?
If yes, go to Question 4. If no, go to Result A3.

As a temporary US resident, do you intend to stay longer and obtain a green card, or do you plan to leave the US and return to your home country (or move to a third country) when or before your current US work visa expires? If you think you will get a green card and stay in the US, perhaps even naturalizing as a US citizen in time, you will want to arrange your portfolio accordingly.

Q6. Does your country have an income tax treaty with the US?
If yes, go to Question 7. If no, go to Result A4.

The US has income tax treaties with a number of countries. Consult this list to see if your home country is included in it.

While browsing this part of the IRS web site, perhaps take a look at the actual treaty text for your own country, if for no other reason than to get an idea of how densely written and difficult to understand US income tax treaties are.

Q7. Does your country have an estate tax treaty with the US?
If yes, go to Question 8. If no, go to Question 9.

The US has estate tax treaties with just a handful of countries. When reading this table from the IRS, be very careful to check all the details thoroughly. If you see 'PR-UC' under comments (you may have to scroll the table to the right to find this field) that is generally a good sign.

In general then, the presence of a country in this list of US estate tax treaties is often just the first step in uncovering whether or not your country is fully protected from US estate taxes. You would need to research thoroughly to be sure that the answer to the question above is really yes.

If your country is not listed though, the answer is clearly no.

Q8. What is the US dividend tax treaty rate for your country?
If below 15%, go to Result A5. If 15%, go to Result A6. Otherwise, for above 15% go to Result A4.

The IRS publishes a table of tax rates for treaty countries (warning, PDF). The Dividends column, income code 6, shows you the US tax treaty rate on dividends from US stocks (and by extension, on US domiciled funds and ETFs) for your country. Be sure to read any relevant notes for your country also, to be certain that the US tax rate you see in this table is in fact the one that you will be subject to.

Most treaties have a 15% rate on dividends from US stocks. A few have a lower rate, and a few a higher rate. The general US tax rate for dividends paid to investors in countries without a US income tax treaty is 30%.

Q9. Do you hold more than $60,000 in US situated assets?
If yes, go to Result A4. If no, go to Result A6.

For holdings below $60,000, see also the results from following Question 8.

The US levies its estate tax on the US situated holdings of non-resident aliens. This includes US domiciled funds and ETFs. US estate taxes apply to the entire holding, not just any accrued but as-yet untaxed gains, begin at a miserly $60,000 of US situated holdings (a level that is far below the exemption allowed to US citizens and residents), and climb rapidly to a rate of 40%. This is territory that comes close to confiscation of assets, and is certainly something you would want to steer well clear of.

A1. This chart does not apply to you
You are a US resident US citizen or green card holder fully intending to retire in the US.

You have no need of this flowchart process.

However, if you want to see the sorts of US tax issues that plague investors who plan to retire outside the US, and those that plague non US investors contemplating investing through US domiciled funds and ETFs, feel free to peruse the other flowchart Results sections below.

A2. Avoid non-US domiciled funds and ETFs
You are tax-resident outside the US, but at the same time the US claims you as a 'US person'.

Unless your country of residence does not levy any income taxes, your income is fully taxable to potentially several conflicting tax regimes at the same time. The intersection of multiple incoherent tax regimes is a deeply uncomfortable position for any investor.

PFIC tax problems
Your major problem when investing will be the US's PFIC tax regime. This draconian law punishes holdings of non-US domiciled funds and ETFs with heavy taxes that can, if left long enough, rise to consume 100% of your gains, something you would want to avoid at all costs. For you then, the most obvious way to defuse this problem is to use only US domiciled funds and ETFs for your index tracker investing.

Unfortunately, this is not always possible. Your home country may well have its own 'anti-offshore funds' rules, similar to the US PFIC rules (although unlikely to be anything like as unpalatable), and these would capture any US domiciled funds or ETFs you hold. Worse still, US domiciled funds and ETFs could well be entirely unavailable to you where non-US brokers do not offer them and US brokers refuse service to investors who are not US residents (even if they are US citizens).

If you are stuck in this way, your main other option is to invest through individual stocks. These escape PFIC and other 'anti-offshore funds' rules. You may be able to hold PFIC funds inside of foreign pensions and so avoid the worst of the US PFIC tax treatment, but then the US rules on foreign pensions can themselves be punitive where these pensions are not protected by treaty (and indeed, many treaties do not cover pensions at all well).

Failing this, if you have a non US spouse you might consider letting them do all the investing for the pair of you. They will have to be careful as non US investors themselves to avoid the multitude of US tax traps, but at least they will be free and clear of US PFIC tax difficulties.

US estate and gift tax problems
There is no unlimited marital exemption for US estate and gift taxes where the recipient spouse is not a US citizen. This can produce a harsh outcome for mixed-citizenship couples, although the high estate tax exemption allowed to US citizen usually makes this a non-issue. When gifting to a non-US spouse though, care should be taken to fill out the appropriate gift tax return where the gift exceeds the US annual gift allowance for non-US spouses.

Pension problems
A few treaties provide for non-US pensions to be treated for US tax in a way approximately equivalent to US pensions. For those that do not, and for non-treaty countries, a local pension can quickly become a US tax nightmare.

Symmetrically, many countries do not recognise US pensions as tax deferred, meaning that holding one while living in that country can become another tax nightmare. How much of a nightmare depends on any treaty and the local tax laws for 'offshore' accounts.

A3. Create a relocation-resistant portfolio
While a US resident or green card holder, see also Result A2.

You are tax-resident in the US, but think you might move or retire outside the US.

International relocation is a huge problem for investors. It can lead to upheaval not just in taxable portfolios, but potentially also in pension and any other tax sheltered or tax deferred wrappers. If possible, you want to build a portfolio that you can hold across international move, but often this simply cannot be done.

Pension problems
Specifically for pension savings, the first thing to consider could be whether a Roth IRA might be useful to you. If you are moving to a country without an income tax, a Roth will be fine. A few of the US income tax treaties also protect Roth accounts against tax by another country, but these tend to be rare. The most likely case is that you move to a country that will 'look through' the Roth wrapper and tax income from these assets as if the Roth did not exist. In that case, either hold assets inside the Roth that will not be subject to punitive local taxes, or (worst case) collapse the Roth and take the cash to your new country, then invest locally.

Taxable account problems
For unwrapped and taxable accounts, check with any applicable US income tax treaty that the investments you hold in it will not be subject to punitive local taxes when you move. Again, some countries either do not levy income taxes or perhaps do not tax investment income. Other are not so benign.

US expatriation tax problems
In all cases you may also need to watch out for the US's expatriation tax if you renounce US citizenship or abandon a green card in order to simplify your tax situation by reducing the number of tax regimes you have to live under from several to just one.

A4. Avoid US domiciled funds and ETFs and prefer Ireland or other non-US offerings
You are a US non-resident alien with poor or nonexistent US tax treaty coverage.

If you hold US domiciled funds or ETFs, you will overpay US taxes on dividends, and you also potentially risk a huge loss to US estate taxes if you have the poor judgement to die while holding them.

Reduced US dividend tax
By investing through Ireland or other non-US domiciled funds or ETFs (Luxembourg is also popular as an ETF domicile), you will reduce your US tax liability from as much as 30% for non-treaty countries, down to 15% US rate on dividends from the US stocks held by your ETFs, and down to 0% US rate on non-US stocks held by your ETFs.

This happens because an ETF domiciled in Ireland can use the US/Ireland tax treaty to obtain a 15% rate on US dividends.

Eliminated threat of US estate tax
When you hold ETFs domiciled in Ireland or another non-US domicile, you do not directly hold any US assets. This means that you are now entirely protected from unpleasant US estate tax surprises. The US estate tax cannot 'look through' a fund or ETF to the ultimate individual owner of shares in that fund or ETF.

Most popular non-US domiciled ETFs can be purchased on the London Stock Exchange and the Euronext exchange, so you will need to find a broker that offers the appropriate exchanges. Interactive Brokers is a popular choice for many.

A5. Consider preferring US domiciled funds and ETFs
You are a US non-resident alien with surprisingly good US tax treaty coverage.

You are in the unusual position of having both a low US tax rate on dividends and a fully usable US estate tax treaty (This is a rare combination -- so rare, in fact, that there is a good chance that you are Japanese.)

In this case, depending on how local taxes operate (in particular, credits for US taxes paid) you may find that using US domiciled funds or ETFs is preferable to Ireland or other EU domiciled ones. You do however need to check your situation carefully. It is not often that US domiciled funds or ETFs are the most tax-efficient option for non US investors.

A6. Choose your funds and ETFs for best local tax outcome
You are a US non-resident alien with average US tax treaty coverage.

Your own country's US dividend tax rate is equal to that paid by a non-US domiciled ETF. In this case, you can choose your holdings carefully to optimise for local taxes. This requires you to fully understand the tax regime in your own country, especially any 'anti-offshore fund' rules or regulations, but the results can be worthwhile.

Funds that track US indexes
For funds or ETFs that track only the S&P 500 or other purely US stock indexes, choosing a US domiciled fund may be a good option. You will pay 15% to the US, but if that can be claimed against any local tax then you do not lose by picking a US domiciled fund or ETF.

By comparison, a fund or ETF domiciled in Ireland and tracking the same index would pay 15% to the US on the dividends it receives, and pay the remaining 85% to you. But it is likely that this 85% paid out is now fully taxable to your local country, and with no way of obtaining a credit for the 15% paid internally by the ETF (countries differ on this, so check local details carefully). In this case you will pay a higher tax overall on the Ireland domiciled ETF compared with the US domiciled one.

Funds that track non-US indexes
For funds or ETFs that track only non-US stock indexes, there is no gain from using a US domiciled fund except perhaps for the lower fund annual management charge. In this case, you would pay 15% in US tax reclaimable against local tax. By comparison, if you held an Ireland domiciled fund tracking the same index, you would suffer no withholding tax but then have to pay full local tax on the entire dividend, for the same end result.

Funds that track global indexes
For global funds, containing a mix of US and non-US stocks, the picture is blurry. Overall you might come out ahead with a US domiciled fund because around 50% of the world's market cap is from US stocks, but the actual outcome is almost entirely impossible to predict with any accuracy.