Difference between revisions of "Non-US investor's guide to navigating US tax traps"

From Bogleheads
Jump to navigation Jump to search
m (Fix broken link.)
m (Clarify Canada/US estate tax treaty (again).)
Line 154: Line 154:
 
The US has ''[https://www.irs.gov/businesses/small-businesses-self-employed/estate-gift-tax-treaties-international estate tax treaties]'' with just a handful of countries.<ref group="note">At the time of writing, the US maintains estate tax treaties with Australia, Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Switzerland, and the United Kingdom. The estate tax treaties with Ireland and South Africa may be deficient in important areas.</ref> Consult this list to see if your home country is included in it.
 
The US has ''[https://www.irs.gov/businesses/small-businesses-self-employed/estate-gift-tax-treaties-international estate tax treaties]'' with just a handful of countries.<ref group="note">At the time of writing, the US maintains estate tax treaties with Australia, Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Norway, South Africa, Switzerland, and the United Kingdom. The estate tax treaties with Ireland and South Africa may be deficient in important areas.</ref> Consult this list to see if your home country is included in it.
  
{{Notice|Canadian investors should note that the US maintains a combined income and estate tax treaty with Canada, so even though Canada is ''not'' included in the IRS list of estate tax treaties, Canadian investors receive protection equivalent to the countries that ''are'' included in the IRS list.}}
+
{{Notice|Canada does not have a separate estate tax treaty with the US. Instead, the US maintains a single treaty with Canada that combines both income taxes and estate taxes. Under this combined treaty, Canadians receive protection up to the level of the US estate tax exemption allowed to US citizens, the same as generally provided by the separate US estate tax treaties for other countries.<ref>{{cite web| url=https://www.irs.gov/businesses/international-businesses/canada-tax-treaty-documents| title=Canada - Tax Treaty Documents| publisher=IRS| accessdate=August 9, 2020}}</ref>}}
  
 
{{Warning|Estate tax treaties are generally controlled by your ''[https://en.wikipedia.org/wiki/Domicile_(law) domicile]'' rather than your country of residence. ''Domicile'' is where your permanent home is, and although it includes residence as one of its elements, residence alone in a country may not be enough to gain you coverage from a US estate tax treaty, so you may need to be particularly careful here. A few US estate tax treaties also cover citizens even when perhaps not resident or domiciled in the treaty partner country,<ref>{{cite web| url=https://core.ac.uk/download/pdf/147634389.pdf| title=Estate, Gift, and Generation-Skipping Transfer Tax Treaties| publisher=SMU Law Review| date=1983| accessdate=August 1, 2020}}</ref> for example the UK.}}
 
{{Warning|Estate tax treaties are generally controlled by your ''[https://en.wikipedia.org/wiki/Domicile_(law) domicile]'' rather than your country of residence. ''Domicile'' is where your permanent home is, and although it includes residence as one of its elements, residence alone in a country may not be enough to gain you coverage from a US estate tax treaty, so you may need to be particularly careful here. A few US estate tax treaties also cover citizens even when perhaps not resident or domiciled in the treaty partner country,<ref>{{cite web| url=https://core.ac.uk/download/pdf/147634389.pdf| title=Estate, Gift, and Generation-Skipping Transfer Tax Treaties| publisher=SMU Law Review| date=1983| accessdate=August 1, 2020}}</ref> for example the UK.}}
Line 164: Line 164:
 
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'''. The US estate tax treaties with Canada and the UK are known 'good' treaties.<ref>{{cite web| publisher=IRS| url=https://www.irs.gov/irm/part4/irm_04-025-004| title=4.25.4 International Estate and Gift Tax Examinations| accessdate=March 17, 2019}}</ref>
 
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'''. The US estate tax treaties with Canada and the UK are known 'good' treaties.<ref>{{cite web| publisher=IRS| url=https://www.irs.gov/irm/part4/irm_04-025-004| title=4.25.4 International Estate and Gift Tax Examinations| accessdate=March 17, 2019}}</ref>
  
With the exception of Canada, if your country is not included in the IRS list of US estate tax treaties, the answer is clearly '''no'''.
+
With the possible exception of Canada, if your country is not included in the IRS list of US estate tax treaties, the answer is clearly '''no'''.
  
 
{{Notice|It is often difficult in practice to obtain the text of a US estate tax treaty. The IRS does not publish them on its web site, and most are very old, and so were signed into law well before the age of the internet. However, at the time of writing the helpful folk at ''[https://taxtreatylaw.com/ Tax Treaty Law]'' offer convenient access to both [https://taxtreatylaw.com/estate-gift/ US estate tax] and [https://taxtreatylaw.com/income-tax/ US income tax] treaties.}}
 
{{Notice|It is often difficult in practice to obtain the text of a US estate tax treaty. The IRS does not publish them on its web site, and most are very old, and so were signed into law well before the age of the internet. However, at the time of writing the helpful folk at ''[https://taxtreatylaw.com/ Tax Treaty Law]'' offer convenient access to both [https://taxtreatylaw.com/estate-gift/ US estate tax] and [https://taxtreatylaw.com/income-tax/ US income tax] treaties.}}

Revision as of 17:35, 23 October 2020

Ambox globe.svg This page contains details specific to global investing. It applies to non-US investors, United States (US) investors, and US citizens and US permanent residents (green card holders) living outside the US.

US tax laws contain multiple traps for unwary investors based outside the US and for non-US citizens living in the US. US nonresident aliens, US citizens or green card holders living outside the US, and non-US citizens living temporarily in the US are all at risk. In the worst cases these traps can lead to outcomes such as US income tax rates of 100% on gains,[1] loss of 40% of total assets[2] to US estate taxes, and huge fines for non-disclosure of assets.[3][4]

This page contains a guide for investors based outside the US who plan to use index funds or exchange-traded funds (ETFs), with the aim of helping these investors to avoid falling into US tax traps by navigating around, through, or between them. It also outlines some of the investing issues that arise from moving either into or out of the US, and aims to help investors who are now, or plan to become, non-US citizens living in the US, to avoid the worst of the US tax traps that arise when beginning or terminating US tax residence.

Introduction

US tax laws are extensive,[5] intrusive, complicated,[6] and far-reaching,[7] for both US investors and non-US investors.

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 lawful permanent residents who live outside the country either temporarily or permanently.

It also applies onerous estate taxes[8] to US situated assets held by non-US persons (that is, non-US citizens who are also not US residents, referred to in IRS documents and US tax laws and regulations as 'nonresident aliens').

Investors based outside the US and susceptible to hidden US tax traps fall into three main categories:

  • Nonresident aliens living outside the US and holding US investments or assets
  • US citizens and green card holders living outside the US
  • Non-US citizens living temporarily in the US on a nonimmigrant work visa (such as H-1B or L-1) or a green card

All three groups face significant difficulties with US taxes. By following the guidelines below these investors should be able to avoid the worst of the issues presented by US taxes. If you fall into any of these groups, read on.

Why fund domicile matters

Just like a person, a fund or ETF has a domicile. This is the country in which the fund's holding company is legally incorporated, and typically where the administration and management of the fund itself takes place.

For example, Vanguard offers two separate S&P 500 index tracker ETFs, and they have different domiciles:

  • VOO, provided by Vanguard US, domiciled in the US and traded on US exchanges
  • VUSD, provided by Vanguard in Europe, domiciled in Ireland and traded on the London Stock Exchange and other European exchanges

Both of these ETFs hold the same underlying stocks, and so the return to investors from them should be the exact same (excluding perhaps a tiny offset due to any small difference in annual charges). So why do Vanguard do this? Surely an investor could choose either at will and get the same results?

The answer is US taxes. Despite investing in identical underlying assets -- that is, not just asset class, but actual assets -- investors in varying personal 'tax circumstances' will get different results depending on which of these two ETFs they choose to hold. Sometimes wildly different.

For a US resident, US citizen or green card holder investing in the S&P 500 through VOO, the US will not withhold any tax on dividends, and the individual investor is responsible for their own tax payments to the US. If this person invested in the S&P 500 through VUSD instead, the US would apply a punitive 'offshore fund' tax regime on the ETF returns that in some cases could reduce the overall gain to nothing.[1]

For a nonresident alien or non-US person investing in the S&P 500 through VOO, the US will withhold up to 30% tax on dividends (the actual rate might be reduce by a tax treaty, typically to 15%), and will levy an estate tax of between 26% and up to 40% on the balance on the holder's death[9][2] (again, depending on treaty). If this person invested in the S&P 500 through VUSD instead, the fund pays 15% internally[10] to the US on dividends but the investor receives all of the remaining 85%, and there is no risk of US or Irish estate tax.

Worse, where an ETF holds no US stocks, the US tax treatment is the same as shown above. For nonresident aliens, this creates an even greater advantage for ETFs domiciled in Ireland over those domiciled in the US. The US dividend tax for a nonresident alien investing through a US domiciled ETF holding non-US stocks is again 30% (or lower, if there is a treaty), and with a risk of 26% to 40% US estate tax on the balance (depending on treaty).[9] For an Ireland domiciled ETF with identical holdings the US dividend tax loss is 0%, so that the investor receives the full 100% of dividends, and with no risk of US or Irish estate tax.[10]

For all of the above cases, whether or not the investments are held inside a pension or other tax-mitigating wrapper may create further significant differences to the tax results. And for investors who have or plan an international lifestyle, moving into or out of the US can create large and damaging discontinuities in tax treatment.

Between the extremes lies a whole spectrum of outcomes. For non-US investors, the decision flowchart below aims to help you uncover where you fall on this spectrum, as a way to guide non-US investors on the decision of whether to hold your investments through the usual Vanguard ETFs discussed by and used by US investors, or whether to hold them through different ETFs -- specifically, non-US domiciled ones. For investors with an international lifestyle and who are currently or who may become US tax residents, or who plan to end US residency, it aims to help chart a route through the maze of US tax traps that you will face.

Decision 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.

NonUS flowchart 20180322173402.png

Interview section

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.

The results of using this process are guidelines, not rigid rules. Local factors or conditions may mean that even though it suggests that you use one ETF domicile, it is better somehow, perhaps for reasons of liquidity, spread, or practical access to ETFs, to use another. If this is the case for you, at least after following it you will know the potential pitfalls of the route you choose to take.

Go to Question 1 to begin.

Q1. Are you a US citizen?

If yes, go to Question 3. If no, go to Question 2.

Q2. Are you a green card holder (US lawful permanent resident)?

If yes, go to Question 3. If no, go to Question 3b.

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.

Q3b. Are you a US tax resident?

If yes, go to Question 5. If no, go to Question 6.

Q4. Do you plan to retire in the US?

If yes, go to Result A1. If no, go to Result A3.

Q5. Do you plan to get a green card?

If yes, go to Question 4. If no, go to Result A3.

Q6. Does your country have an income tax treaty with the US?

If yes, go to Question 7. If no, go to Result A4.

Q7. Does your country have an estate tax treaty with the US?

If yes, go to Question 8. If no, go to Question 9.

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.

Q9. Will 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.

Results section

Results

Following the flowchart interview will guide you one or more of the Results sections below.

You can of course read others for interest or entertainment, but the one or ones that the flowchart guides you to are the only Results that are relevant to your own circumstances and which you should consider applying to your own investing.

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.


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'.

Or, you are tax-resident inside the US, but still hold investments in a country you lived in previously.


A3. Create a relocation-resistant portfolio

While a US resident or green card holder, see also Result A2.
For an outline of the situation when you are no longer a US resident or green card holder, see also the results of following Question 6 as if you are now resident in your new country.

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


A4. Avoid US domiciled funds and ETFs and prefer Ireland or other non-US offerings

You are a US nonresident alien with poor or nonexistent US tax treaty coverage.


A5. Consider preferring US domiciled funds and ETFs

You are a US nonresident alien with surprisingly good US tax treaty coverage.


A6. Choose your funds and ETFs for best local tax outcome

You are a US nonresident alien with average US tax treaty coverage.

Or, you will never hold more than $60,000 in US situated assets.

Notes


See also

References

  1. 1.0 1.1 "Passive foreign investment company § Effect of PFIC status". Wikipedia. https://en.wikipedia.org/wiki/Passive_foreign_investment_company#Effect_of_PFIC_status. Retrieved March 17, 2019.
  2. 2.0 2.1 "Estate tax in the United states § Non-residents". Wikipedia. https://en.wikipedia.org/wiki/Estate_tax_in_the_United_States#Non-residents. Retrieved March 17, 2019.
  3. "Report of Foreign Bank and Financial Accounts (FBAR)". IRS. https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar. Retrieved March 17, 2019.
  4. "Summary of FATCA Reporting for U.S. Taxpayers". IRS. https://www.irs.gov/businesses/corporations/summary-of-fatca-reporting-for-us-taxpayers. Retrieved March 17, 2019.
  5. "Taxation in the United States". Wikipedia. https://en.wikipedia.org/wiki/Taxation_in_the_United_States. Retrieved March 17, 2019.
  6. "Income tax in the United States § The complexity of the U.S. income tax laws". Wikipedia. https://en.wikipedia.org/wiki/Income_tax_in_the_United_States#The_complexity_of_the_U.S._income_tax_laws. Retrieved March 17, 2019.
  7. "Extraterritorial jurisdiction § Economic law". Wikipedia. https://en.wikipedia.org/wiki/Extraterritorial_jurisdiction#Economic_law. Retrieved March 17, 2019.
  8. "Estate taxation of a nonresident alien". JPM Financial Services. http://www.jpmfinancialservices.com/images/PDFs/EstateTaxation.pdf. Retrieved March 17, 2019.
  9. 9.0 9.1 "U.S. ESTATE AND GIFT TAX RULES FOR NON-RESIDENT ALIENS". Grant, Herrman, Schwartz & Klinger LLP. https://www.ghsklaw.com/sitefiles/4482/u.s.estate.and.gifttaxrules.pdf. Retrieved March 20, 2019.
  10. 10.0 10.1 "Taxation of Irish Exchange Traded Funds (ETFs)". Deloitte. https://www2.deloitte.com/ie/en/pages/financial-services/articles/taxation-of-irish-etfs.html. Retrieved March 17, 2019.

External links