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

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US tax laws contain multiple traps for unwary non-US investors, a category that includes both US nonresident aliens and US citizens living outside the US. 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.

Contents

Introduction

US tax laws are extensive, intrusive, 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 lawful 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, referred to in IRS documents and US tax laws and regulations as 'nonresident aliens').

Non-US investors 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 H1B or L1) or a green card

All three groups face significant 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.

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.

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 could levy a 40% estate tax to the balance on the holder's death (again, depending on treaty). If this person invested in the S&P 500 through VUSD instead, the fund pays 15% internally to the US on dividends but the investor receives all of the remaining 85%, and there is no risk of US estate tax.

And for either 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.

Between the extremes lies a whole spectrum of outcomes. The decision flowchart below aims to help you uncover where you fall on this spectrum, as a way to guide 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.

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.

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 lawful permanent resident)?

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

You have the status of US lawful permanent resident if you are authorised to live and work in the US by holding a green card. If you are in any doubt about your green card status you can use the green card test to determine it.

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, and do not hold a US work visa such as H1B or L1) then you are not a 'US resident for tax purposes' and the answer is no, 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' and the answer is yes.

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. Consult this list to see if your home country is included in it.

Estate tax treaties with some countries contain a 'pro rata unified credit' provision that generally raises the US estate tax exemption to the same level as provided to a US citizen. Countries with this provision are Australia, Canada, Finland, France, Germany, Greece, Italy, Japan, Norway and Switzerland. Countries with 'new' treaties that would generally also raise the US estate tax exemption are Austria, Denmark, Netherlands and UK. Ireland's treaty is 'old' and may not contain any provisions to raise the US estate tax exemption.

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.

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.

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 nonresident 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.

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.

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

See also Taxation as a US person living abroad.

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.

If you live outside the US, 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.

If you live inside the US, any investments you hold in countries you lived in previously may be at risk from punitive US 'anti-offshore' tax laws.

Avoiding the US PFIC tax trap

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 or former 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 live outside the US and 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.

Avoiding the US estate and gift tax trap

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.

Beyond the estate and gift tax exemptions a 'QDOT' trust is one possible way to lessen the US tax bite on gifts and bequests to a non-US spouse

Avoiding the US pension tax trap

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.

In practice, there is often little that can be done to neuter this tax trap. Many countries do not permit any early access to pension funds, meaning that you could have to deal with tax fallout from such accounts for perhaps many decades.

Avoiding the US tax-free investment wrapper tax trap

The US generally does not recognise any other country's tax-free wrapper accounts. The result is that anything you hold in those is fully taxable to the US under normal rules, including PFIC treatments and potentially complex trust tax reporting.

Examples include UK ISA accounts and Canadian TFSAs. Both are entirely tax-free to local country residents who are not US persons, but fully taxed by the US if you are a US citizen or a green card holder.

Using US tax treaties

Tax treaties offer a number of tax mitigation benefits, but most of these benefits will be inaccessible to 'US persons' due to the use of a treaty saving clause by the US.

A treaty 'saving clause' allows the US to ignore the treaty where US citizens or residents are concerned. A handful of other treaty clauses are usually noted in the treaty as exceptions to the 'saving clause', but the general effect of the 'saving clause' is that large segments of the treaty are rendered unusable by US persons, meaning that they cannot use them to mitigate US tax on their non-US income.


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.

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.

Avoiding US and non-US tax traps on a US pension

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.

If a Roth is not an option, see if you have any treaty coverage for non-Roth US pensions. If not, the worst that usually happens is that your US pension is treated as an unwrapped investment account in your new country. It may be tempting to close the US pension entirely and take the balance as cash, but the US's early withdrawal penalties on pensions can make that an undesirable option. Also, weigh up how much employer contribution is in the pension before deciding.

Whether to save into a 401k or IRA at all can be a tricky decision in itself. Where a US pension will be a tax nightmare once you no longer live in the US, there may be arguments for not using these accounts, or perhaps only participating up to the maximum employer match. To make this decision you will need to compare your employer match with the IRS (and any state) early withdrawal penalty on 401ks and IRAs.

If you draw from a US pension as a nonresident alien, the standard US tax withholding rate is 30% and the income counts as 'effectively connected' income on a 1040NR tax return, so is taxed at graduated US rates. However, many tax treaties modify this, for example, for a UK resident, 401k and IRA withdrawals are taxable only to the UK and the US rate is 0%. In this case the 401k or IRA provider should not withhold any tax under the relevant treaty. However, some are known to ignore this and withhold US tax anyway, meaning that a 1040NR US tax return is required to recover the over-withholding.

Avoiding US tax traps on a non-US pension

In tandem with the above, you may also need to consider carefully the US tax implications of holding a non-US pension while you are resident in the US. If you still hold a pension from the 'old country', unless protected by a treaty the US will tax gains within it annually as if it were just another offshore investment account. This can produce some horrific tax results, and ones that are sometimes unavoidable where that country's pension tax laws do not permit any form of early withdrawal.

Double-tax on your pension gains are entirely possible, if the US taxes your pension gains while you are resident but you must again pay local country tax on withdrawals after leaving the US. And you should watch out especially for PFIC issues in such accounts, as well as tiresome and duplicative annual US tax 'information reporting forms' for holding this type of account.

You should also watch out for US tax traps that can apply to non-US accounts that you retained after moving to the US. Some tax-mitigating wrapper accounts, such as UK ISAs and Canadian TFSAs, can be used as alternatives to a pension in their country of origin, but as the US does not recognise these account types as tax deferred all the usual US tax rules and tax traps will apply to them for US residents.

Avoiding US taxable account traps

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. In the worst case you can sell to cash and take that with you, although this may generate a US capital gains tax that you would rather avoid.

Avoiding the US expatriation tax trap

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.

This tax is hard to avoid once you have passed the asset and time limits. One useful method to sidestep it though, is to give away enough assets (even if that means filing US gift tax returns where required) so that you then fall below the asset limit.

Treaties may offer scant protection here. In many ways, the US expatriation tax is written to override existing US tax treaties, even though this potentially violates the Vienna Convention on the Law of Treaties.


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

See also Nonresident alien taxation and Nonresident alien with no US tax treaty & Irish ETFs.

You are a US nonresident 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.

Reducing or eliminating the US dividend tax trap

By investing through Ireland domiciled funds or ETFs, 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, and whatever the appropriate treaty rate is with Ireland for dividends from other country stocks.

Eliminating the US estate tax trap

If you die while holding US situated assets, the US can apply an estate tax of up to 40% of the balance above a $60,000 exemption. However, 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

See also Nonresident alien taxation.

You are a US nonresident 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

See also Nonresident alien taxation and Nonresident alien with no US tax treaty & Irish ETFs.

You are a US nonresident 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.

Accumulating (or capitalising) funds

Funds and ETFs that pay out dividends regularly to investors are known as 'distributing' funds. The US regulations for funds and ETFs require a US domiciled fund to pay dividends to holders at least annually. It must also pay out capital gains realised internally by the fund as distributions to holders under some circumstances.

Non-US domiciled funds do not have this restriction. Non-US domiciled funds do not pay out capital gains distributions. And there is a class of non-US domiciled funds and ETFs known as 'accumulating' or 'capitalising'. These funds and ETFs retain all the dividends paid to them by the stocks that they hold, so that their 'net asset value' rises in response.

Different countries treat 'accumulating' ETFs differently, but in some cases this can lead to an investor advantage.

The neutral case is where a country taxes 'notional' dividends annually. That is, it taxes the dividend as if the investor received it, even though they did not (and later allows a reduction for any capital gains taxes). Here an investor holding 'accumulating' ETFs in a taxable account has no tax advantage. There can be a useful extra convenience in holding these inside tax shelters such as pensions, though.

There is a better outcome where a country treats the entire return as a capital gain and where the capital gains tax rate is lower than the rate on dividends. Here, an investor holding 'accumulating' ETFs effectively transforms dividends into capital gains for a tax advantage.

See also