Introduced in 1999, the Individual Savings Account - or ISA – is a hugely popular form of tax-free savings in the UK.
An ISA acts as a tax-proofing wrapper for UK tax payers. Investors can use ISAs to hold savings in the form of cash, shares, or collective investments such as unit trusts or other funds. If held inside an ISA, no further UK tax is due on the income generated by these holdings. ISAs are also free of capital gains tax.
Unlike pensions there is no tax rebate on contributions to ISAs. But ISAs are highly flexible, in that the money can be accessed at any age, and does not have to be earmarked for retirement spending.
Under current rules UK citizens over the age of 18 can save up to £20,000 a year into an ISA. Those aged 16 to 18 can invest up to the same limit into a Cash ISA.
I’m an American in the UK. Can I open an ISA account?
So popular are ISAs that it’s likely that Americans who move to the UK for work or family reasons will consider opening ISAs themselves. But can they?
The technical answer is yes, says Trevor Egan, a specialist accountant at Buzzacott. But he points out that there are scant tax advantages from the point of view of those who have to pay tax to the US taxman, the IRS.
“An ISA is ‘look through’ for US tax purposes,” he explains.
“The individual is considered to hold the assets within the ISA directly and is taxed on them under normal US rules. The UK tax free treatment of the ISA is not replicated in the US.”
In practice this means that cash ISAs will generate interest income for US tax purposes. Stocks and shares ISAs produce taxable dividends and capital gains on an “arising” basis, meaning tax becomes due even where there is no cash distribution to the individual.
“None of this is particularly onerous on the individual,” he points out, “other than there being a US tax charge where there is no equivalent UK charge (together with some additional US reporting obligations).”
So if there are no particular advantages to an ISA for US persons in the UK, are there any disadvantages?
Where ISAs can present difficulties for Americans – and the main reason that some people assume that Americans should simply avoid them as a general rule – is because there can be undesirable tax consequences that result not from the ISAs themselves, but rather, from the types of investments often held inside them.
In the UK, some the most popular forms of investments for individuals include funds structured as unit trusts or “open ended investment companies”.
These are very commonly held within savers’ ISA accounts.
Unfortunately, these types of investment can fall foul of certain IRS rules and result in penal taxation.
“The particular problem can arise when a Stocks & Shares ISA is invested in Unit Trusts as opposed to individual company stockholdings,” says Trevor Egan.
“This can result in income and gains being taxable under the US Passive Foreign Income Company (PFIC) regime, which can result in exorbitant US tax charges,” he warns.
Put simply, the term “PFIC” generally applies to all non-US investment funds. Most “collective investments” – such as unit trusts or open-ended investment companies in the UK – are deemed to be PFICs for US purposes.
“For this reason alone, from the US tax perspective, unit trust based ISAs are perhaps best avoided by Americans.”