American citizens living in the UK (or elsewhere overseas) quickly discover that when it comes to investment advice, their options are extremely limited.
Several factors come together to reduce the services and choices available to them.
These factors include:
- US citizens living overseas face onerous tax reporting requirements. These can apply even where no tax is payable. (In some cases, they can even apply to people who have never lived or worked in the US.)
- There are strict rules governing the type of investments US citizens can hold. Some of the most prevalent and popular investments available in the UK, for example, are taxed punitively by the US authorities. To ensure they don’t make extremely costly mistakes, Americans abroad almost always should obtain good and regular investment advice, from someone who is knowledgeable about the relevant tax issues.
- New legislation that took effect in July 2014, called FATCA (see below), placed heavy obligations on non-US banks and financial companies to report details of their US-linked customers to the US Internal Revenue Service. Rather than do this, many companies simply stopped accepting Americans as clients, and began asking those they did have to move their accounts elsewhere.
Today Americans have more banking and investment options than they did four years ago, but their choices are still relatively limited, and they can end up paying more than non-Americans for basic services.
In brief: how the US tax system treats US investors living in the UK and elsewhere
American citizens living overseas are broadly subject to the same income tax regime as would apply if they were still in the US. This is because US tax law differs from that of virtually all other developed countries around the world, in that it taxes on the basis of citizenship rather than on residency.
In other words, if you’re an American citizen, the fact that you have lived in another country for 40 years and may even have been a citizen of that country for all this time doesn’t mean that you don’t have to file a US tax return each year, and potentially be liable for US taxes.
So if you are a US citizen, or a “US person” (see below for more on this), the US tax authorities will consider themselves to have a potential tax claim over your income, wherever in the world it is earned.
The only mitigating factor is double taxation agreements (DTAs), that the US has with virtually all other countries, that are designed to ensure that an individual isn’t taxed twice on the same income.
However, if there is something that an individual isn’t taxed on where they currently live, but would be taxed on in the US – such as capital gains tax on the profit realised when they sell their home – they may find Uncle Sam will expect his share anyway.
There are, though, mitigating options that American expats may make use of, such as the Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credits. But normally people need professional help from tax experts in arranging their finances to be able to take advantage of these, while at the same time steering clear of the many potential tax traps that exist for US persons living abroad.
FATCA, FBAR and other tax reporting issues for US expatriates living in the UK
Given the fact of the US’s citizenship-based tax regime, the Internal Revenue Service (IRS) has long wanted to know about the overseas wealth of its citizens – particularly that of its wealthiest constituents. But until recently, it lacked the regulatory tools to obtain this information.
It certainly has them now, though. The first, introduced in 1970 but little known about until recently, is a requirement that all US citizens and other individuals with US connections must file a Foreign Bank Account Report (FBAR) each year, for any and all non-US (thus “foreign”) bank or other accounts that they have in which the balance has exceeded US$10,000 during the year. All foreign accounts are reportable, even those with zero balances, if the aggregate total in all accounts exceeds $10k.
The IRS is interested in the maximum amount held in these accounts, by the way, even if it was only in that account for a day.
The FBAR form is separate from an individual’s US tax return, and for this reason many Americans living abroad weren’t aware it was required – in some cases only finding out when they were told that they needed to pay a penalty as well as tax deemed to be owing on their non-US holdings, as a result of their failure to file FBARs.
While the FBAR was a start, it was FATCA that at last gave the IRS the unobstructed view into the offshore financial accounts of American citizens – resident in the US as well as elsewhere – that it evidently had been dreaming of.
The Foreign Account Tax Compliance Act (FATCA) was signed into law by President Obama in 2010, and came fully into force in 2014.
Under FATCA, non-US banks and other “foreign financial institutions” are obliged to report to the IRS – as provided for by inter-governmental agreements signed by the governments of the various jurisdictions in which the relevant financial institutions are located, and the US government – on the assets held by their American clients.
Firms that fail to do this face potentially significant penalties, which is why some have decided that it would be more cost-efficient for them to avoid having any American clients at all, rather than having them but going through the costly hassle of complying with the regulations on their behalf.
Particularly in countries like Britain, which are home to many international financial businesses, FATCA is taken extremely seriously.
The result is that these days, the likelihood that the IRS will find out whenever US citizens are failing to report their non-US bank accounts and other financial holdings is extremely high. And when it does, the penalties can be severe.
One case that was publicised in January 2019, for example, involved an American woman who failed to report accounts she’d held at HSBC and UBS in Switzerland in the early 2000s.
Sometime after 2009 she had been issued with an FBAR “wilful” non-filing penalty of US$697,229, which was said to have been equal to 50% of the highest balance held in the accounts.
As a US person in the UK, you may have to file an American tax return – even if you’ve no tax to pay
If you’re a US citizen or US person living in the UK, you may have to file a return even if you’ve no tax to pay.
But if you do have to, at least there are a few ways you may reduce your US tax liability. The two main exemptions are the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit.
Even where these are applied in such a way as to eliminate a tax liability, though, the requirement to file a tax return is almost certain to remain.
How do you know if you’re a “US person”?
The expression “US person” was coined because there is a distinction between US citizens and US persons.
If you are a tax resident of the US, or a Green Card-holder, you are a US person – even if you are not a citizen.
If you’re a US Citizen you are a US person automatically. And this is where it can get complicated.
You may be a US citizen even if you were born outside of the US and have never lived if there if, for example, one or both of your parents were citizens themselves.
And you remain a citizen – with all the applicable tax obligations – until you formally relinquish that citizenship.
This is how many people find themselves unwittingly in breach of the US tax rules. They are sometimes called “accidental Americans”.
Why is it so difficult for US citizens to get specialist investment advice in the UK?
A very small number of wealth managers have chosen to invest in the expertise required to service American investors living in London and elsewhere. Schroders Wealth US Ltd is one of these, and is also one of a small number of firms to have obtained a licence from the US regulator, the Securities Exchange Commission.
As noted above, many firms are put off by the compliance obligations FATCA introduces into the business of looking after Americans. This can mean a significant added cost, particularly if you don’t have many American clients.
The PFIC problem: what types of investment are US citizens living in the UK allowed to own?
The UK’s highly developed investment market has tended to favour two types of collective fund structures: unit trusts and open-ended investment companies (OEICS). But these vehicles need to be established in a certain way if they are not to be treated by the US Internal Revenue Service as Passive Foreign Investment Companies (PFICs). Most are not.
PFICs are taxed more severely by the US tax authorities than other assets. As a result, US investors in the UK or elsewhere should avoid owning them. This effectively means avoiding investing in the vast majority of popular collective vehicles, and creates a number of problems for American investors overseas. It is yet another reason why those people with US reporting requirements struggle to obtain investment advice.
What is a PFIC?
The Internal Revenue Service rules on PFICs seek to distinguish between investments in operating businesses and investments which pursue a passive income stream. There are two tests which qualifying investments must pass: the “income test” and the “asset test”.
The definition of passive income is complex. Company dividends and interest might qualify as passive income – but that depends on the nature of the entity producing them. Shares quoted on a major stock market may or may not be classed as PFICs, depending on the nature of the business which issued them. But a general upshot of this test is that shares in operating businesses – where revenues are largely derived from the sale of goods or services - would pass the tests.
Unfortunately, when these shares are brought together in a portfolio, such as popular unit trust managed by a UK asset manager, the vehicle itself is likely to fail the tests and thus be regarded as a PFIC and potentially subject to higher taxation.
Schroders Cazenove thanks Trevor Egan, partner with London-based specialist accounting firm Buzzacott, for his help with this piece.