When Americans think of investing, among the first things to come to mind are mutual funds and ETF's. With countless options from giant financial companies like Fidelity, Vanguard, and BlackRock, mutual funds and ETF's can be some of the best ways to achieve diversification (which is a fundamental investing principle) at a low cost. They can also save quite a bit of time for the average investor, because a mutual fund's investments are researched and selected by the fund's professional investment staff instead of the investor themselves. But many American expats are surprised to find out that there can be serious complications to using mutual funds and ETF's in their portfolios while they live abroad. First, investing in overseas mutual funds can cause significant tax consequences for Americans living abroad. Second, many U.S.-based mutual funds limit access to their funds to only those living inside the U.S. Third, some countries, particularly those in the E.U., disallow investments in U.S.-based ETF's for anyone within their borders, including American citizens.
Taxes and Overseas Mutual Funds
The IRS doesn't look kindly on mutual funds based outside the U.S. Historically, American investors would stash their investments abroad to avoid paying U.S. taxes, which created a cascade of legislation to ensure U.S. citizens were reporting their investments to the IRS and to incentivize bringing their investments back within American borders. The net result is that investing abroad can be cumbersome and costly from a tax perspective.
The problem with investing in overseas mutual funds is that they are typically classified as passive foreign investment companies (PFIC's). PFIC's are defined as a foreign fund or corporation that earns 75% or more of its gross income from passive sources or holds at least 50% of its assets in order to produce passive income. Common PFIC's include ETF's listed on a foreign stock exchange, foreign real estate investment trusts (REIT's), and foreign mutual funds.
Reporting Requirements for PFIC's
When an investment is classified as a PFIC, American citizens who own the fund will have additional reporting requirements to make sure they stay on top of. You may need to fill out the following:
Form 8621 details your investments in a Passive Foreign Investment Company or Qualified Electing Fund. You can also use this form to choose how your PFIC will be taxed.
The Foreign Bank Account Report (FBAR) details your financial accounts held outside the U.S. It's required if the combined value of your overseas accounts is over $10,000 at any point during the calendar year.
Form 8938 is the Statement of Specified Foreign Assets, and it's often referenced using the acronym FATCA for the Foreign Account Tax Compliance Act which instituted it. It requires disclosure of certain financial assets held outside the U.S. and levies hefty fines for those who don't disclose them.
How Overseas Mutual Funds Are Taxed
In addition to adding burdensome reporting requirements, PFIC's can cause difficult tax scenarios to arise. The details are complex, but in general, you'll end up paying more tax and/or paying your tax sooner by choosing to invest in an overseas fund. I strongly recommend working with a tax specialist if you're considering investing in a mutual fund domiciled outside the U.S.
PFIC's can be taxed in one of three ways: Excess Distribution, Mark-to-Market, or Qualified Electing Fund.
Excess Distribution as a Section 1291 Fund is the default taxation method for PFIC's. Under this taxation method, amounts that exceed 125% of the average of the prior three years' distributions from the fund are taxed at the highest tax rate available under the tax code, rather than the lower qualified dividends or long-term capital gains tax rates.
Mark-to-Market taxation means that at the end of each year, the amount the investment's value increased over the year will be taxed as an ordinary gain (instead of the more favorable long-term gains treatment). Rather than waiting to pay this tax until you sell the investment, you'll owe tax on it each year.
Qualified Electing Fund is the third taxation method for PFIC's, and it must be chosen in the first year you own the investment. You'll be taxed on the pro-rata share of undistributed earnings in the fund. If the PFIC's annual information statement isn't available, however, you may not be able to use this method.
Taken together, the additional reporting requirements and special tax treatment of foreign mutual funds serve to penalize those who would take their investments outside the U.S. In general, I don't recommend that U.S. investors choose overseas mutual funds due to the added work and higher taxes typically associated.
Expats and U.S.-Based Mutual Funds
Although overseas mutual funds can cause serious headaches for Americans living abroad, choosing U.S. mutual funds can cause problems for other reasons. Most U.S. mutual funds have had rules on the books for years disallowing non-residents from purchasing them, but they were rarely enforced. Recently, amid a rapidly changing regulatory landscape, mutual fund and brokerage companies are stepping up their compliance procedures, and expats are finding these funds suddenly unavailable for purchase.
What's going on that's causing the change? Ultimately, mutual funds are upping their rules enforcement in response to increased regulation both at home and abroad. FATCA has created many new compliance burdens on financial institutions serving U.S. citizens abroad, resulting in many foreign financial institutions refusing to serve American clients. Other standing legislation such as the 2001 Patriot Act as well as a renewed emphasis on offshore tax enforcement have further encumbered the regulatory landscape. The U.S. isn't alone in complicating cross-border investing. The E.U., for example, has produced legislation such as the Alternative Investment Fund Managers Directive (AIFMD), disallowing some U.S. mutual funds from being sold to Americans living abroad.
Fundamentally, U.S. mutual funds are reluctant to offer their investments to non-U.S. residents for two reasons. First, by offering their funds to investors outside the U.S., fund companies could be violating the laws of the countries in which their investors live. Second, in order to make use of favorable tax treaties between the U.S. and certain foreign governments, mutual funds may need to certify that all of their investors live in the United States. Facing increased scrutiny from American and foreign governments, U.S.-based mutual funds are less willing to overlook these considerations than they have been in the past, and Americans living abroad are finding that their access to U.S. mutual funds is rapidly disappearing.
Should American Expats Use ETF's?
Mutual funds and ETF's share many characteristics, making ETF's a natural substitute for those who don't have access to mutual funds. In some locations, this is a valid alternative and a welcome way to create low-cost diversification in their portfolios. However, some regions, most notably the E.U., have placed restrictions on their residents from purchasing U.S.-based ETF's, whether they are American citizens or not.
The difficulty in this scenario is slightly different from the inability to purchase U.S. mutual funds. In that case, it is primarily the mutual fund companies themselves who are reluctant to sell overseas. In the case of ETF's, foreign regulatory bodies are responsible for preventing trading in U.S. ETF's.
So what's the solution? If overseas mutual funds, U.S.-based mutual funds, and ETF's are all off the table, how do Americans living abroad build a diversified portfolio?
Developing an Alternative to Mutual Funds and ETF's for Expats
A diversified portfolio is still possible without mutual funds or ETF's if investors are willing to put the time and energy into researching individual securities such as stocks and bonds. The primary difference for most investors will simply be the amount of effort they have to put into designing their portfolios. With mutual funds and ETF's, investors should still put thorough research into selecting the funds, but the actual stocks and bonds held by the fund are researched and purchased by the fund's investment staff. This results in significantly less hands-on work for the investor. Without a fund's investment team to carry the load, investors will need to develop an investment philosophy and a process for investing, both of which will take ongoing, intentional effort to create and execute.
If you'd like some thoughts on getting started with investing as an expat, check out our post: 5 Crucial Steps to Start Investing for Expats.
For more on developing an investing process, here's another post: The Most Underrated Factor for Investing Success
If you're not sure taking all the time and work to build your own investment portfolio is the right move for you, consider hiring a financial advisor who specifically works with expats to help. They'll get to know you and your goals and help you build a portfolio that matches your unique situation. Polaris Asset Management specializes in helping expats invest, and we'd be glad to talk to you about your investing needs. Click below to schedule a no-strings-attached consultation.
The preceding article should not be considered specific tax or investment advice, and may not be appropriate for your situation. Consult a tax or investment professional for specific guidance.