| Some Tips for Investing Outside the U.S. |
U.S. persons who venture offshore for better investment opportunities are also subjected to more complex and costly tax accounting. In some cases, the added costs of accounting for foreign investment transactions can wipe out the gains in a small or modest size account and can greatly reduce the rate of return on larger accounts.
Regardless of who prepares your U.S. tax returns for a foreign trust or foreign corporation, there are some potential problems that U.S. investors may want to avoid or at least to minimize.
First, investments by U.S. persons in foreign mutual funds can cause some tax nightmares and substantial accounting expenses to comply with IRS requirements. Here are three rules of thumb that can help to avoid some of the potential problems.
First, if possible, invest in funds that are organized as partnerships rather than as corporations or unit investment trusts.
Second, if the foreign fund is a corporation (or UIT), invest in funds that are controlled by U.S. investors and that will provide you with the kind of detailed annual information that you would get from a partnership so that you can make what is called a QEF election. This election will permit you to avoid adverse tax treatment.
A third choice is to invest in foreign funds that are listed on the major foreign exchanges of major countries where you can buy or sell and get price quotes the same as on a U.S. stock exchange. This will allow you to elect to pay tax on the fund income based on the gain in share value during the year or the time the shares are held if less than a full year.
If your offshore account manager buys and sells foreign mutual funds that don't allow you any of the above options, there is a punitive tax treatment of any fund gains and there is no deduction for fund losses -- even in the same year. Gains are taxed and losses are lost. Also, it will be necessary for a U.S. tax accountant who is familiar with these rules to analyze every fund transaction throughout the year in order to prepare the required reports. Pooled income funds of foreign banks are treated as foreign mutual funds. The accounting is extremely time consuming and if there are a lot of transactions, it can become very costly.
If your foreign account manager suggests that your trust set up a corporation to buy and sell investments, I encourage you to be sure that the entity that is formed is eligible to be treated as a foreign disregarded entity. International business companies, foreign limited liability companies or corporations in most tax havens can make an election to be disregarded for U.S. tax purposes. BUT -- SA corporations in most Central or South American countries are not permitted to be a disregarded entity and must be taxed as a foreign corporation. That would have the effect of converting tax favored dividends or capital gains into ordinary income and to prohibit current deductions for some losses.
As with your US investments, you will need to ask your account manager to keep track of the cost of each investment and the sales proceeds of each sale. Some dividends paid by foreign corporations may be eligible for the reduced dividend rate on dividend income and someone will need to take the time to make that determination for dividends received from each separate foreign company.
Buying and selling debt obligations can also require extensive accounting to comply with U.S. tax rules. Special attention must be paid to discounted debt obligations, interest paid on purchases and interest received on sales.
Hedge transactions involving straddle transactions also require special treatment. If a hedge fund is very, very profitable, it can be worth the cost of the accounting to deal with the U.S. tax requirements, but only for substantial amounts. Gains on small hedge funds can be wiped out with tax accounting fees.
When investment transactions are made in a foreign currency, the change in currency value is generally treated as part of the total gain or loss on the investment. It is unlikely that you will do this, but I have had a client who invested in foreign currencies directly and would move funds from one currency to another -- such as from the Euro to the Swiss Franc or the English Pound. I had to treat each transaction as if the currency had been sold and converted into US dollars and then invested in the second currency. It was very time consuming.
Although I'm sure that some of this information may be discouraging, I offer it to you in the hope that it will help to avoid more costly problems.
Vernon Jacobs
The information herein is not intended to be personal tax or financial advice and may not be appropriate or applicable for every recipient of this message. If personal advice is needed, the services of a qualified legal, investment or tax professional should be sought.
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