US Foreign Taxation

Are you a US person?

The rules of this article concern the taxation of foreign investments. They are relevant to you if you have any foreign investments (including foreign bank accounts) and if you are a US person. Not knowing these rules can lead to significant penalties and a punitive taxation of foreign investments that may offset any potential earnings. Therefore, let us first identify under what circumstances you should worry about the tax rules of this article. They apply to you if you are a "US person":

• US citizen or US permanent resident. If you are a US citizen or US permanent resident, you are a US person and all these rules apply to you regardless of where you currently live (even if you never lived in the US).

• US resident for tax purposes (see "substantial presence test"). You are also a US person if you spent sufficiently many days over the last three years in the US, regardless of your visa status, unless you meet certain exemption criteria. The most notable exceptions are students (on F1 visa) and exchange researchers / teachers / etc. (on J1 visa) which can exclude some of the time spent in the US because they count as "exempt individuals". The rules also apply analogously to M and Q visa holders if they are teachers or trainees (including researchers, such as postdocs). In either case, you need to file Form 8843 with your tax return, while you count as exempt individual. You do not have a choice for this. However, after the respective time period is over, you can either file as US person (all later rules apply) or argue that you continue to be an exception to the substantial presence test by claiming the "closer connection exception" (which everybody meeting the substantial presence test should check) or the "closer connection exception for foreign students" (which has weaker requirements, but can only be used by students).
  As of writing (March 2021), the rules are as follows: You can exclude the days you spent in the US during the first x calendar years on the respective visa (with x=5 for students and x=2 for teachers), from the substantial presence test. For example, if you start to study in the US October 2014 and complete your program in summer 2019, you will be able to exclude any days in the five calendar years 2014, 2015, 2016, 2017 and 2018. Starting in the year 2019, any days present in the US count for the purpose of the substantial presence test. Depending on when exactly you exactly finish your program and potentially leave the US, you might or might not be a US person for the year 2019. Again, for the substantial presence test in the year 2019, you will need to add up any days present in the US for the years 2017-2019, but as you were exempt in the previous years, you would only count the days for the year 2019.

The following requirements apply to all US persons who have accounts outside of the US, i.e., in particular:

• US citizens and permanent residents living abroad and have bank & investment accounts there.

• Foreign nationals living in the US as tax residents (see exemptions above) who still have accounts in their home country.

Report of Foreign Bank and Financial Accounts (FBAR)

US persons are required to provide detailed information about their worldwide assets. You can find further information on the official IRS website. Put simply, you need to declare any foreign bank or financial account whose belance ever reached 10,000 USD during the year. If you not do this, there may be harsh penalties, so it is typically advised to rather overdeclare than underdeclare. For example, it is disputed which type of foreign retirement accounts and similar are required to be listed as part of the FBAR report, but it is usually be best to declare everything when you are unsure.

Note that you do not need to declare accounts that are directly held with US financial institutions, though be careful with accounts held by foreign subsidiaries of US institutions, as those will need to be declared. For example, an Interactive Brokers account will only need to be declared if it was opened at a non-US subsidiary with a foreign address, while an Interactive Brokers Lite account held with Interactive Brokers LLC in the US will not need to be included in your FBAR report.

Punitive taxation of passive foreign investment company (PFIC)

If you are a US person or expect to be a US person in the future, you should completely avoid to invest in a passive foreign investment company (PFIC). The reason is that the IRS will heavily tax any income or capital gains derived from such an investment. While this may sound like a complicated and obscure investment vehicle, a large number of foreign investment vehicles fall into this class:

• Foreign mutual funds.

• Foreign ETFs.

• Foreign money-market accounts.

It is very important to note that "foreign" means that the respective investment fund or bank account is domiciled outside of the US (i.e., managed by a foreign financial institution), while it does not matter where the respective fund invests. For example, the Vanguard Developed Markets Index Fund (VEA) primarily invests in European stocks, but it is managed by Vanguard in the US and is therefore domiciled in the US and does not count as PFIC. In contrast, the Vanguard S&P 500 UCITS ETF invests in US companies, but is managed by Vanguard Ireland, domiciled in Ireland and therefore falls under the PFIC regulation.

This regulation particularly affects foreigners who come to the US, but still have investments in their home country. As soon as you become a resident for tax purposes in the US (see above), you need the PFIC regulation will apply to you. This may mean in some situations that it is advantageous to sell your foreign investments (and pay the respective capital gains tax in the US, sometimes even in your home country based on the relevant tax treaty) and move the money to the US and invest into US registered investment vehicles (such as ETFs).

EU regulations: Markets in Financial Instruments Directive (MiFID II), Packaged Retail & Insurance-based Investment Products (PRIIP) and Key Information Document (KID)

Sometimes additional regulation that is supposed to help consumers makes it worse for certain groups. This is certainly true for some recent EU regulation on financial products, which requires financial institutions to provide certain documentation to consumers. As many US institutions are not particularly keen on selling their products to EU consumers (as they may have EU subsidiaries offering similar products with higher fees), they will often not adhere to these requirements and do not provide such documentation.

The consequence is that US persons living in Europe often have a really hard time to avoid the punitive PFIC regulation, as they are not able to invest in US registered ETFs using the European brokerage accounts. Note, however, that the EU regulation does not make it illegal for European residents to own such shares, so the main problem is only that European financial institutions will not sell them to you. There are the following solutions:

• Have a US brokerage account. The easiest solution is to keep or open a US brokerage account. This often requires to open the account with a US reference address and some brokers are known to close accounts if they become aware that a customer is also tax resident of a country outside of the US. I have had excellent experiences with Interactive Brokers Lite.

• Apply for an exemptions. Professional traders and high net worth individuals can apply for an exemption, such that their European based broker will not treat them as retail clients anymore, such that above regulation does not apply to them anymore. For most normal people, it will be difficult to meet the required conditions and just keeping a US brokerage account (see above) is the better solution. According to the regulation, you need to satisfy two out of the following three conditions to be exempt:
  (1) You have carried out trades in significant size (EUR 200,000 or greater) on the relevant market at an average frequency of 10 per quarter over the previous 4 quarters.
  (2) Your entire portfolio including cash (and positions held with other institutions) exceeds EUR 500,000.
  (3) You have worked in the financial sector for at least 1 year in a professional position.

Catch-22: Additional punitive taxation from other country of residence

A particularly delicate situation arises if you are a US person who lives in a country that itself imposes a punitive tax on certain foreign investment vehicles. An important example of such a country is the UK with punitive tax rates on non-UK registered investment funds. A similar regulation existed in Germany until January 2018, when a new investment tax law ("Investmentsteuergesetz") was passed, which simplified taxation of foreign funds and removed punitive taxation.

Countries, such as the UK, often leave US persons with a choice between two unsatisfactory options:

• You can either invest in US domiciled funds, but face unreasonably high taxes in the other country.

• Or you invest in funds that meet the requirements of your country of residence, but face punitive taxes and complex filing requirements of the US regulation for PFIC.

As none of these options are particularly appealing, you are probably seeking for a better alternative.

• Only invest into individual shares. Most punitive taxes can be completely avoided if you only invest in regular shares (stocks of individual companies), as they are usually treated the same regardless of where the country is located. In this case, you only need to deal with source taxes on dividends, which can often reduced to 15%. The main disadvantages of this strategy is that you will need more capital in order to diversify sufficiently (and you will probably never reach as much diversity as an international ETF investing into thousands of companies worldwide) and you will probably also have some trouble to invest into emerging markets (in particular: China), which can more easily covered by purchasing an appropriate ETF or mutual fund. While this might not be the best option for everybody, you can still get a reasonably

• Search for special investment vehicles that satisfy both filing requirements. While there is no general solution for all countries, there often special solutions tailored specifically to the needs of US expats living in a specific country. At least if the US expat community in the respective country is sufficiently large. In the case of the UK for example, there exist US registered funds that still satisfy the reporting requirements of the UK, i.e., they have "UK reporting fund" status. You will often need to make compromises as the number of funds will be limited and they may incur higher fees, but this may still be the best solution overall if you put in the work to find the right investment product. Apart from searching the internet, there are special advisors/companies (such as Thun Financial) and expat communities (on Facebook/Reddit/etc.) which may provide relevant information for your specific situation.

Further resources

• ThunFinancial.com provides services and information for Americans living abroad. In particular, they explain why US persons should never invest in certain foreign investment funds and how US persons living in the UK can avoid the catch-22 mentioned above.

• FIRE across the Pond provides valuable information for US persons living in the UK with a particular focus on how to optimize retirement savings (which accounts and investment vehicles to use and how to avoid the catch-22 mentioned above).