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THE FOREIGN MUTUAL FUND TAX TRAP

You are receiving this e-mail as part of your subscription to David Tanzer’s newsletter about asset protection and offshore living and investing. Please feel free to share this message with your colleagues and friends.
 
Our last newsletter How to Use an International Trust for Investing” outlined basic asset protection and investment strategies, highlighting the importance of segregating different types of assets into different entities you control for aggressive asset protection.
 
Today we step outside of the box a little and take a look at a potentially huge problem for the uninformed investing in foreign mutual funds unwittingly creating complex tax burdens and compliance nightmares when investing outside of the U.S. We then look at more preferred methods of how to invest offshore.
 
I just can’t emphasize enough to……
 
Watch Out for the Foreign Mutual Fund Tax Trap!
 
First, keep in mind that using as international trust for asset protection does not mean you need to invest offshore. A perfectly valid strategy includes keeping assets closer to home, yet placed in a properly structured international trust for asset protection.
 
However, particularly in today’s environment, more and more investors are looking elsewhere for better returns, and increased protection.
 
Whether for asset protection or investment diversification (or both), a U.S. citizen or tax resident can freely invest in mutual funds located within the U.S. But beware: investing in a mutual fund outside of the U.S. is a trap of mammoth proportions for the unwary.
 
In the name of protecting the innocent, U.S. mutual fund groups in the past have lobbied to gain a huge advantage by protecting their market niche at home……. and with the help of the U.S. government, they now have a watchful eye over all they rule.
 
Today, in the U.S. in particular, we are witnessing the fall-out of poorly managed domestic financial institutions – even with household names that we all trusted in the past - it gives fresh reasons for diversifying and investing offshore.
 
But before you take the plunge with investing offshore, be aware that one of the most confusing aspects of foreign investing is the difference in the treatment of foreign mutual funds as compared to U.S. based mutual funds.
 
While I don’t personally provide financial or tax advise or tax opinions to clients on offshore investing, I believe the topic is so critical to offshore investors that at least a basic overview of the problem is essential for international investors.
 
To understand the problem a little more, it helps to begin with a basic explanation of the tax treatment of U.S. shareholders investing in a mutual fund located within the U.S.
 
Generally, a U.S. mutual fund is treated in a manner similar to a partnership with respect to the income and the gains of the fund. The income is then passed through to the shareholder-partners in proportion to their holdings and reported to the IRS by the mutual fund.
 
The information reported to the IRS by the mutual fund is then paired up against the reporting of the taxpayer.
 
Unlike with domestic mutual fund companies, the IRS is not able to keep a watchful eye over foreign investment companies or mutual funds, as they are not subject to the same kind of reporting and disclosure as their domestic brethren. And foreign companies and funds want nothing to do with the U.S. reporting burdens.
 
Instead, the IRS places the burden on the U.S. shareholder-taxpayer to determine their share of the income of the offshore investment company. Any type of corporate mutual fund outside the U.S. is referred to in the tax code as a PFIC (passive foreign investment company).
 
Without doubt, the U.S. tax laws are clearly designed to deter U.S. persons from investing in mutual funds outside the U.S. where the income or gains of the foreign funds are not subject to current taxation, as are the gains and other income of most domestic mutual funds.
 
In addition, the tax law clearly seeks to deter U.S. persons from using a foreign corporation as an investment fund by placing stringent requirements on these entities.
 
For example, if a foreign mutual fund is a PFIC, the U.S. shareholders will be subject to severe tax treatment on any distributions from the PFIC unless the PFIC elects to be subject to the SEC and the IRS reporting requirements, or the U.S. shareholder elects to pay tax on the undistributed current income of the PFIC (which requires the co-operation of the PFIC), or the PFIC is listed on a national securities exchange and the shareholder elects to pay tax on any increase in the market value of the shares from one year to the next.
 
Got all that?
 
All done and said, a U.S. citizen is far better off investing directly in the stock of a foreign mutual fund not considered a PFIC, or to otherwise invest in a U.S. mutual fund that invests in foreign stocks or foreign mutual funds.
 
In some cases, a U.S. person may be able to utilize a foreign variable annuity or variable life insurance contract to invest in foreign mutual funds, but the tax treatment will be based upon the rules for investments in annuities or life insurance rather than for investments in the underlying stocks or mutual funds.
 
Since 1992, the United States has changed the way certain offshore investments are taxed. The most onerous tax implication facing American investors is the default Section 1291 tax on accumulated income distributions and on gains from any dispositions of fund shares.
 
A U.S. investor who purchases offshore mutual funds must now pay annual capital gains from that investment even if there was no distribution. That means any investor holding an offshore fund must pay capital gains taxes every year, assuming he or she has gains, from a separate source of income.
 
The QEF election (Qualified Elected Fund) is the best alternative short of not investing in foreign mutual funds as it preserves capital gains treatment, qualified dividend treatment and loss deductions in a manner similar to a U.S. mutual fund or partnership.
 
The above makes offshore mutual funds a bad investment for Americans and U.S. tax residents.
 
The bottom line is that there are huge problems associated with U.S. citizens and tax residents investing in foreign mutual funds, which can lead to obscene results, and where the tax and penalties can exceed the total income and/or gains.
 
Ouch, and that can hurt. 
 
The reason for this outlandish outcome is that the gains from the funds are allocated to all of the years the fund has been owned. Tax is then computed for each year based on the highest rate in the tax tables – without regard to the marginal tax bracket of the taxpayer.
 
To add insult to injury, a non-deductible interest charge is added to the amount of tax and compounded on a daily basis. Because gains cannot be reduced by losses, the tax and interest can easily exceed the total net gain from the investment.
 
Before you delve into the offshore investment world, your number one priority should be figuring out your tax situation. In other words, understand how your investments will be taxed - and which investments should be avoided - because of the harsh tax consequences found in the U.S. tax code.
 
Repeatedly, I've heard of numerous disaster stories where investors made offshore investments through a foreign bank account, but didn't bother to check out the tax consequences before investing. Later, they were shocked when they were hit hard by punitive taxes.
 
What is the best way to invest offshore?
 
According to our tax counsel, international stocks are a different story altogether. If you choose to buy foreign stocks, either domestically or from a private bank abroad, then make sure you buy these securities in a taxable account so you can reclaim the dividend withholding at source.
 
Foreign bonds are another good option, but pose a dilemma to some retirement investors.
 
If you buy international bonds in an IRA or in any other tax-deferred account, interest income will be withheld. And because you cannot reclaim a credit in a retirement plan, you'll lose a portion of the income, a bad result since interest-income is a big part of a bond's total return. But you can claim that withholding outside of a retirement plan.
 
Going global with even a portion of your investment portfolio can yield some impressive long-term results, in addition to risk management. But make sure you fully understand the tax implications of investing in foreign securities before investing…. and get good tax advice.
 
And what of opening and depositing your money directly into foreign banks?
 
This is also a good method for offshore investing, whether used for investing in foreign currencies, businesses or real estate, so long as you remember to report foreign bank and financial accounts.
 
The topic of opening and working with foreign banks will be covered in a future newsletter as this is a different world today.
 
So while international trusts are great tools for asset protection, global investment diversification and pre-migration planning, U.S. citizens and tax residents must still use caution with the type of assets they invest in.
 
To start learning more about how to protect your assets see How to Legally Protect Your Assets for more information. And for more on how to live and invest offshore… these topics and much more are covered in Offshore Living & Investing.
 
For more free information, visit www.DavidTanzer.com and there are free Past Articles and more posted for your reading.
 
Until next time.
  
David
 
David A Tanzer, Esq.
JD, BSc, Ph.D (Hon)
For more information visit www.DavidTanzer.com or email to Datlegal@aol.com. David is the author of “How to Legally Protect Your Assets” and “Offshore Living and Investing.”

David A Tanzer & Assoc., PC.
Datlegal@aol.com
DAT@DavidTanzer.com
www.DavidTanzer.com

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Tel. (970) 476-6100
Fax (720) 293-2272

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(Licensed to Practice Law in U.S. States & Federal Courts;
Assoc. Member Auckland, N.Z. District Law Society - Foreign Lawyer; &
Assoc. Member Queensland Law Society, AU - Foreign Lawyer)
 
(C) Copyright 2008 David Tanzer all rights reserved. The comments herein are not intended to constitute a legal or tax opinion regarding any specific legal or tax issue as additional issues may exist; does not reach a conclusion with respect to any specific legal or tax issue addressed herein or any additional issues not included; and cannot be used for the purpose of avoiding legal obligations or penalties under code section 6662(d), et al with respect to issues in or outside the scope of herein.
 
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