U.S. citizens and residents investing overseas need to be aware of the risks and complications they face when investing overseas. Not only are there complicated tax issues, but foreign regulations regarding investment protection are not as strong as they are in the United States. In fact, in many countries, investment protection safeguards don’t even exist! Additionally, foreign inheritance laws are difficult to navigate which makes estate planning and wealth transfer hard to accomplish. Foreign investments also expose investors to risks that they do not necessary face when compared to investing in the U.S. market. Political risk and currency fluctuations have significantly impacted the returns investors thought they were receiving with their foreign investments. As we explore these risks in greater depth below, you will see why you should be invested in the U.S. market.
Tax treatment of Foreign Investments is unfavorable
Many investors are unaware that they might be invested in Passive Foreign Investment Companies (“PFIC”). Does it matter if you are? Absolutely. The tax treatment of PFICs is extremely punitive compared to the tax treatment of similar investments that are incorporated in the US. For example, a U.S. resident who owns a US incorporated mutual fund invested in European stocks pays the low long-term capital gains rate of 15%, if the fund is held for more than one year. The same investor who buys a nearly identical fund listed outside the U.S. will find their investment subject to the PFIC taxation regime, which counts all income (including capital gains) as ordinary income and automatically taxes it at the top individual tax rate (37%). In some cases, the total tax on a PFIC investment may rise to well above 50%. Furthermore, capital losses cannot be carried forward or used to offset other capital gains.
IRS is searching for your investments
Tax compliance involving foreign investments is complicated. With passage of The Foreign Account Tax Compliance Act (FATCA) of 2010, global financial transparency gained X-ray vision. The IRS aggressively pursues U.S. residents with assets outside the United States who have not complied with the United States tax laws and/or their Bank Secrecy Act reporting obligations.
FATCA has created requirements for foreign financial institutions (banks, brokerages, insurance companies, hedge funds, etc.) to disclose accounts held by US persons, US Green Card Holders or signatories. Failure to understand the basic rules of tax compliance and financial reporting/disclosure requirements can expose a person to financial penalties—not to mention the possibility of jail time.
Estate planning with foreign investments can be complicated
In many countries, for will drafted in the United States to be valid in a foreign country, it must be formally valid under the laws of that jurisdiction. Some foreign jurisdictions, however, will not recognize a will drafted in the United States under any circumstance or will recognize the U.S. will only under certain unique circumstances. In the United States, an individual is free to dispose of his or her estate as desired. However, France makes almost no provision in its succession laws for a surviving spouse. So, if an individual had no will in place and the property there was purchased individually, then the surviving spouse would have no claim to that foreign property. In countries where the U.S. will is not recognized, assets may revert to probate court requiring the potential heirs to travel to the foreign country to deal with the probate issues (or hire a foreign attorney to fight on your behalf). A proper estate plan can ensure that U.S. based investments are transferred to the designated beneficiaries.
Hidden risks of Foreign Investments
Investors in the United States are provided certain protection from banks or brokerages that fail. The FDIC (Federal Deposit Insurance Corporation) is an independent agency of the United States government that protects you against the loss of your insured deposits up to $250,000 per account if an FDIC-insured bank or savings association fails. FDIC insurance is backed by the full faith and credit of the United States government. The SIPC (Securities Investor Protection Corporation) protects against the loss of cash and securities – such as stocks and bonds – up to $500,000 held by a customer at a financially-troubled SIPC-member brokerage firm. If a foreign bank or brokerage firm fails, you won’t have this protection and recovery of your investment could be incredible difficult, or even impossible.
Why investing in the United States is so attractive
From 1900 to 2018, the S&P 500 has returned an average of 10% per year, based on a 10 year rolling return period. There are a myriad of investment products that can help you defer taxable gains, transfer wealth tax free, and provide equity-like returns while also providing protection to your investment. The key to successful investing in the United States is to first define your financial objectives and then identify the investments that can meet these goals.
How can I get help with my investments?
As complex as investment management and tax compliance are, they only comprise two pieces of the entire wealth management puzzle. Tax planning and issue resolution, estate planning, and gift planning are just some of the other pieces that need to be addressed correctly to complete the puzzle. To be properly invested and protected from tax compliance and foreign country pitfalls, it’s important to work with a team that views your entire financial picture in a comprehensive and coordinated way.
Freeman Tax Law has a strategic partnership with financial advisors who can help you develop a financial plan and determine which investments are appropriate to meet your objectives. Please contact our office if you would like someone from our team to contact you to discuss strategies to mitigate your tax obligations and focus on building wealth.