Walter B. Wriston (former CEO of Citicorp): “All the Congress, all the accountants and tax lawyers, all the judges, and a convention of wizards all cannot tell for sure what the income tax law says.”
Applying US tax law to “foreign” legal structures is problematic.1 This is one of the great frustrations of trying to comply with the US system of citizenship based taxation (and one of the reasons why this extraterritorial application of US law should be carefully considered by all countries who negotiate tax treaties with the US). Inevitably there will be differences of opinion as to how US law applies to particular foreign income or taxes – and these differences will lead to different US tax treatment of the same or similar items. There may be no single “right” answer, and we (or the tax professional we have hired) will have to choose how to interpret US tax law to determine our US tax liability on our foreign (home) income. Understanding how our local law meshes with the structures defined in the US tax code is the first step.
In Australia, we have two advantages relative to much of the rest of the world (especially those which are not part of the Commonwealth). First, our laws are written in English. While there are several Aussie colloquialisms that differ in meaning from American English, our laws and other formal writing are written in language that is mostly the same as US English (with a few extra vowels here and there, and the occasional “zed” that has been replaced by an “s”). Second, our legal system is derived from the British system, so many of the underlying principles are at least similar between the two countries. Even so, there are differences.
In this post I’d like to explore two areas where the application of US tax law to Australian financial products is not completely clear: managed funds and superannuation. An understanding of these US tax issues is critical for determining how the tax treaty (either the current treaty or a new one) can be used to protect Australian residents (and the Australian economy) from extraterritorial taxation by the US of Australian income.
Retail managed funds are an essential savings tool for Australians. They provide diversification with a relatively low initial investment. Under Australian law, managed funds are required to distribute all income and realised gains annually – just like mutual funds in the US. However, Australian managed funds are toxic investments for US taxpayers because most are classified as Passive Foreign Investment Companies (PFICs)2.
PFICs entered the US Tax Code in 1986. At that time mutual funds in the US were just gaining popularity and would not have been found in the investment portfolio of many smaller individual investors. The intent of the PFIC rules was to remove a planning opportunity where wealthy investors could invest via a foreign corporation that did not distribute income currently, thereby deferring tax on interest and dividend income. Australian retail managed funds do not allow for any income deferral, so why are they PFICs? Let’s start with the definition: PFICs are corporations organised outside of the US where most of the assets are passive investments. Australian managed funds are certainly organised outside of the US and own exclusively passive investments; but are they corporations? Most are organised as “unit trusts,” a structure that doesn’t have a strict parallel in US law.
In the early 2000s, I doubt there were many Australian managed fund investors reporting their funds as PFICs on their US returns. At some point, however, the idea of PFICs entered the collective consciousness of tax professionals working on US expat returns. (The earliest reference I can find to this treatment is in 2009.) The more conservative return preparers decided to start reporting all foreign mutual funds as PFICS, and started writing articles about how toxic PFIC investments were. As this treatment became more common, it became expected. Now, most US tax preparers who work on expat returns will classify all foreign mutual funds as PFICs, even though they are not at all like the foreign investments originally targeted by Congress in 1986. In some sense, conservative compliance choices have changed the way US tax law is applied to Australian investments.
Superannuation is another area where compliance choices may end up dictating the treatment expected by the IRS. There are several different ways that superannuation can be analysed in determining how (or whether) to report super on a US tax return. In some ways, super is similar to US Social Security:
- employers are required by law to contribute an amount that is a percentage of salary,
- benefits from super contributions are not available to the employee until a condition of release has been met (most frequently retirement after a specified age), and
- “The primary objective of the superannuation system is to provide income in retirement to substitute or supplement the age pension.”3
In other ways, super is similar to a 401(k) account:
- accounts are attached to individual employees
- most are defined contribution plans over which employees have limited ability to direct the underlying investment,
- voluntary contributions can be made in addition to the required employer contributions (subject to limits),
- “concessional” contributions are made with before-tax dollars, and
- income inside the account is not taxable to the employee.
And in other ways, super is different from anything available in the US:
- contributions are taxed inside the fund at 15% on the way in,
- investment income is taxed inside the fund at 15% while funds are accumulating,
- income is completely tax free once withdrawals begin, and withdrawals are completely tax free after age 60,
- substantial non-concessional contributions can be made with after-tax dollars,
- super funds are not necessarily connected to employers, some are run as non-profit entities catering to a specific industry, others are owned and operated by banks,
- it is possible to transfer your balance into a self-managed fund while still keeping it inside the superannuation system, and
- self-employed individuals are not required to contribute to superannuation, but may make contributions which are deductible from their taxable income.
So, how is super to be treated on a US tax return? Like the blind men and the elephant, the answer depends on which part of the system you focus on. Tax professionals have advanced several theories – see an extended discussion here, on the Isaac Brock Society website. Until there’s a definitive ruling by the IRS, no one knows for sure! So, which part of this elephant should you focus on?
You certainly have no obligation to choose the interpretation that maximises your tax liability. In fact, you have a right to use a reasonable interpretation of the law that minimises your liability. In some cases you should disclose this interpretation very carefully in your return (consult a professional).
And, if anyone tells you there’s ONE right answer – ask them where the IRS ruling is that backs up that assertion. Until that ruling exists, any position you take on your US return is just an educated guess as to how US law applies to Australian legal structures.
DISCLAIMER – this goes without saying (and I’ve said it on the About page already) – I am NOT a lawyer or a tax professional. While we endeavour to make sure the information on this site is correct, you should consult an adviser who can take your own personal facts and circumstances into account!
- This post is assuming that you have already determined that US tax law should reach into Australia and tax your Australian source income and savings. For those who are not yet caught in the US tax system and have minimal ties to the US (such as Accidental Americans), consider very carefully the implications of entering the US tax system and whether US law should have any bearing on your Australian life.
- For a clear technical explanation of why PFICs are toxic, see PFICs Gone Wild! by Monica Gianni.