Investment Constraints 5: Final Thoughts

In this series we’ve discussed how Australian investments impact a US tax return. To finish up, this post will discuss the pros and cons of investing directly in the US as well as a quick discussion of the types of records you should be keeping to assist with US tax preparation.

This is the final installment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. This post covers investing in the US and what records should be kept. These are the areas we have covered in all five posts in this series:

1. Superannuation
2. Homeownership
3. Real Estate
4. Australian Managed Funds
5. Australian Shares
6. Business Ownership Structures
7. Investing in the US
8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.

7. Investing in the US

One of the policy objectives of the punitive US tax rules discussed in this series is to keep American money invested in the US. So, why not just invest in US mutual funds, shares and retirement accounts? This may be a reasonable answer, at least partially, especially if you have plans to return to the US at some point and will have USD-denominated living expenses when you withdraw your savings. For those who plan on retiring in Australia, it is possible to hedge the currency risk, at a cost – but seek professional advice unless you’re experienced with hedging.

Even if you’re willing to bear the currency risk, opening a new investment account, or even maintaining an existing one, in the US while living in Australia can be difficult. While the US PATRIOT Act is often cited as a reason for banks closing accounts of those living outside the US (including US citizens), it does not appear that the Act directly prohibits these accounts. What the PATRIOT Act did was to strengthen Anti-Money-Laundering and Know Your Client (AML/KYC) rules. This, along with increased visibility of compliance obligations brought about by FATCA and the highly publicised Swiss Banking Scandal have prompted some US financial institutions to decide that denying accounts to overseas customers was just easier than ensuring compliance for these customers. Importantly, institutions offering brokerage and mutual fund accounts have to consider whether having non-US resident accounts violates foreign securities registration and marketing laws as well as the complexity of complying with US withholding of tax at source for dividends paid to non-residents. For all of these reasons, it can be very difficult to find an institution willing to open more than a simple transaction account unless you have significant funds to invest.

It is possible to purchase US investments directly through an Australian account. All of the Big-4 banks will allow you to trade on US exchanges via their online trading platform (as will several of the online brokerage companies). Fees are higher than for trading on the ASX, and there are large differences between them, so shop around. Besides brokerage fees, consider any foreign exchange fees (often hidden in the quoted exchange rate) and account keeping fees. Each company you invest in will have an online share registry, and you will be asked to fill in a W8-BEN or W9 as appropriate (W8-BEN is for non-US citizens only). With a W9, the company will send you (and the IRS) an annual form 1099 reporting any dividends paid, and there should be no US tax withheld from dividends as long as you have provided a valid social security number.  Non-citizens who complete a W8-BEN claiming treaty benefits will have US tax of 15% withheld from their dividend payments and will receive a form 1042-S annually.

One workaround to the difficulty of opening US mutual fund accounts is to purchase Exchange Traded Funds (ETFs). Shares in an ETF represent a pro-rata share of a portfolio of assets and there are ETFs specialising in a wide variety of asset classes including large companies, smaller companies, bonds, currencies, and commodities. US-domiciled ETFs, that is ETFs both registered and run in the US, will not be PFICs. It is possible to purchase US-domiciled ETFs on both US exchanges and the ASX. While Australian-domiciled ETFs may be marketed as more appropriate for Australian investors, for US citizens living in Australia, US-domiciled ETFs will avoid a lot of US tax problems. When investing in ETFs, you need to consider all of the issues you should normally consider with mutual funds (how does the fund fit into your overall portfolio, is the fund actively or passively managed, what are the fees, how well-capitalised is the fund manager) plus whether the fund trades at a discount or premium to net asset value, and how stable that relationship is.[1]

While investing directly in the US will simplify your US tax return, it’s also important to consider the Australian tax implications as well. Dividends from US investments will be taxable on your Australian return and will generally be US-source income (unless you have a managed fund or ETF investing in a third country). This means that you get a offset against your Australian tax for any US tax paid on those dividends. The source rules for capital gains, however, are different. Shares are considered personal property (as opposed to real property), and therefore fall under Internal Revenue Code §865: Source rules for personal property sales. This means that, if you are resident in Australia, your capital gain (or loss) on the sale of US shares is treated as Australian source income and you get a credit against your US tax liability for the capital gains tax paid in Australia.

As for US retirement accounts, if you have earned income on your US return (that is, if you do not use form 2555 to exclude all of your earned income), you may qualify to make an IRA contribution – assuming, of course, that you can find a US financial institution that will allow you to open an IRA account or add to an existing account. Any US-deductible IRA contribution will not reduce your Australian taxes. I do not know how the ATO would view an IRA set up while resident in Australia, but my understanding is that, under current law, existing IRAs are taxable in Australia only when the funds are distributed from the account.[2]

8. Record Keeping

Good record keeping is always important; even more so when managing taxation by multiple countries. The following is not an exhaustive list – if you think additional records are necessary, please mention this in the comments.

• Assets held when entering Australian tax system – Australian cost base is the value (in AUD) when you became an Australian tax resident, so keep records of that.
• Super – keep a spreadsheet showing how much (contributions and possibly income) was included in US taxable income each year (unless you’re taking position that super is social security) – you will need this data until your super balance is drawn down to zero to compute the US taxable gain on Super withdrawals.
• Principal residence – The US taxes gain on the sale of your principal residence with an exclusion of US$250,000 per person, so keep records of any capital improvements / renovations (not repairs) to add to your US cost base and reduce any US taxable gain on sale.
• Managed funds / PFICs – keep statements showing purchases (including dividend reinvestment) as long as you hold the investment. In the year of final sale, these records should be retained as long as you retain the rest of the tax records supporting that year’s return.
• Estate and Gift Tax: Gift tax returns need to be kept forever (to document unified credit computation on Estate tax return). The statute of limitations on gift tax returns is three years from the date the return is filed. If no return is filed, the IRS can audit forever. So, any significant gifts, especially those near the annual limit, should be documented and records kept forever to document that a return was NOT required.
• Record retention guidelines (support for income/deductions on the return) – Generally, the statute of limitations on a US tax return is three years after the later of the due date or the date the return was filed. However, if there is an understatement of taxable income of 25% or more, the IRS has six years to audit your return. In the case of fraud or failure to file a return (or Form 5471 for a controlled foreign corporation), there is no limit on how far back the IRS can go. The IRS recommends that taxpayers keep records for three years from the date of filing.

Concluding remarks:

We started this series because of a claim that only the very wealthy are disadvantaged by the US practice of taxing non-resident citizens on their worldwide income. Over five posts we’ve discussed how business owners, savers, and even homeowners can end up owing US tax on Australian source income, in addition to being required to complete complex, intrusive, and expensive annual returns.

In the first post we discussed superannuation. All Australian employees have superannuation contributions made on their behalf, so this is an issue that affects Australian-resident US taxpayers at all income levels. Under the most prevalent treatment of superannuation on US tax returns, employer contributions are added to earned income. For most, there is no additional US tax when these contributions are made. As long as the fund is not treated as a foreign grantor trust, or the employee is not treated as “highly compensated”, appreciation inside the super fund is generally not taxed currently on the US return. However, once the taxpayer is retired, withdrawals (tax-free in Australia after age 60) are taxed by the US. Since foreign tax credits can only be carried over for 10 years, it is likely that retirees will eventually end up paying US tax on their super withdrawals.

Real estate, both for investment and as a principal residence, was the topic of our second post. While sale of a principal residence is not a taxable transaction in Australia, any gain in excess of USD250,000 (twice that if filing jointly) is taxable on a US tax return. Furthermore, the gain is measured under the ludicrous assumption that purchase and sale were in US dollars, which has the effect of conflating real gains and exchange rate movements. And, if you have a mortgage in AUD, the US will want to tax any phantom currency gains. When real estate is purchased for investment, Australian rules are more generous than US rules in allowing deductions against other income. This, along with currency fluctuations, could mean that an investment that generates a tax-deductible loss in Australia actually generates taxable income on a US return.

Equity, in the form of direct shares or managed fund investments, is a widely used savings vehicle. In the third post in this series we discussed how these differed from a US tax perspective. Essentially, any type of managed investment, including managed funds, real estate investment companies, listed investment companies or exchange-traded funds, will be subject to the punitive PFIC rules on a US return unless it is organised and run in the US. Direct share investments don’t have this drawback, but will require research and regular attention to ensure you maintain a diversified portfolio that will meet your investment objectives.

In the fourth post we discussed various Australian legal structures that could be used for business or investment. US tax rules are xenophobic – any foreign business or trust will require extensive US reporting at a minimum. In some cases, US tax rules will ignore trusts or corporations and tax all income on the individual tax return.

And in this final post we discussed the alternative of investing in the US. After all, one of the purposes of provisions such as the PFIC rules is to encourage US taxpayers to “Buy American”. We wrapped up the series with a discussion of what records you should keep to assist with US tax compliance.

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[1] Detailed discussion of these issues is beyond the scope of this post, though I am happy to answer questions in the comments section.

[2] Get Australian tax advice before consolidating or rolling over existing IRAs, I have heard of these transactions being treated as a complete distribution by the ATO.