I was sad to hear of the death of Jack Bogle last week. Jack was the “father” of modern index funds. He founded Vanguard Investments in the 1970s. His no-load, low-fee index fund was a major innovation in a world where investing had been only available to those who were willing to pick their own stocks or pay professional fund managers large fees to get results that weren’t statistically any better than a broad market index.
An index fund invests in all of the shares in the market (or the index that measures the market) – there are no investment decisions to make, and very little trading is necessary. This innovation has delivered market returns to small investors all over the globe at very low cost .
So, why am I talking about Jack Bogle and index funds on a website devoted to Australia/US cross-border tax issues? Because nonresident US citizens are punished for owning local versions of this basic investment!
Index funds didn’t really take off until the 1990s. In 1985, index funds accounted for less than $500million in assets, by 2016 they reached $4TRILLION![1] Back in 1986, when most investors were unaware of index funds, Congress added a new provision to the US tax code – punitive tax rules for Passive Foreign Investment Companies (PFICs). At the time, Congress thought that PFICs were only available to wealthy individuals, and that the only reason wealthy individuals would invest in a PFIC was to avoid US tax.
But, as index funds have exploded all over the world, they have become a major part of the retirement savings of the middle class in almost all developed countries around the globe. And, if you live and work in Australia, it doesn’t make sense to take on the currency risk of investing in US index funds (if you can even open an account). Unfortunately, the US tax code has not kept up. In many countries index funds distribute all dividends and realised gains annually – there’s no deferral other than the deferral of unrealised capital gains that is available with most investments. So, a provision originally targeted at investments that did allow deferral is now being used to punish middle class savers for investing outside the US. In fact, some of the products offered by Vanguard Australia are just funds that invest in US Vanguard funds; but because they interpose an Australian fund (to make it easier to sell to Australian residents), the US tax compliance industry treats them as PFICs!
Now, if the US wants to prevent US residents from investing overseas, that’s their right. However, as long as the US tax code insists on taxing the tax residents of other countries, they should not write the tax code to punish ordinary savers for exercising their right to choose what country they want to live (and invest) in.
While I’m sure Jack Bogle was proud that his innovation was adopted so broadly around the world, I think he would also be sad that nonresident US citizens were being frozen out of local index funds because of an anachronistic provision in the US tax code
[1] For a history of index funds, written by Jack Bogle in 2016, see this link.