60% of Australians own equity based investments (listed or non-listed) outside of institutional superannuation accounts, and 37% of Australians own listed shares (2017 ASX Australian Investor Study). There are two main ways to invest in equity – purchase shares directly on the share market or purchase a slice of a portfolio managed by a professional portfolio manager. For Australian investors who are claimed by the US, the US tax implications of these two choices are quite different.
This is the third instalment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:
- Real Estate
- Australian Managed Funds
- Australian Shares
- Business Ownership Structures
- Investing in the US
- 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.
If you get advice from a financial planner, chances are that managed funds will be a significant portion of the recommended portfolio. A managed fund is a slice of a larger portfolio of shares, bonds, real estate, or other investments. The fund may be actively managed, with analysts selecting specific investments based on some proprietary investment criteria; or passively managed, meaning the portfolio is invested in the companies in some broad market index. Managed funds are a cost-effective choice for small investors as they provide diversification and the transaction costs are spread across all investors in the fund. Unfortunately for US-taxpayers, Australian managed funds are classified as PFICs.
Passive Foreign Investment Companies (PFICs) are foreign (non-US) corporations meeting either of two conditions:
- 75% of the company’s income is passive income (interest, dividends, etc.) or
- 50% of the company’s assets produce, or could produce, passive income.
The PFIC rules were added to the US tax code by the Tax Reform Act of 1986. Non-US mutual funds are not all subject to rules that require current distribution of realised income, and this was seen by US mutual funds as an unfair advantage. However, many countries, such as Australia, have income distribution requirements that are similar to those in the US. By imposing a “one-size-fits-all” approach to taxing “foreign” investments, the PFIC rules are excessively punitive to investments in countries with tax systems that are roughly equivalent to the US.
If you own an investment classified as a PFIC, you have two choices: either include all increases in market value in ordinary income every year, or apply an extremely punitive anti-deferral regime that taxes all gains at the highest possible marginal rate (currently 39.5%) and charges daily compounded interest on the deemed deferral of tax. (There’s actually a third choice, but it requires an election and reporting by the foreign mutual fund directly to the IRS, which is very unlikely to happen). The record keeping and reporting is outrageously complex, and the net effect is a denial of capital gains treatment and a high effective tax rate on gains that can easily exceed the tax paid in Australia. Before FATCA and the push for “offshore” enforcement by the IRS, many taxpayers had no idea that their non-US mutual funds were taxed punitively in the US.
To get an idea of the complexity of US tax compliance for PFICs, take a look at this flowchart for those making the mark to market election to include all increases in value as taxable income on an annual basis. Note that the IRS estimates that the annual information return required for all PFICs, Form 8621, has an estimated time burden of:
Recordkeeping……………………………………………….. 16 hr. 58 min.
Learning about the law or the form…………………. 11 hr. 24 min.
Preparing and sending the form to the IRS……… 20 hr. 34 min.
No wonder this is one of the most expensive forms to have professionally prepared! Most US tax professionals advise clients to stay away from non-US managed funds to avoid both the compliance and punitive taxes associated with PFICs.
To avoid owning PFICs, investors can buy shares directly on the ASX. It is important to note that some investments traded on the exchange may be PFICs, so if you’re investing in direct shares in order to avoid the PFIC rules, you should also be avoiding Exchange Traded Funds (ETFs), Listed Investment Companies (LICs), Real Estate Investment Companies (REITs), early stage start-up companies with no operating revenue, and any company whose assets are mainly investments in other companies. If you stick to operating companies, the applicable US tax rules will be similar to the rules applied to US-listed companies. Dividends received from a company incorporated in Australia (or any of the countries listed in this table) are considered “Qualified Dividends” and taxed at capital gains rates as long as certain holding period rules are met. Gain on shares held for more than a year also qualifies for capital gains tax rates, which are lower than ordinary tax rates. Any US tax on dividends or capital gains can be offset by Australian tax paid on investment income under the Foreign Tax Credit (FTC) rules (claimed on form 1116).
Of course, if you’re living in Australia, you are also paying Australian tax on this income, and the Australian tax benefits of owning shares may mean that you have little Australian tax available for FTC. When an Australian company pays dividends out of income that has already been taxed in Australia, the company tax attributable to that dividend is passed out to the shareholder as a “franking credit”. A numerical example may help illustrate these rules. Say a company has a net profit of $100 before tax. Australian company tax is a flat 30%, so the company will pay $30 in tax and have $70 of net income. If we assume the company pays all of this out as a dividend, the shareholder will receive $70 in cash. The $30 tax paid by the company is passed to the shareholder as a franking credit. The shareholder then reports $70+$30=$100 in dividend income on her Australian tax return and takes a tax credit of $30 against her total tax liability. If her marginal Australian tax rate is 19%, the $100 of dividend income will increase her tax by $19, but the $30 credit means that her net tax bill is $11 less with the dividend than without it. The franking credit is refundable, so investors with only dividend income can actually get a refund.
So, how does this affect US tax on Australian dividends? The US will tax only the cash dividend, and not the franking credit. However, the franking credit will reduce Australian tax available for FTC. Given relative tax rates between the two countries, and the reduced US tax rate paid on qualified dividends, it is quite possible that no US tax will be due. However, it is worth planning carefully to be sure.
Well, I’ve topped 1000 words again, and only barely scratched the surface. The PFIC rules are particularly complex. As always, you should consult a professional advisor before entering into any significant transaction. Next week we’ll wrap up this series with a post on business structures and investing in the US.