International Tax Matters
U.S. traders move abroad, others make international investments and non-resident aliens invest in the U.S. How are their taxes handled?
- U.S. resident traders living abroad
- U.S. resident traders with international brokerage accounts
- Report of foreign bank and financial accounts
- IRS Offshore Voluntary Disclosure Program
- Foreign retirement plan elections and reporting
- Foreign assets reported on Form 8938
- U.S. traders move to Puerto Rico to escape capital gains taxes
- Renouncing U.S. citizenship or surrendering a green card
- Non-resident aliens are opening U.S. brokerage accounts, and
- Foreign partners in a U.S. trading partnership can be tax-free
U.S. resident traders living abroad
U.S. tax residents are liable for federal tax on worldwide income whether they live in the U.S. or a foreign country. If you qualify for “bonafide” or “physical residence” abroad, which is living abroad for an entire tax year, try to arrange Section 911 “foreign earned income” benefits on Form 2555. Avoid double taxation by paying tax in both a foreign country and the U.S. by availing yourself of foreign tax credits reported on Form 1116. If you live in a country which charges higher taxes than the U.S., sometimes it makes sense to skip the Section 911 exclusion and use just the foreign tax credit.
U.S. resident traders with international brokerage accounts
Many traders living in the U.S. have a foreign brokerage account. It’s complicated when traders open these accounts held in a foreign currency. Counterparties outside the U.S. do not issue Form 1099-B, and accounting is a challenge. Traders should separate capital gains and losses, including currency appreciation or depreciation, from changes in currency values on cash balances, which are Section 988 ordinary gain or loss.
Report of foreign bank and financial accounts
U.S. residents with a foreign bank, brokerage, investment and another type of account (including retirement and insurance in some cases) who meet reporting requirements must e-file FinCEN Form 114, Report of Foreign Bank and Financial Account (known previously as Foreign Bank Account Reports or “FBAR”). If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing FinCEN Form 114.
IRS Offshore Voluntary Disclosure Program
Consider entering the IRS Offshore Voluntary Disclosure Program (OVDP), which has been extended to encourage taxpayers to come clean before getting busted by the IRS. The OVDP penalties are high (though there are exceptions). It’s not amnesty by any means and it’s an expensive undertaking with tax attorneys and accountants. But if you wait to get busted by the IRS, your foreign bank or anyone else, the penalties are far higher. Criminal penalties may apply too unless you join the program first. The current OVDP program has no end date, but the IRS has explicitly stated it may revoke it at any time. On July 1, 2014, the IRS created a “streamlined” program for those taxpayers who were negligent in not filing FBARs (but did not do so on purpose). U.S. resident taxpayers pay just a 5% penalty with this streamlined program.
Foreign retirement plan elections and reporting
Don’t assume international retirement plans are like U.S. pension plans with tax deferral on income until you take taxable distributions. For U.S. tax purposes, the IRS considers many international retirement plans taxable investment accounts because they aren’t structured as qualified plans under Section 401 unless they qualify under Section 402(b) as an employees’ trust established by an employer. While that seems unfair and counterintuitive to many, it’s the rule, and it catches many unsuspecting taxpayers and accountants off guard. To the extent that Section 402(b) does not apply, you may have to pay a high Passive Foreign Investment Company (PFIC) tax. Include these retirement plans on the annual FinCEN Form 114 each year, whether or not the plan has deferral.
In October 2014, the IRS acknowledged the tax-deferral problem on Canadian retirement plans and provided assistance. In Revenue Procedure 2014-55, the IRS repealed the need for filing a tax election, which means Canadian retirement plans automatically qualify for tax deferral. These rules are retroactive, so it abates back taxes, interest, and penalties. It’s no longer needed to file Form 8891 (U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans). This relief does not apply to international retirement plans outside of Canada.
Foreign assets reported on Form 8938
Tax Form 8938 is more about giving the IRS a heads up regarding your international assets. It’s not about reporting income and loss — there are other tax forms for that. The filing threshold for Form 8938 is materially higher than the FBAR threshold, and it’s even higher for Americans living out of the country. (See Form 8938 instructions.)
U.S. traders move to Puerto Rico to escape capital gains taxes
Puerto Rico (PR) is not a state or foreign country; it’s a “possession” with a government and tax system (Hacienda). Residents of PR report particular types of income to Hacienda and other forms of revenue to the IRS. Trading gains are capital gains on “personal property” taxed where the seller’s tax home is.
PR enacted tax incentive acts that are tailor-made for traders/investors, investment managers, and financial institutions. Passed in 2012, PR Act 22 allows investors and traders with bona fide residence in Puerto Rico to exclude from PR and U.S. taxes under Section 933 100% of all short-term and long-term capital gains from the sale of personal property accrued after moving there. Personal property includes stocks, bonds, and other financial products. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can be made with a U.S. broker or on any exchange around the world. This capital gain tax break applies to professional traders using the default realization method, or Section 475 MTM.
There is a different PR tax incentive act for investment managers, who charge advisory fees. They sell their services to investors outside of PR and hence they can qualify for PR Act 20 tax incentives for “export service businesses.” The Act 20 tax incentive is a 4% flat tax rate on net business income. The owner also receives Act 22 100% exclusion on dividends received from the PR business entity, and exclusion from U.S. tax, since Section 933 excludes PR-sourced dividends.
On Nov. 30, 2015, PR enacted Act 187-2015 amending Acts 22 and 20 to stiffen the requirements. For Act 22 incentives, PR requires new applicants after Dec. 1, 2015, to purchase residential property in PR within two years and open a deposit account. For Act 20 incentives, PR requires gradually hiring five full-time employees in PR.
A new $5,000 annual PR charity requirement was added to Act 22 in 2017 as well. (For more on these 2017 changes, see BDO PR Newsletter: Act 43 & 45 – Amendments To Incentive Acts 20 & 22.)
When Hurricanes Irma and Maria severely damaged PR in September 2017, many newly established residents had to evacuate the island. These former U.S. residents are concerned they will not meet the required day count in PR due to hurricane damage, subjecting them to U.S. taxation on capital gains. There is some relief from the IRS. (See How To Protect Puerto Rico Tax Incentives In The Wake Of Hurricanes Irma And Maria.) Consult a PR tax expert.
These PR tax benefits are not easy to arrange. Moreover, the political and economic conditions are uncertain, to say the least. Traders and investment managers need to move their family and operations to PR to get these tax breaks while they retain the benefit of U.S. citizenship with a passport.
Renouncing U.S. citizenship or surrendering a green card
Some countries have much lower tax rates than the U.S. and a few countries exempt capital gains from tax. Increasingly, traders, investment managers, and other taxpayers are surrendering their U.S. resident status (citizenship or green card), which requires potentially paying a Section 877A expatriation tax. The expatriation tax only applies to “covered expatriates” who have a net worth of $2 million or 5-year average income tax liability exceeding $139,000. The IRS assesses the expatriation tax on unrealized capital gains on all assets — fair market value less cost-basis including debt — on the expatriation date. Only the net amount over $600,000 is taxable. Deferred compensation and IRAs are included and taxable, too.
While the expatriation tax is likely to take a big tax bite out of the wealthy, it won’t apply to the majority of online traders who may not have significant unrealized net gains and who are not covered expatriates. There are other tax issues to consider including U.S. real property and estate planning in connection with beneficiaries residing in the U.S. Learn more about the expatriation tax on IRS Form 8854. There’s an election to defer tax, and regular income tax rates apply.
Non-resident aliens are opening U.S. brokerage accounts
Non-resident aliens are subject to tax withholding on dividends, certain interest income and sales of master limited partnerships like energy companies. They have U.S. source income — effectively connected income (ECI) — on real property and regular business operations located in the U.S.
A non-resident alien living abroad can open a U.S.-based forex or futures trading account and not owe any capital gains taxes in the U.S. U.S. tax law has long encouraged foreign taxpayers to invest and trade in U.S. financial markets. Caveat: the exclusion does not benefit dealers. A non-resident alien living abroad can also open a U.S.-based securities account, but there could be some dividend tax withholding. If the non-resident spends more than 183 days in the U.S., he owes taxes on net U.S. source capital gains, even though he may not trigger U.S. residency under the substantial presence test. (U.S. residency is triggered with legal residence status or by meeting the substantial presence test.) There are exemptions from the 183-day capital gains tax rules for employees of foreign governments living in the U.S. and special rules for students temporarily in a school in the U.S. The non-resident alien doesn’t need a U.S. tax identification number and isn’t required to file a U.S. non-resident tax return, Form 1040NR. As a non-resident alien individual, fill out W-8BEN and furnish it to the broker.
When a non-resident alien opens a non-U.S. person account with a U.S.-based broker, there are also U.S. estate tax considerations. Non-U.S. persons should ask their broker how repatriation of funds work on death and they should also expect delays due to probate of the estate. By opening a U.S.-based brokerage account, it lands those account’s funds in the U.S., which could trigger U.S. estate taxes on death. While many types of funds like fixed income are exempt from estate tax, U.S. equities are taxable. The estate exemption for non-resident aliens is $60,000, however, many treaties provide a significantly higher threshold, like Canada with $2 million. That is still far less than the $5.6 million estate exemption for U.S. residents. The estate tax rate starts at 18% and rises to 40%. (Learn more about non-U.S. person brokerage accounts with U.S.-based brokers on Schwab’s Website and U.S. Tax, and Estate Disclosure to Non-U.S. Persons.
Foreign partners in a U.S. trading partnership can be tax-free
If the non-resident is a member of a U.S.-based “pass through” taxable entity — such as a hedge fund or proprietary trading firm — that person is still exempt from effectively connected income. Typically, foreign partners in U.S. partnerships are considered to have U.S. ECI on their Schedule K-1 income. But if the partnership is a trading company — in financial markets, not goods — the income is considered portfolio income, including the partner’s share. Typically, U.S. partnerships withhold taxes on foreign partners, but that is not required if the foreign partner only has portfolio income not subject to U.S. tax. It gets more complicated with dividends in the partnership since dividends tax isn’t withheld for the share owned by the foreign partner.
For U.S. estate tax purposes, partnership interests are not considered taxable in the U.S.
International tax matters are complicated and often involve tax planning between the U.S. and one or more foreign countries or possessions. There are significant international opportunities for income and tax savings, but many pitfalls and compliance rules, too. Don’t try to cheat on your taxes by hiding assets and income offshore; the IRS has extensive operations around the world to bust tax cheats. Engage tax attorneys and CPAs with extensive international experience, so it works out well.
For more in-depth information on international tax matters, read Green’s 2018 Trader Tax Guide. The above content is a short excerpt from the guide.