US citizens who have been living in the UK for a long time, like me, are facing significant changes in how we will be taxed in the UK. Unfortunately, we got caught in the cross-fire when the UK set its sights on about 100,000 long-term UK residents who don’t pay tax on investment income to the UK, under the UK’s generous non-domicile rules, or to their country of domicile either, as almost no country in the world taxes its citizens when they live abroad. No country, that is, but one: the US. These new UK rules mean that US citizens who are long-term resident in the UK face the risk of being punitively taxed, or even double-taxed, by the UK and the US.
I’ve attended half a dozen meetings with accountants, lawyers and financial advisors who have done their best to explain the new rules to me. Even more complex than the rules are some of the remedies being proposed.
At Elm Partners, we think we’ve got a simple and tax efficient investment solution for US-UK investors. We’ve taken our Separately Managed Account offering, which is already cost efficient and tax efficient for most US investors, and made some modifications that should also make it tax efficient from a UK perspective for US-UK investors like me.
that is complex and each of us has a different tax situation, and even within a family, different
pools of savings are taxed differently. You should always seek professional advice. I’m not
qualified to give, and this note is not, tax advice. The information in this note is purely
illustrative and for purposes of encouraging discourse and further research.
From April 2017, individuals who have been resident in the UK for 15 of the last 20 years will be deemed to be UK-domiciled for income tax and capital gains tax purposes.
Many US-UK investors currently elect the remittance basis of taxation, which means that for an annual remittance fee, they are only taxed on income and gains that they bring into the UK. The remittance basis of taxation allows US-UK investors to focus almost exclusively on the US tax efficiency of their investments, and to give limited attention to UK taxation. As the IRS taxes offshore investments made by US citizen punitively (e.g. PFIC taxation), US-UK investors tend to invest in US-domiciled products such as LLCs, LPs, or US-listed equities, mutual funds and ETFs.
Unfortunately, from April 2017, US-UK investors who remain in the UK will be stripped of the safe harbour of the remittance basis, and will have to think about whether their investments are tax efficient from both a US and UK perspective.
What’s the Problem?
Most (but not all) US-domiciled funds are taxed unfavourably in the UK. In a typical UK-domiciled fund, income and capital gains are treated separately. Income is taxed as it arises at the rate of 45%1 and Capital Gains is taxed at realisation at a lower rate of 20%.
Just as the US is tough on US investors investing in offshore vehicles, the UK is too. And just as the US tends to treat the UK as if it were a tax haven, the UK treats US-domiciled funds as “Offshore Funds” too.2 This means that a UK investor in a US domiciled fund will have all returns, whether Income or Capital Gains, treated as Income and taxed as they arise at the higher rate of 45%, which isn’t good as it’s higher than the rate at which they’d be taxed in the US.3
This isn’t so bad if the US-UK investor intends to keep his investment in the US fund until he leaves the UK, as that investment will not be subject to tax at all in the UK if there are no distributions and the investment is not sold.4 However, if he wants to liquidate that investment or if it’s a private equity fund that makes distributions, then the capital gains are taxed at the higher rate of 45%, which will be well above the long-term capital gains rate in the US and hence leave our investor with a tax inefficient outcome.
The problem is more complex, and can potentially be worse, if the investment is in a US LLC, which is a typical structure for many hedge fund and private equity investments. In the US, an LLC is treated as a partnership and investors are taxed on an arising basis (via a k-1) whether or not there have been distributions. By contrast, the UK will likely tax this income as it is received at 45% as a dividend. The UK will not allow an offset for US taxes paid in the past on that income, and it may be difficult to get an offset in the US on the tax paid, due to timing and character differences.5
Benefits of US funds under the HMRC’s Offshore Fund Reporting Status Regime:
To mitigate the onerous treatment of Offshore Funds, the HMRC allows funds to apply for “Reporting Status”. An offshore fund which benefits from reporting status is taxed similarly to a UK-domiciled fund. Under the regime, a Reporting Fund reports its income (whether distributed or not), which is then taxed on an arising basis at 45%, and the remaining Capital Gains are taxed on realisation at 20%. A full list of Offshore Funds which benefit from the HMRC’s Reporting Status can be found here.
At Elm, we’ve been searching through this list (about 50,000 line items) and have identified a sufficient range of low-cost US-listed funds and ETFs which have UK Reporting Status to be able to build a balanced and diversified portfolio that should be tax efficient from both a US and UK perspective. Through our existing relationship with our brokerage in the US, we can offer this solution to US-UK investors through our Separately Managed Accounts, which we can help open with minimal hassle.
Summary: some thoughts on the relative efficiency of different investment options from a US-UK perspective
Individual equities and bonds:
This is probably the most tax efficient solution6 for US-UK investors, but it is difficult and expensive to build and maintain a portfolio of the hundreds (or thousands) of individual equities and bonds you would need to be well-diversified, unless you’ve got a really big portfolio to invest.
US listed Index funds and ETFs with UK Reporting Status:
Tax efficient from a US and UK perspective, and a cost efficient manner of creating and managing a globally diversified balanced portfolio. Elm Partners offers Separately Managed Accounts for US-UK investors constructed of these US listed ETFs with UK Reporting Status.7 See this short slide deck for details on all the changes we made to our basic SMA program to be a better fit for US-UK investors. Vanguard is currently the only blue-chip provider whose ETFs benefit from Reporting Status, but we would expect more providers to follow suit. We are in discussions with a number of index fund and ETF sponsors encouraging this to happen.
US domiciled funds without UK reporting status:
For US-UK investors who are confident they will not sell their holdings until they leave the UK, these investments may be tax efficient from a US-UK perspective, as they should not generate taxable gains in the UK if they are not sold.8 Income, however, would be taxable in the UK, but as long as interest rates and dividend yields remain low, the overall tax efficiency should remain high. Elm Partners has a non-distributing Delaware fund which fits this category. However, if the investor has a change of plans, or heart, and liquidates the investment at a gain while still subject to UK tax, this may turn out to be tax inefficient.
Hedge funds and Private Equity:
These investments tend to be relatively tax inefficient for US investors from a solely US perspective (see our note on hedge fund vs long only equity taxation here). The tax inefficiency of these investments may be compounded from a combined US-UK perspective, depending on the exact structure of the investment and the circumstances of the investor.9 These investments also tend to be cost inefficient and low on diversification and liquidity.
-  I’m using the highest marginal rate as I’m assuming the typical US-UK investor is HNW.
-  An investment in a limited partnership might be treated differently under UK tax rules, with all income being deemed to pass to the investor as it arises and maintaining the character of the income. Limited Partnerships tend to be less commonly used as pooled investment vehicles in the US.
-  For the purpose of this note, I’m going to ignore the effect of withholding tax on dividends from equities, and use of those withholding taxes in US and UK tax returns.
-  For investors who intend to leave the UK before realising their investment, there is a bright side to being invested in a non-distributing LLC, as the HMRC should treat the LLC as a company and will only tax income as it is distributed. However, you need to find an LLC investment that doesn’t make distributions. You won’t be surprised that at Elm Partners, we can offer that option to US-UK investors too.
-  Even this is somewhat complicated by the recent ‘Anson vs HMRC’ case, in which an investor in a US LLC, Mr Anson, successfully argued that the LLC should be treated as transparent by HMRC. HMRC has stated that it intends to continue to treat LLCs as companies, except for in special circumstances matching the Anson case. See here for more details. The implications of this case are not fully known, so it is important to speak to your tax advisors if you are in this situation.
-  It is possible that owning individual equities may be the best way to be able to reclaim dividend withholding taxes on a UK tax return. We have not found a definitive answer on this question.
-  Mutual funds are another good option but may be difficult to buy, as some brokerages such as the one we use, will only allow mutual fund purchases if the investor has a US address.
-  Funds in the form of LPs may not be treated this way by HMRC, but rather as a pass-through.
-  As noted above, whether these investments take the form of an LLC or LP can have a significant impact. We believe there is nothing to stop an LLC applying for UK reporting status, but it may actually prove to be more detrimental to investors, as the payment of income tax would be brought forward to an arising basis. Worse still, the payment of tax in this way may not be able to benefit from double tax relief due to the mis-alignment of tax treatment between the US and the UK.