If you’re a citizen or resident of the United States, it’s a challenge to purchase many of the tens of thousands of offshore mutual funds traded worldwide—at least not without highly unfavorable tax consequences.
This is a consequence of the "passive foreign investment company" (PFIC) provisions of the U.S. Tax Code, which I described in my most recent blog entry.
Fortunately, several "safe harbors" exist on which you can rely on to avoid the PFIC rules.
For many U.S. investors, the most practical way to purchase offshore funds is to rely on the Treasury’s "mark-to-market" rules to calculate your gains (or losses) in offshore funds. Under these rules, U.S. investors pay tax at ordinary income tax rates on income or gain from the fund each year.
Unfortunately,these rules apply only to publicly traded offshore funds listed on a "qualifying" securities exchange. A long list of additional requirements must be met for these rules to apply, and no official list of approved countries or exchanges exists. However, many offshore funds traded on major securities exchanges appear to qualify.
Again, the mark-to-market rules apply only to publicly traded offshore funds. If you want to purchase offshore funds that aren’t publicly traded, without unfavorable tax consequences, there are only three practical alternatives for doing so:
1. Purchase the offshore through your IRA or other type of pension plan. Income or gain within a tax-deferred retirement plan isn’t taxed until it’s paid out. When you receive it, it’s taxed as ordinary income. There’s no provision in the U.S. Tax Code for income or gain from offshore funds to be taxed any differently. This offers a convenient and relatively simple way to avoid the PFIC rules.
2. Purchase offshore funds through an offshore variable annuity. Under U.S. tax law, a variable annuity serves as a tax-deferred "wrapper" for an underlying investment account. Income or gain in the account isn’t taxed until it’s actually distributed to the beneficiary. Again, there’s nothing in the Tax Code subjecting offshore funds held within a variable annuity to a different standard. As with any other investment wrapped in a tax-qualified variable annuity, income or gains from offshore funds is tax-deferred until you receive it, without the PFIC interest charges.
You should be prepared to invest at least US$100,000 in a variable annuity to make this strategy worthwhile. Some offshore insurance companies may be willing to issue an annuity for a smaller investment. Due to state and federal insurance licensing and securities laws, you may need to travel to the country where the annuity contract is issued to put it into force.
3. Purchase offshore funds through a variable offshore life insurance policy. A life insurance policy provides the advantages of a variable annuity and more: the death benefit received by beneficiaries is not subject to income tax. The policy can be structured to make the death benefit free of estate and generation-skipping taxes as well.
This is a more complex strategy that requires substantial customization according to your individual requirements. For that reason, you should expect to invest a minimum of US$500,000 to make it worthwhile. Some offshore insurance companies may have lower minimums. Again, you may need to sign the insurance contract in the country where it’s put into force.
WARNING: For a foreign variable annuity or life insurance contract to be "qualified" for U.S. tax purposes, stringent IRS requirements must be followed. You as the U.S. policyholder may not make investment decisions, although you can make a non-binding request to appoint a particular investment advisor or follow a particular investment strategy. Consult with a qualified international tax advisor to confirm that any policy offered by an offshore insurance company is U.S. tax compliant.
If you’re interested in implementing one or more of these strategies, please contact The Nestmann Group at for more information. We can assist U.S. persons in setting up tax-compliant offshore structures to purchase offshore funds and other international investments.
Copyright © 2008 by Mark Nestmann
