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Five Things for Americans to Know Before Moving to the United Kingdom

Five Things for Americans to Know Before Moving to the United Kingdom

by | Mar 13, 2023 | ,

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With our historical links and common language, it is no surprise that hundreds of thousands (at least 200,000) American citizens reside in the United Kingdom. London has long been a truly international city and many Americans live and work in the greater metropolitan area. In my professional experience, more U.S. expats in the United Kingdom choose to remain in the UK than may be the case in any other foreign country. In fact, many clients come to identify as Brits and hold U.S./UK dual citizenship. 

However, whether you are considering a short, intermediate, or long-term move to the United Kingdom, there are a variety of planning topics that are best considered prior to making the move. In this blog, I discuss five key issues, but there are many, many more unique tax, estate planning, and investment issues that Americans in the United Kingdom may have to deal with once they become a resident in the United Kingdom. Each one of these issues below would merit a separate article, so consider this a cursory examination of these five topics that hopefully lead to further inquiry and discussion with your accountants, attorneys, and/or financial planners.

UNDERSTAND THE DIFFERENCE BETWEEN REMITTANCE BASIS AND ARISING BASIS TAXATION

Unlike the United States tax policy of taxing its citizens on their global income regardless of where they reside, most countries, including the UK, subject only those who are tax residents of that country to income taxes on both their country-sourced and non-country-sourced income (i.e., their worldwide income). To attract affluent foreigners and foreign companies to the UK, the UK has created a temporary tax status for non-UK nationals who chose to become residents of the UK called the “remittance-based” election. 

Accordingly, during the first seven years of UK tax residency, a non-UK national may elect the remittance basis on their UK income tax return, and thereby pay UK income tax only on two types of income: (1) UK-sourced income, and (2) non-UK-sourced income that is remitted to the United Kingdom. Remitting generally means that the funds are physically moved to the UK or used to pay UK obligations or purchase goods, services, or other assets in the United Kingdom. This election can be freely made for the first seven years; but, there are substantial fees/taxes paid to the HMRC (Her Majesty’s Revenue & Customs) to extend that privilege for a limited period (up to eight more years) thereafter. For those that do not elect the remittance basis, or for those whose remittance-basis term has expired, UK taxes income on the “arising basis,” meaning simply that all income from all sources (foreign and abroad) is taxed in the year in which it is received by the taxpayer.

At first blush, remittance basis sounds like a proverbial no-brainer for any expatriate that will derive any income from outside of the UK, whether that income is earned through business conducted outside of the UK, earned through passive investments in real estate, stocks, bonds, etc., or otherwise is characterized as non-UK-sourced income. However, the decision to elect the remittance basis in any of those initial seven years of UK tax residency is one that should be very carefully considered. Without going into considerable detail (and the rules surrounding remittance taxation contain meticulous details) the remittance basis can create accounting headaches, perhaps even nightmares, whenever funds are eventually remitted to the UK and the UK taxes come due on that part of the remitted funds that are attributable to income earned during the period in which remittance basis was claimed. The process of attribution involves what has come to be known as the “clean capital ordering rules,” and pitfalls abound when trying to track and trace the underlying UK tax characteristics of offshore funds (in particular investment accounts) when some of those resources are remitted to the UK. 

With our historical links and common language, it is no surprise that hundreds of thousands (at least 200,000) American citizens reside in the United Kingdom. London has long been a truly international city and many Americans live and work in the greater metropolitan area. In my professional experience, more U.S. expats in the United Kingdom choose to remain in the UK than may be the case in any other foreign country. In fact, many clients come to identify as Brits and hold U.S./UK dual citizenship. 

However, whether you are considering a short, intermediate, or long-term move to the United Kingdom, there are a variety of planning topics that are best considered prior to making the move. In this blog, I discuss five key issues, but there are many, many more unique tax, estate planning, and investment issues that Americans in the United Kingdom may have to deal with once they become a resident in the United Kingdom. Each one of these issues below would merit a separate article, so consider this a cursory examination of these five topics that hopefully lead to further inquiry and discussion with your accountants, attorneys, and/or financial planners.

UNDERSTAND THE DIFFERENCE BETWEEN REMITTANCE BASIS AND ARISING BASIS TAXATION

Unlike the United States tax policy of taxing its citizens on their global income regardless of where they reside, most countries, including the UK, subject only those who are tax residents of that country to income taxes on both their country-sourced and non-country-sourced income (i.e., their worldwide income). To attract affluent foreigners and foreign companies to the UK, the UK has created a temporary tax status for non-UK nationals who chose to become residents of the UK called the “remittance-based” election. 

Accordingly, during the first seven years of UK tax residency, a non-UK national may elect the remittance basis on their UK income tax return, and thereby pay UK income tax only on two types of income: (1) UK-sourced income, and (2) non-UK-sourced income that is remitted to the United Kingdom. Remitting generally means that the funds are physically moved to the UK or used to pay UK obligations or purchase goods, services, or other assets in the United Kingdom. This election can be freely made for the first seven years; but, there are substantial fees/taxes paid to the HMRC (Her Majesty’s Revenue & Customs) to extend that privilege for a limited period (up to eight more years) thereafter. For those that do not elect the remittance basis, or for those whose remittance-basis term has expired, UK taxes income on the “arising basis,” meaning simply that all income from all sources (foreign and abroad) is taxed in the year in which it is received by the taxpayer.

At first blush, remittance basis sounds like a proverbial no-brainer for any expatriate that will derive any income from outside of the UK, whether that income is earned through business conducted outside of the UK, earned through passive investments in real estate, stocks, bonds, etc., or otherwise is characterized as non-UK-sourced income. However, the decision to elect the remittance basis in any of those initial seven years of UK tax residency is one that should be very carefully considered. Without going into considerable detail (and the rules surrounding remittance taxation contain meticulous details) the remittance basis can create accounting headaches, perhaps even nightmares, whenever funds are eventually remitted to the UK and the UK taxes come due on that part of the remitted funds that are attributable to income earned during the period in which remittance basis was claimed. The process of attribution involves what has come to be known as the “clean capital ordering rules,” and pitfalls abound when trying to track and trace the underlying UK tax characteristics of offshore funds (in particular investment accounts) when some of those resources are remitted to the UK. 

Accordingly, there are circumstances where remittance basis makes perfect sense. To the extent that:

    • The U.S. expat is confident that the UK stay will not evolve into something longer-term or even permanent, and/or;
    • The U.S. expat has considerable non-UK-sourced income (e.g., from a very large investment within a U.S. taxable brokerage account, or perhaps through partnership income in a global concern where only a fraction of earned income is attributed to UK sources);

then remittance basis should be very seriously considered to lessen the UK income tax burden. Conversely, where the U.S. expat has modest income from non-UK sources or where the UK tax residency may become longer-term or even permanent, then the calculus may well favor UK income taxation on the arising basis from the onset of becoming a UK tax resident. In all cases, this is a decision facing all Americans moving to the UK and should be carefully contemplated with the advice of experienced professionals.

Short on time? Listen to our podcast for Stan’s overview on this topic:

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PFIC AND UK TAX RULES FOR “OFFSHORE FUNDS”

It is fundamental that American expats, who obviously live and transact outside of the United States, understand the perils of “offshoring” their taxable investments. By offshoring, I mean owning foreign-registered pooled investments, such as ETFs that are not registered with the SEC and trade predominantly on foreign securities exchanges, mutual funds that are registered with foreign financial regulators and are not subject to U.S. laws and regulations, as well as foreign private equity funds and hedge funds (both of which are usually organized as limited partnerships). The IRS has created special regulations regarding the tax treatment of such foreign pooled investments, known as the “passive foreign investment company” (or “PFIC”) rules. 

A detailed discussion of how these offshore funds are taxed in the U.S. is beyond the scope of this article. For our purposes, it is simply important to understand that “offshore” funds lose their capital gains character because of the PFIC rules, and, therefore, all gains are taxed as ordinary income. That’s for starters – with income recharacterization to prior years in the holding period, interest, and penalties, the tax rate could be 50% and, in some cases, even higher! The bottom line: buying foreign mutual funds, ETFs and other pooled investments outside of a treaty-recognized foreign pension is usually tax toxic to U.S. tax residents.

So an American living in the UK would do well to avoid the temptation to “go native” and open brokerage accounts in the UK and invest in non-U.S.-registered funds. Can the American expat then avoid offshore tax rules by just keeping their investments in the U.S. and purchasing U.S. mutual funds or ETFs? For the American expat in the UK, the answer is usually “NO,” because the UK has similar tax rules with regards to offshore funds and, from a UK perspective, U.S. mutual funds and ETFs are offshore funds. The general HMRC tax rules in the UK therefore would deprive gains on the sale of these offshore funds of the lower and more favorable capital gains rates and instead levy taxes on realized gains at ordinary income tax rates, which tend to be higher than U.S. ordinary income tax rates. What a mess the U.S. expat investor might find themselves in trying to navigate the offshore funds rules of two different national tax authorities!

One way the U.S. expat might avoid these onerous tax rates would be to avoid “pooled” investments by just buying individual securities and building a fund-free portfolio of individual stocks and bonds. Naturally, this may be an imperfect solution at best for investors that don’t have the capital to adequately diversify such a portfolio. Moreover, even with ample capital to do so, most investors have their own careers, families, and social lives to manage and don’t want to be their own portfolio managers. 

Fortunately, the HMRC’s offshore funds tax rules do provide an important exception: where the foreign fund provides adequate accounting through reports sent annually to the HMRC, investors in these offshore “reporting funds” will be exempted from the special tax rules and will be entitled to capital gains treatment on gains generated from these reporting funds. Although the vast majority of U.S. mutual funds and U.S. ETFs do not qualify as reporting funds in the UK, there are enough decent U.S. funds that are in fact UK reporting funds that a fairly quality, low cost, and well-diversified portfolio can in fact be constructed. The main challenge is scouring the HMRC’s spreadsheet with thousands of reporting funds and identifying those that are indeed U.S.-registered. Beware the foreign “clones” of U.S.-registered funds that carry the same names of their U.S. counterparts but are, in fact, PFICs! 

UNDERSTAND THE INTERPLAY OF U.S. AND UK RULES REGARDING RETIREMENT ACCOUNTS, INCLUDING THE INCOME TAX TREATY

There are some advantageous and truly cooperative nuggets in the income tax treaty (and the technical explanation thereof) between the United States and the United Kingdom, particularly in the area of retirement accounts or “pensions.” For example, because of the treaty, distributions from a U.S. Roth IRA in retirement will enjoy the same tax-free qualities for a UK tax resident (expat or otherwise) as they do for domestic American taxpayers. Additionally, those horrid PFIC and Reporting Fund rules discussed in the previous section will be irrelevant to investments in retirement accounts in either country so long as the treaty benefit is claimed. There are other special rules regarding the special tax-free 25% lump-sum distribution from a UK pension that may benefit a former U.S. expat that participated in a UK pension scheme but thereafter returns to the U.S. before taking the lump-sum distribution. It is critical to work with advisors that can help the U.S. expat position their accounts to truly navigate the tax rules and take full advantage of these types of beneficial treaty provisions.

Unfortunately, for high-net-worth individuals, there have been severe limits put in place in the UK in recent years on how much can be contributed in tax-advantaged pension schemes. These newer rules tend to severely limit the contributions by and on behalf of higher earners in the UK to their company pension and even personal pension (SIPP) accounts. Interestingly, these rules will also dramatically affect the tax deductibility on UK tax returns of contributions to U.S. qualified retirement plans as well. Therefore, for Americans working and earning in the United Kingdom, it is particularly crucial to get the input of a UK tax accountant to assist in determining how much should or can be contributed to retirement plans and pensions regardless of where they are held for each and every UK tax year. Moreover, U.S. retirement contribution eligibility rules, rules on the deductibility of retirement plan contributions, and so forth require the U.S. expat to also discuss all (not just domestic) retirement plan contributions with their U.S. accountant to ensure that the investor’s strategy is tax optimal under U.S. tax rules, too. 

 

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“COMMON LAW?” – CAUTION WHEN BRINGING A U.S. TRUST WITH YOU TO THE UK

Trusts, like most estate planning issues and tools, are a creature of local law. It is a common folly of many expats, and even domestic U.S. attorneys, to believe that an estate plan carefully crafted under the laws of a particular state in the U.S. can be taken abroad and continue to operate as intended. It usually won’t, and, in some instances, a good domestic estate plan may well backfire spectacularly when the family, or one or more of its members, moves abroad. That’s a very broad and general statement, but consider it is based on my experiences as an expat advisor who has witnessed the unintended consequences materialize from a domestic estate plan when the legal and tax issues unfold in the cross-border/expat environment. To put it bluntly: when you move somewhere else, new rules apply, and it is highly unlikely that the original estate plan was crafted with any of the new rules in mind.

Another broad and general statement can be made about trusts: The more sophisticated an estate plan, the more likely that it will backfire in the cross-border environment and the more costly the unintended consequences that will materialize. However, we’re talking about moving to the United Kingdom – the birthplace of trust instruments– and one might think that a U.S. trust would always work just as well in the UK as it would in the domestic U.S. scenario, but one could pay a dear price for such an innocent assumption. 

For example, a U.S. expat family has utilized trusts that provide that one or more of the expat family members who serve as trustee. If the trustees of a U.S. trust become UK tax residents, the trust becomes a UK tax resident. From the UK perspective, the trust has been “on-shored” so to speak, and the trust is now a UK tax resident. Things can get even more complicated from there: what if the trustee(s) returns to the United States thereafter? From the UK legal and tax perspective, this could represent an “off-shoring” of the trust – the trust will no longer be characterized as a UK domestic trust, but as an offshore trust. The tax implications that flow from offshoring a trust are usually that an “exit tax” must be paid, which means that all unrealized gains from trust property are thereby realized and capital gains from the recognition of gain are now owed to the HMRC. 

Quite often, a few minor (or less minor, depending on the trust) changes to the trust could have been made before the trustee(s) moved to the UK, which may have prevented this issue from ever materializing. If minor changes do not suffice, the trust might need to be dissolved prior to the move. Accordingly, when family wealth is in any manner managed or protected by trusts, some legal advice (i.e., an estate plan review) from an estate planning expert in the future country of residency (in this case, the United Kingdom) can be critically important.

UNDERSTAND UK “DOMICILE” AND IT’S IMPLICATIONS

U.S. and UK income taxes differ in a variety of ways (e.g., the tax liability on the sale of a primary or secondary residence) and there may be a substantial income tax-rate divergence between the two countries for a given U.S. expat living in the United Kingdom, depending on the expat’s current income. However, the taxation of wealth transfers (gifts during your lifetime, or bequests/transfers upon death) should also be considered as the expat accumulates wealth. Like the U.S, the UK may tax gifts made during the life of the donor and will also tax the estate of a decedent before their wealth is transferred via their estate plan. Unlike the U.S., there may be income tax owed by the donor (known as a “deemed disposition”). Here, the opportunity for divergence between U.S. and UK tax exposure can be quite profound, due largely (but not exclusively) to the different exemption levels under the current tax laws of both countries. 

For example, in 2021, the United States provides a very generous lifetime personal exemption for gift and estate taxes of $11.7 million ($23.4 million for a U.S. married citizen couple). In stark contrast, the UK individual estate (IHT) exemption is only £325,000 (£650k for a UK domiciled couple), with possibly an additional allowance of £125,000 for the decedent’s primary residence. That differential puts a tremendous premium on estate tax planning and financial planning in general. 

A crucial part of determining the current and future UK IHT tax exposures for a U.S. expat family centers on whether the family, or individual members thereof, have voluntarily or involuntarily attained the status of a UK domicile. If a person is determined to be domiciled in the UK, then their worldwide estate would be subject to IHT. If tax residency and entrenchment have not yet crossed the threshold of domicile, then only the UK situs property will be subject to potential IHT tax liability. Domicile is a common law term that combines residency and long-term intention. Accordingly, there is a degree of subjectivity when determining whether an American expat has become entrenched in the UK to the point that this key threshold has been breached. 

It can be difficult to ascertain in close cases whether an expat’s behavior demonstrates enough intent to assure an HMRC finding that the expat is a UK domicile. On the one hand, if an expat moves to the UK on a work assignment (secondment) and spends five years living with family in a home that is rented by the company, it is certainly less likely that the status of domicile has been achieved. However, if that expat and family buy a home, apply for citizenship, sell their U.S. home, and effectively cut most ties with their old American community, the probabilities increase dramatically that the family would be considered UK domiciles. 

To combat the efforts for long-term UK tax residents to evade domicile status, the UK has created a “deemed-domicile” status or threshold based on the more objective criteria of how many years an individual has held UK tax resident status. Under the rules that went into effect in 2017, once the expat has held UK tax residency for 15 years of a 20-year period, that expat is thereafter deemed a domicile of the United Kingdom, regardless of any other circumstances. Beyond IHT exposure, this will also mean that the expat can no longer utilize the remittance basis of taxation (which requires substantial payments beyond year seven but is now unavailable at any cost after year 15).

Prior to obtaining domicile, steps can be taken to protect non-UK wealth from IHT exposure, but such planning is going to require retaining very specialized estate planning counsel. Given that the deemed domicile status is, in a temporal sense, the maximum but by no means a minimum time within which domicile can occur, an important first step for such planning would be to have counsel conduct what is sometimes referred to as a “domicile audit,” which may be a series of meetings and/or detailed questionnaires to first determine the current status of an expat, as well as determine what, if any, wealth might be strategically sheltered from the expat’s taxable (IHT) estate.

PLANNING AND INVESTMENT ISSUES ABOUND

Please consider this a very cursory examination of five key issues that should be considered and incorporated into your financial planning and your portfolios before completing the journey to live in the United Kingdom. This is by no means an exhaustive inventory, nor a complete examination of the financial, tax and legal issues within each area. It is our intention at Walkner Condon to enrich the expat communities around the world through sharing knowledge about such topics and to assist Americans who are or may be contemplating a move abroad in the near term or in the future. Through a little pre-move planning and strategic positioning, we believe that the transition to a new home can be less stressful and, ultimately, more rewarding. If you find these issues resonating with your personal situation, I, or one of my team members here at Walkner Condon, would be happy to schedule an introductory meeting with you.

Stan Farmer, J.D., CFP®️

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The Hidden Costs of Claiming the Foreign Earned Income Exclusion

The Hidden Costs of Claiming the Foreign Earned Income Exclusion

by | Mar 3, 2023 |

Many U.S. expats have learned to use and cherish the Foreign Earned Income Exclusion (FEIE), a provision in the U.S. tax code allowing workers to exclude up to $120,000 (for 2023) of their non-U.S. salary for Federal taxation. If nothing else, the FEIE stands out for its absolute simplicity in an otherwise endlessly convoluted tax code: anyone deriving income from a foreign employer can claim the FEIE by filing form 2555, and there are remarkably few exceptions and caveats. It is one of the few “breaks” that expats get in their otherwise needlessly complex financial lives, so it’s perhaps no surprise that it represents the go-to, default option for most U.S. taxpayers abroad when it comes to avoiding double taxation. For the majority of expats, claiming the FEIE each year will absolutely be the right thing to do. However, in this article I will consider some of the drawbacks of using the FEIE, and consider instances where claiming the FEIE may actually have hidden costs. Once these costs are factored in, the same taxpayer may actually find that claiming the FEIE is not the optimal tax strategy.

Hidden cost #1: Missing out on unused foreign tax credits

Interestingly, many expats who use FEIE don’t actually need it, and could use the mechanism of tax credits to avoid double taxation instead (claiming credits in one country for taxes paid in the other). Expats in high tax jurisdictions in particular probably pay enough in foreign taxes to fully offset any potential U.S. tax liability, even without excluding any income.  Other higher income earners may also use a combination of the two approaches: the FEIE up to the statutory limit, and tax credits for the remainder of their income. The benefit of the tax credit approach is that any unused foreign credit can be rolled over for 10 years, and, therefore, may be used in the future to offset potential U.S. tax liability. While using foreign credits is not always easy (indeed many foreign tax credits end up expiring), certain situations such as moving to a low tax country, or using certain pension withdrawal strategies, may give rise to very attractive opportunities for an expat to capitalize on their unused foreign tax credits. Using the FEIE may reduce or completely eliminate these opportunities.

Hidden cost #2: Losing the ability to contribute to an IRA

Excluding your income from federal taxation sounds great, but if you exclude all of your income, you may be making yourself ineligible for IRA or Roth IRA contributions, which require the presence of employment income as the primary criterion for eligibility. As a result, you could be missing out on the opportunity for tax deferred or even tax exempt growth afforded by IRAs and Roth IRAs. The benefit of making such contributions will vary greatly depending on your personal circumstances and country of residence, and some expats may not benefit from them at all. For a more detailed discussion on IRA contributions for expats please refer to my previous article on the topic: 

https://usexpatinvesting.com/educational-materials-for-ex-pats/can-i-contribute-to-an-ira-as-an-american-expat/

Hidden cost #3: not receiving refundable tax credits

For expat parents who may qualify for child care tax credits, using the FEIE may have another hidden cost: it will make you ineligible for the refundable portion of that credit. In practice, this could mean missing out on the opportunity to receive USD $1,400 per child annually paid to you in cash, due to specific tax rules making FEIE claimants ineligible for tax credit refunds. Filers who simply claim foreign tax credits are unaffected and remain fully eligible for this tax credit, including the refundable portion. 

Given the drawbacks outlined above, it is clear that while the FEIE is intuitively attractive for its efficient and straightforward nature, careful analysis may reveal certain shortcomings that could very well prompt some expat taxpayers to reconsider its use in favor of the tax credit approach. Unfortunately, the IRS does not let taxpayers simply flip-flop between credits and the FEIE. Once the FEIE election is revoked, it cannot be claimed again for at least 5 years, and will require a specific written request and IRS approval to re establish.* For many taxpayers, that convoluted procedure alone may justify the added cost of using the FEIE, and in all cases it is clear that revoking the FEIE should only be done after very careful consideration and consultation with your accountant and advisor.

* https://hodgen.com/flip-flopping-the-foreign-earned-income-exclusion/

ABOUT THE AUTHOR

Headshot of financial advisor Syl Michelin in a blue suit with white button up shirt and gray background

Syl Michelin, CFA®

US EXPAT FINANCIAL ADVISOR

Syl Michelin is a Chartered Financial Analyst and fee-only, fiduciary financial advisor who works with cross-border families and American expatriates. 

You should always consult a financial, tax, or legal professional familiar about your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.

 

Navigating the Expatriation Process for U.S. Citizens 

Navigating the Expatriation Process for U.S. Citizens 

by | Mar 1, 2023 |

Why Expatriate?

Americans tend to be a relatively patriotic group, even when life’s journey takes them overseas to live. However, as many Americans become settled over time in a new country, it is only natural that they adapt to the culture, the language, the environment, etc. and adopt a new country as their “home.” Many of our expat clients acquire dual citizenship after spending significant time in a new residence country, or are able to acquire a second passport even faster due to the nationality of their parents or grandparents. 

Unfortunately, and quite unfairly, the retention of U.S. citizenship often then becomes a special burden to them, because of the unique laws of the United States that base income tax residency on citizenship, not on actual residency. Accordingly, the U.S. “dual national,” who may feel the ties to the U.S. ever fading, is also a “dual tax resident,” meaning that they are also subject to income taxation on worldwide income, from all sources, in both their new “home” country and the United States. Moreover, should they choose to gift wealth during their lifetime, or bequeath their wealth to others at death, the gift, estate and/or inheritance tax laws of both countries may stake a claim to tax these wealth transfers.

Complications for Long-Term U.S. Residents

There is another, larger group of U.S. taxpayers that may find themselves in this same situation: long-term U.S. residents. These are noncitizens that held a U.S. green card and lived in the United States for eight years in any fifteen-year period. Once you become a long-term resident, U.S. tax residency permanently follows you when you leave the United States, whether the long-term resident returns to their home country or elsewhere. They may let their green card expire, but the tax residency is not so easily shed.

Severing Ties with U.S. Tax Residency

There is a way out for both the U.S. citizen abroad and the U.S. long-term resident abroad that wants to sever ties with their burdensome U.S. tax residency: Formal expatriation, first through immigration filings renouncing long-term resident status (Form I-407) or citizenship (State Department Form 4079, Form 4080, Form 4081, and Form 4082), followed thereafter in a final U.S. tax resident form 1040 filing, accompanied with special expatriation tax filing form IRS Form 8854 (the Expatriation Statement). 

As a financial advisor who has had many client and prospective client discussions regarding the tax consequences, formal tax process, and tax-minimization strategies concerning expatriation, I will focus on the tax aspects of expatriation rather than get into the less familiar weeds of the surrendering of green cards or passports. I have only one point to emphasize on initiating the process through an expatriating act (Form I-407 or Forms 4079-4082): Do NOT go through with this until you have worked out the details of the tax filings and statements associated with expatriation, discussed below, and conclude that this is the right time to set this process into motion. 

Form 8854 and “Covered Expat” Status

Form 8854 is, essentially, a declaration of the expatriate’s complete balance sheet as of that day before they formally expatriated (the “valuation date”). It must include all the items that would be considered to be in their taxable estate if they were to have died on the day before she formally expatriated. Valuations of assets ranging the gamut, including real estate, art and jewelry, private business ownership interests, etc. must be attested to by licensed appraisers, while pensions, retirement accounts, brokerage accounts must be listed and provide their market values as of that same date. In addition to itemized valuations as of the valuation date, cost basis information must also be provided, for reasons that will be made clear below. Moreover, the expatriating individual must also make an attestation that they made full, complete and accurate tax filings to the U.S. Department of Revenue for the last five years.

The expatriation statement, tax returns over the preceding five years, and personal attestation of complete transparency and accuracy will help determine the most critical element of expatriation, namely, whether the expatriating individual will be deemed to be a covered expatriate. This status will largely determine the financial and consequences of expatriation, now and into the future. If covered expat status is avoided, the expatriating individual will pay their last U.S. federal tax bill as a tax resident (reporting worldwide income) for the year (or partial year) before expatriating and then, thereafter, would only be liable for U.S. taxes on U.S. source income, and subject to the U.S. tax withholding rules that apply to non-U.S. persons. 

However, should the circumstances trigger the key status as a covered expatriate, additional financial obligations ensue. First, the covered expatriate will owe an exit tax, above and beyond ordinary income tax obligations, in the year of expatriation. More details of the exit tax may be the subject of an article focussing on this particular subject, but, to summarize briefly:

  • The exit tax is calculated as if the expatriating individual sold all of their assets provided on Form 8854 the day before expatriating, meaning that all unrealized gains at that time are now, in-fact, realized. This is subject to a special exemption on the first $737,000 of realized gains (2020, adjusts annually); and
  • For retirement accounts, the exit tax is calculated as if the expatriating individual took full distribution of the pension, deferred compensation plan, retirement plan or IRA account. As this is ordinary income to the expatriate, the capital gains exemption above does not reduce taxes owed from these implied distributions. For qualified retirement plans like 401(k)s, but not IRAs, there is an ability to defer the tax from this implied distribution to when actual distributions are made, subject to special conditions, including application of the 30% withholding tax on each distribution and the waiver of the future right to reduce this withholding rate by tax treaty.

The burdens do not stop with the exit tax, either. Additionally, the covered expat will be deterred in the future from gifting or bequeathing assets to U.S. tax residents, such as family members that do not expatriate. Gifts and bequests from a covered expatriate are not entitled to a gift or estate tax exemption, and are taxed at the maximum tax rate by law on the entirety of the gift or bequest (currently 40%, or even 80% on generation-skipping gifts or bequests). This tax is actually paid by the beneficiary/recipient U.S. tax resident.

Covered Expat Status “Test”

By now, given the punitive taxation that accompanies the covered expat status, it is obviously critical to understand the test for acquiring this unfortunate status and the exceptions that otherwise prevent the triggering of covered expat status. Basically, the covered expat status is triggered by any one of three tests – fail any of the there following tests, and the expatriating individual shall be deemed a covered expat:

  • The Compliance Test – As mentioned above, the expatriating person must certify they have been compliant with federal tax laws over the past five years. Failure to certify and/or failure to submit adequate evidence to substantiate compliance will result in covered expat status. Expect extra scrutiny of these tax forms during the process.
  • High Income Tax Liability Test – Looking at those past five years of tax returns, the expatriating individual will be deemed a covered expatriate if their average federal income tax liability over the five-year period exceeds $172,000 (2021, adjusted annually). Do not confuse this with annual income or adjusted gross income – the standard is an actual tax liability on average per year exceeding $172,000, which implies high earnings and/or significant capital gains realization during part or all of those five years.
  • High Net Worth Test – Looking at the balance sheet of the individual taxpayer, as submitted in Form 8854, including substantiation of the valuation of assets and liabilities, if the expatriating person’s net worth on the valuation date exceeds $2 million, the expatriate shall be deemed a covered expat. Remember, joint assets should be apportioned between individuals, so this is an individual net worth threshold, not a joint threshold. Unlike the high income tax liability test, the $2 million threshold does not adjust to account for inflation.

It should come as little surprise that this third test, high net worth, is more often the test that triggers covered expat status, especially considering that net worth covers each and every item that would fall within the expatriating person’s taxable estate. However, getting around either of those tests’ thresholds may be a matter of timing, or, especially in case of the high net worth test, a matter of strategically repositioning family wealth among family members.

There are a couple of important exceptions for those that would otherwise fail the covered expat tests:

  • Dual nationals from birth (oftentimes considered “accidental Americans”), who have lived in the U.S. less than 10 of the previous 15 years prior to the year of expatriation, who continue to be citizens and tax residents of that other country for which they hold citizenship; and
  • Citizens who expatriate before the age of 18 ½ , who were resident of the United States for less than 10 years.

Remember that all expatriating persons must still file Form 8854 and go through the tax process of expatriation, even though these two groups may do so without fear of being deemed a covered expatriation.

Conclusion: A Complex Process Demands Upfront Professional Planning

To generally recap the tax rules regarding expatriation – the procedure for eliminating tax residency on the basis of citizenship or long-term residency status – the expatriating person must commit an expatriating act and complete the tax filing and certification process outlined above. For the citizen, this will involve forms and procedures to formally terminate citizenship, e.g., surrendering of the U.S. passport. For a long-term tax resident, this might involve voluntarily surrendering your green card. Letting a green card expire without renewal, by itself, may not be an expatriating act. Therefore, the completion of Form I-401, entitled “Record of Abandonment of Lawful Permanent Resident Status,” is critical to establish intent to expatriate for long-term residents. This will then trigger the obligation to complete Form 8854 and certify compliance with U.S. federal tax laws. 

During this tax process to conclude expatriation, a critical factor determining the real cost to get out of U.S. tax residency will be whether covered expat status is triggered. Because the consequences of that status can be so punitive in the present (exit tax) and thereafter to the American beneficiaries or heirs, it seems only logical to suggest that the expatriating person get some meaningful tax and financial advice well in advance of committing the expatriating act. In particular, if there is any real possibility that the three tests for covered expatriation could be met, and the two exceptions for covered expats will not apply, then developing and implementing a comprehensive strategy for expatriation with experienced financial and tax professionals may prove pivotal to navigating this process without creating unnecessary tax burdens for the expatriating person and their American families. 

How We Can Help

At Walkner Condon, our international team of financial advisors is here to help guide clients that want to consider the possibility of expatriation. The first step of the process may be to determine what real tax advantage would flow from successfully expatriating. This requires an analysis of both U.S. and resident country tax laws and whatever tax treaties or compacts may factor in the distribution of tax payments by the client to each country. 

If there may be financial relief to be gained through expatriation, then an evaluation of whether the client would meet the covered expat criteria, or, importantly, whether there are steps necessary prior to expatriation to either (a) avoid covered expatriate status, (b) at least reduce the exit tax consequences, or (c) modify estate plans to reduce the gift and/or estate tax consequences flowing from the decision to expatriate. 

Ultimately, if a general strategy map toward expatriation is formulated, we’ll make sure that clients also get the tax and legal expertise needed to successfully implement that strategy and successfully navigate the complex rules of formal expatriation. It begins with a conversation, and we’re here to provide knowledge, support and advice that is helpful and impactful. 

Stan Farmer

 

AS PORTUGAL’S EXPAT POPULATION BOOMS, ITALY AND GREECE JOIN THE COMPETITION

AS PORTUGAL’S EXPAT POPULATION BOOMS, ITALY AND GREECE JOIN THE COMPETITION

by | Feb 15, 2023 |

Over the past few years, our Expat Group at Walkner Condon has covered the success of Portugal’s Non-Habitual Residence (NHR) program extensively. As a former expat who lived in Portugal before returning to the states in 2011, finding other Americans living in Portugal (well, Lisbon at least, as I can’t say I was laying back and enjoying the calmer life of the Algarve, which at that time was known mainly as a British expat enclave) was difficult. However, over the past handful of years, the transformation of Portugal into a key in-demand destination for Americans (retirees but also non retirees) has been absolutely stunning. According to Forbes, the number of Americans living in Portugal rose 45% in 2021 from the prior year. And 2022 got off to an even hotter start, with VISA-motivated investment by Americans more than tripled in the first quarter of 2022 over the first quarter of 2021, according to SEF, the Portuguese Immigration and Border Service. The American Expat trends in Portugal certainly show no sign of slowing. Rising housing prices in the U.S., a favorable Euro/USD exchange rate and the popularity of remote work have no doubt added kerosene to the NHR fire!

Portugal’s NHR success story has not gone unnoticed by other fiscally-challenged EU member nations that would like to attract more talented and/or wealthy expats to immigrate and contribute to their economies and tax rolls. It should come as very little surprise that Italy and Greece have prepared to enter the competition for these expats, whether they be citizens that fled in years past for better opportunities elsewhere, or foreigners looking for attractive low-cost living options in Southern Europe with enticing scenery, warm climates, rich in cultural tradition and, of course, tax breaks. 

Perhaps as the influx of expats in Portugal continues to crowd its beaches and inflate the once-attractive housing market, it’s time to consider these relatively new tax programs in Italy and Greece and compare them with each other and with Portugal’s NHR program. Obviously, the competition for the would-be expat’s visa application comes down to more than tax arithmetic, but understanding a few key features of the Italian and Greek tax programs for expats should prove to be a valuable launching point into further inspection and study of these countries as potentially viable competitors of Portugal for expats moving forward. Accordingly, we’ll briefly outline some key tax features introduced in Italy, and then we’ll take a similar look at what Greece is doing to entice attractive expats.

ITALY’S TAX INCENTIVES: A TALE OF THREE REGIMES

While Portugal’s NHR program offers, for the most part, the same thing for everyone (the exception applying to Portuguese-based earnings, where incentives are afforded only to workers in only certain professions), Italy takes a completely different approach: three distinct tax incentive regimes. Any would-be expat shopping for a program will therefore study each of these three regimes and determine whether one of them would fit the bill. The highlights (NOTE: only a cursory overview) of each of these three regimes are set out individually below. Like most things I’ve learned about the Italian tax system in general, they’ve designed this with complexity and special rules and exceptions abound.

The Impatriati Regime – Calling all Digital Nomads/Remote Workers, Self-Employed Businesspersons, Freelancers or Others Landing Employment in Italy

The Impatriati Regime looks to attract people moving their tax residency to Italy that are willing to commit to Italian tax residency for two years. Eligibility requires that you have not been a tax resident of the country for the two prior years. The regime is designed for workers – those who are going to earn taxable income – because the Impatriati regime tax incentives apply to employment (or self-employment income).

The main tax incentive is that participants are taxed on only thirty percent (30%) of their employment or self-employment income. If the participant moves to one of the southern regions of Italy, the employment/self-employment incentive improves for the participant, as they will be taxed on only ten percent (10%) of their self-employment income. Note that these incentives do not reduce the applicable required Italian social security contributions, nor do they apply to capital gains taxes. The incentives are designed to reduce active income from employment, not passive income nor pension income. It is important to note that there is NO CAP on the amount of income that can be reduced per this regime.

The Impatriati tax incentives last for five years. However, the regime can be extended for another five years under certain conditions: (a) the individual has at least one minor child, or (b) the individual, their partner, or their child purchase a home in Italy the year preceding the beginning of their participation or thereafter. However, the amount of income-tax-exempted income is reduced from 70% (or 90% if applicable) to 50% during this extended period, unless the participant has three or more minor children (which I guess that’s one way to combat the aging population crisis!).

The Fixed Tax Regime – Attention Ultra-High Net Worth Individuals

Completely different from the Impatriati regime’s incentives that focus on employment/self-employment income, this regime (we’ll call it “Fixed” or “UHNW”) focuses on income generated from offshore sources and caters to a very select group of potential immigrants.  This program applies to foreign sourced income generated abroad that would otherwise subject Italian tax residents to income taxes or capital gains taxes. It also applies to inheritance or gift taxes that would otherwise apply to gifts given or received or inheritances received from abroad.

The incentive is considerably more straightforward than those in the Impatriati regime: the participant pays a fixed €100,000 annually and no further taxes are due on the above-referenced income, capital gains, gift or inheritance items. Additional family members can be included in this regime for an additional €25,000 annually. 

Membership in this regime has further privileges. First, it lasts for fifteen (15) years. Second, it exempts participants from paying wealth taxes on their offshore assets. Finally, it even excludes participants from having to make a declaration to the Italian tax authorities on their offshore assets.

While this regime does not reduce Italian taxation on Italian-sourced income (normal rates apply), the Fixed/UHNW regime might be particularly attractive to affluent expats with substantial investment portfolios and/or foreign-source income.

The Flat Tax Regime For Foreign Pensioners

To qualify for the Flat Tax regime, you have to be retired, or at least receiving a pension income. The pension can be public (e.g., Social Security) or private (e.g. 401k or IRA). Participants must not have been an Italian tax resident in any of the previous five tax years. Significantly there is also an important geographic/demographic restriction to participate in this regime:  the participant must establish residency in a municipality with less than 20,000 inhabitants in the Southern regions of Italy. Therefore, extensive exploratory visits to remote locations in Southern Italy are highly recommended before planning to participate in this regime.

For those retirees, or semi-retirees, comfortable with those limitations, very attractive tax incentives await. First, participants will enjoy a flat tax of seven percent (7%) on their foreign-source income, including pension income and also capital gains on otherwise taxable foreign investments/property. Second, participants are exempt from any applicable wealth tax. Finally, participants also are not required to declare their offshore (foreign) assets. Ordinary Italian income and capital gains rates will apply to Italy-source income.

This regime’s incentives last for ten (10) tax years, so this fits right between the time limitations of the best incentives in the Impatriati regime and the Fixed/UHNW regime. For retirees looking for some of the lowest cost destinations Italy has to offer in order to kick back and enjoy a peaceful retirement environment with a warm climate for a decade, the Fixed Regime may indeed prove to be an ideal tax incentive regime. Thereafter, taxes revert to regular Italian rates on all (worldwide) income (or wealth) from all sources.

GREECE – LAST TO THE PARTY BUT EXTREMELY COMPETITIVE

Much like Italy, Greece’s economy has suffered tremendously for quite some time, and particularly so with the onset of the pandemic. Another key similarity to Italy and Portugal:  the existing tax regime for residents was highly unlikely to make it a choice destination for retirees and/or high net worth expats (45% marginal tax rate on income over €35,000). With that in mind, Greece has also joined the tax reform race to attract a much-needed injection of wealthier foreigners and expatriate nationals. The approach by Greece is almost a carbon-copy of the Italian reforms discussed above, but differences will be noted below.

Tax Relief for Expats on Earned Income from Greek Employment and Self-Employment

Originally, this tax incentive program was created in 2020 to benefit persons gaining tax residency in Greece in order to work for Greek companies or foreign companies with a permanent establishment in Greece.  In 2021, special provisions were added to provide these tax incentives to self-employed expats to attract the growing masses of “digital nomads” who could work remotely from almost any country to provide their services to clients. The Visa process for digital nomads would naturally be different and Greece may still be working out the wrinkles, so you may need some expert assistance from an immigration expert in Greece (whatever one would call the equivalent of an Italian “commercialista”).

The key tax benefit of these programs is a huge tax break on earned income:  Under the programs, Greece will levy taxes on only 50% of annual earned income for the seven (7) year duration of the program. There are several conditions to these incentives:

  • Applicants were not a tax resident of Greece for at least five of the previous six years before transferring tax residency to Greece;

  • Tax residence is transferred from an EU member state or EEA (EU plus Iceland, Liechtenstein and Norway) or from a country with which Greece has an administrative cooperation agreement on taxes with Greece (this includes the USA as these countries have a valid income tax treaty in place for over 50 years);

  • The applicant provides services in Greece in the context of an employment relationship with a Greek legal entity, a permanent establishment of a foreign entity in Greece, or (post 2021) through self-employment business activity; and

  • The applicant must commit to remain a tax resident of Greece for a minimum of two years.

As you can see, the Greek tax regime for expat employees/self-employed is very similar to the Italian Imperiati regime. The Imperiati regime appears more generous in terms of tax reduction for the first five years and can be extended for an additional five years on level terms for the Greek program, but only if additional requirements are met. On the other hand, the Greek tax incentives last seven years with no possibility of extension. Interestingly, Portugal’s NHR program lasts ten years and provides a flat tax of 20% on Portugal-source earned income, but only for certain professions, which can change over time, which makes it less comprehensive when it comes to domestic source earned income.

 

Ultra-High Net Worth Fixed Tax Regime a/k/a “Non-dom Investor” Status

Just like Italy, Greece has added a Fixed or UHNW tax option, whereby participants moving to Greece may pay exactly €100,000 annually for a maximum of fifteen (15) years, and can add any relative into the deal for another €20,000 per person per year.  This will relieve the participants of any further income tax obligations from non-Greece sources. Furthermore, participants are not subject to Greek inheritance, gift and parental grant taxes as well. And, unsurprisingly, the non-dom status also relieves participants from having to declare their income earned abroad. 

To qualify for non-dom status in Greece, two important conditions must be met:

  • Prior Non-Residents Only:  Applicants must not have been tax residents of Greece for seven of the prior eight years to qualify; and
  • Investment in Greece:  Applicants must show that they, or their relatives, directly or indirectly (through an entity of which they are a majority owner) invest at least €500,000 in real estate, businesses or transferable securities/shares of entities based in Greece.

Accordingly, while the term and the tax bill is identical to the Italian Fixed/UHNW regime, the key difference is that Greece is requiring a substantial investment in Greece to apply. Of course, anyone with overseas income at a level that makes paying Greece €100,000 each year for taxes on that income a “deal” will likely have no issues buying a residence there for over the €500,000 investment threshold.

 

The Flat Tax Regime For Foreign Pensioners a/k/a “Non-dom Pensioner” Status

Greece also has a non-dom regime for  foreign pensioners, which, like the Italian flat tax regime for pensioners, enables participants to pay a flat rate of seven percent (7%) on all of their foreign-source income to Greece.  To qualify, there are two key conditions for this program:

  • The applicant cannot have been a tax resident of Greece for five of the prior six tax years before transferring their tax residence to Greece; and
  • The transfer of residency must come from a state with which Greece has an agreement on administrative cooperation regarding taxation (includes the U.S.) in force.

As in Portugal’s NHR program, participants in the non-dom regime for pensioners in Greece must declare all of their worldwide income annually, whereas the Italian pensioner regime does not require the declaration of offshore income. 

There is certainly one feature of the Greek program that is superior to both Portugal’s NHR program and the Italian fixed rate tax regime: its longevity. Retirees wishing to not revert to the high tax rates of Western Europe after ten years will no doubt appreciate the fifteen year duration of this tax incentive program. Another critical advantage over the corresponding Italian tax incentive regime is that Greece’s program does not impose geographic/demographic restrictions. If you are a retiree who prefers an urban community, the Greek program may be a better option for you.

CONCLUSION:  LET THE BATTLE FOR EXPAT DOLLARS BEGIN!

This brief explanation of key features, conditions and restrictions of the newer expat tax incentive programs introduced in the last few years in Italy and Greece are both a testament to the success of Portugal’s NHR program for attracting foreign wealth and investment and a strong entry from these fellow EU nations in the competition to attract vital expat residents. The relatively low cost of living, favorable climates, and historical cultural attractiveness are advantages that all have traditionally shared, but their traditional tax regimes did little to enhance the attraction of residency in any of these Western European gems.  With the population explosion of expats in Portugal, property values and, therefore, the expat’s cost of living are on the rise. It may be time for would-be expats, digital nomads and retirees, to focus on these newer programs and broaden their horizons to consider all that Italy and Greece have to offer with a more level fiscal playing field. After all, these expat tax incentive programs appear to share more similarities than differences.

Remember that this is not intended to be an all encompassing comparison of the pros and cons of immigrating to any of the above-mentioned countries that are offering special tax concessions through their programs. Consider this a launching point for further inquiry and research. For example, consider other potential taxes that might affect your decision and which may depend on your unique objectives and financial/familial situation. Inheritance taxes, property taxes, etc. may dramatically alter the financial attractiveness of these destinations depending on your circumstances. Additionally, immigration eligibility and steps to obtaining the ability to become resident, and the costs involved in the immigration process for any of the above-mentioned countries are very important considerations, but are well outside the scope of this article. 

If you are contemplating a move from the United States to live an expat adventure, in Portugal, Italy, Greece, or elsewhere, your financial planning and investment management needs are about to change dramatically, but we’re here to help expats manage through the inevitable complexities. Consider reaching out to me or one of my colleagues, Sylvain Michelin and Keith Poniewaz. You can find a way to schedule a no-obligation consultation with us, and much more useful information regarding expat financial and investment topics, on our website.

ABOUT THE AUTHOR

Headshot of financial advisor Syl Michelin in a blue suit with white button up shirt and gray background

Stan Farmer, CFP®, J.D.

US EXPAT FINANCIAL ADVISOR

Stan Farmer, J.D., is a Certified Financial Planner™ (CFP®) and fee-only financial advisor who specializes in working with U.S. expats and Americans living outside the U.S.

A Bear Market in Search of a Recession – What’s in Store for 2023?

A Bear Market in Search of a Recession – What’s in Store for 2023?

by | Feb 2, 2023 |

I still remember that day – it was sometime in 2007 – I was a young, aspiring private banker in the office of Citibank in Geneva, Switzerland. A dozen or so of us were gathering in Salon Leman on the 6th floor, where some of our best meeting rooms overlooking the lake were located. The topic: capital markets boot camp, a two-day intensive investment training for Citibank staff, led by a senior trader flown in from New York for the occasion.

Despite its name, Salon Leman did not face the lake, it faced the back of the building towards Rue du Rhone, Geneva’s main commercial street. But, from one of the side windows, you could still catch views of the Jet D’eau (Geneva’s iconic water feature) on a clear day. Good for daydreaming…

As it turned out, there would be very little time for daydreaming during our boot camp. Our speaker was witty and engaging, and would proceed to show us the proverbial ropes in a way only a hardened Wall Street veteran could. She had a no-nonsense approach and peppered her presentation with colorful anecdotes about everything from smoke-filled 80s trading floors to investing strategies favored by Japanese housewives.

But out of all topics covered, what stuck with me the most were her comments on bear markets and recessions. What she described was a monetary policy and interest rate pattern that preceded every bear market, without fail, each and every time: “an inverted yield curve,” she said. “And one final rate hike, one rate hike too many…chokes out the economy,” she added, making a strangling motion with her hand around her throat. “The yield curve gets inverted, then the recession hits…”

At that particular time in 2007, the yield curve had been dipping in and out of inversion (inversion simply means that bonds maturing in the short term had higher yields than bonds maturing further into the future, the opposite of what you would normally expect), and the federal reserve had been raising interest rates. Yet there was no talk of recession in the financial media and no signs of economic collapse. “This time is always different,” she told us, the popular explanation for the inverted yield curve at the time was that Chinese buyers had an insatiable appetite for long-dated treasury, keeping long-term interest rates down, and certainly not that we were heading into recession. “There’s always a story,” she said, sarcastically…

LAKE GENEVA (LAC LéMAN) IN
GENEVA, SWITZERLAND

Within a few months of our boot camp, the episode now known as the Great Financial Crisis would begin to unfold. A recession so severe that my former employer, one of the largest banks in the world, nearly went bankrupt.

Today, Citibank no longer occupies the lakefront building in Geneva, and my former colleagues have been relocated to a more functional location on the other side of rue du Rhone, minus the lake views.

What, if anything, is a Recession?

I’ve since had plenty of time to reflect on the lessons from that day, and 2022 has offered yet another opportunity to ponder its wisdom. For most of the year, comparing the 2-year yield to the 10-year yield would have shown clear inversion (2-year yields higher than 10-year yields), and the Federal Reserve has been raising rates faster than any time in recent history. With these factors in place, it would seem like stars perfectly aligned for the start of a dreaded recession.

Depending on how one defines recession, it may in fact have already happened. With negative annual growth numbers in Q1 and Q2, 2022 delivered the often cited “two consecutive quarters of negative growth” that constitutes a recession in the mind of many. By that definition, we are either in a recession or just coming out of it.

Indeed, the word “recession” has grabbed headlines all over the world. If Google searches are any indication, it also occupied mind-shares like never before, even more than it did during the 2008 crisis, or the height of COVID lockdowns.

Judging by this apparent recession mania, one might imagine a world engulfed in the depth of a devastating recession. Yet, if this is indeed a recession, it certainly does not feel like one.

The hallmark of a recession, to my mind anyway, involves hardship among the general population, rising poverty, and weakness in the job market in particular.

Yet a photo from the 1930s Great Depression could hardly be more different from what we are seeing today, not only because of how incredibly well-dressed unemployed people were in the 1930s, but also because there simply isn’t any form of employment or income crisis in the US currently.

While some layoffs in grossly overstaffed tech firms have been making headlines, the reality on the ground for most businesses is still that of a labor shortage: a struggle to find enough workers.(1)

While much has been made about declining real (inflation-adjusted) wages, a closer look at income data (Figure 1.C) indicates that keeping up with inflation in this red-hot job market requires one simple step: switching jobs. Indicating that lagging wage growth has had more to do with payroll inertia than anything else.

To be sure, despite strength in the labor market, more bearishly-inclined observers may point to various softer pieces of data, including ISM manufacturing PMI (a survey of 400 industrial companies) which has now declined below 50, indicating anticipated decline in purchasing activity.

Yet once again, growing employment trends appear disconnected from negative survey results, begging the question: if manufacturers anticipate slower activity, why do they keep hiring?

Historically, disconnects between employment data and the more volatile survey results tend to resolve themselves with PMI data catching up to the reality of hiring activity. In other words, watch what companies do, not what they say.

Economic growth returned in Q3 with real GDP increasing by 2.9%, while companies continued to deliver strong results. Whichever way you look at it, the dreaded recession, so far, has failed to materialize. Setting aside news headlines, one might even conclude that as we enter 2023, the US economy isn’t actually slowing, but accelerating.(2)

Never go full Volcker

Much of the continued recession fears boil down to well-founded expectations that the Federal Reserve may hurt the economy with excessive monetary tightening. The pace of rate increases even prompted some observers to suggest that Fed chairman Jerome Powell had “gone full Volcker” a reference to Paul Volcker, the 1980s Fed chairman renowned for bringing rampant 1970s inflation under control.(3) Yet, current monetary policy is a far cry from anything resembling the early 1980s. During Volcker’s tenure, the US experienced the longest period of 5%+ real (inflation-adjusted) interest rates recorded in the post-war era. In contrast, despite all the noise and commotion, the current level of nominal interest rate is still well below inflation levels, and is actually one of the most deeply negative real interest rate environments ever recorded. Against this backdrop, it’s unclear what the current Federal Reserve leadership has done to deserve any comparison with their 80s counterparts. This did not stop public opinion from turning strongly against central bank actions, and a chorus of voices ranging from Elon Musk to the United Nations rang the alarm bell.
As for balance sheet reduction (the other half of the Federal Reserve’s two-headed tightening monster) some perspective is, I feel, also needed. For all the dramatic headlines, it is worth remembering that 2022 is not the first time we’ve seen the Federal Reserve reduce the size of its balance sheet: it had previously declined from about $4.5 trillion in October 2017 to roughly $3.8 trillion in September 2019, before Fed leadership eventually reversed course. Based on today’s balance sheet size, a comparable 15% reduction would require almost $1.3 trillion dollars to roll off the Federal reserve’s balance sheet. Since March this year, the current tightening phase has only resulted in a fraction of that decline (about $0.28 trillion). As things stand currently, the balance sheet remains more than twice as large as it was when the last tightening phase ended in 2019. In a recent report, a team of economists at Wells Fargo estimates the end result of the current tightening phase would involve a $6.5 trillion balance sheet in Q1 2025, a level that would have felt almost inconceivably high in the pre-COVID era.(4) As is the case with the interest rate debate, the mass hysteria over balance sheet reduction seems a bit naive once placed in a broader historical context, or perhaps it is symptomatic of a deeper underlying malaise (more on that later…) At the core, much of the monetary policy debate hinges on your perception of what drives current price pressures. Some believe that inflation is largely driven by temporary disruptions related to post-COVID hangover and the Ukraine war. If that is the case, then current interest levels may indeed already be too high, and the Fed may be committing a policy mistake by raising interest rates in response to transient supply-related factors.
On the other hand, if one believes that demand-related factors (possibly stemming from past monetary excesses) are at the root of current inflationary pressures, one could easily make the case that the current policy stance is still far too dovish and that higher interest rates are needed. Reality is, of course, more nuanced, and both demand and supply factors overlap and interact in unextractable ways. Nonetheless, demand vs supply factors is a piece of data that federal reserve officials have been tracking and are actively aiming to quantify.(5) Interestingly, the Federal Reserve bank of San Francisco’s data in Figure 1.G suggests that, while acknowledging that a lot of inflation remains “ambiguous,” 2022 marked a key cross-over point where demand-related factors have overtaken supply in its impact on inflation. Simply put, prices are rising because people are buying stuff, which is perhaps no surprise when considering the continued strength of the job market and rising wages.

This time won’t be different

Where is the recession then? And what should investors make of the deeply inverted yield curve? And did I, after all these years, forget the lessons of my strikingly prescient 2007 teacher?

The current level of yield curve inversion sends an ominous signal. Not only is it inverted, but the depth and breadth of inversion has reached levels that have always been associated with recession in the past. This time is unlikely to be different.

In 2007, however, it’s worth noting that my boot camp instructor held a deeply contrarian view. At the time, the economy was strong, and analysts were almost unanimously bullish even as markets were making new highs. This could not be more different from the current environment, which is characterized by generalized bearishness among investors large and small. As shown in the left side chart in Figure 1.I, current levels of “net bullishness” (a measure of sentiments among individual investors) is historically associated with very strong equity return in the subsequent year. The chart on the right (Figure 1.I) indicates extreme amounts of negative net positioning (bets that the market will fall) among speculators in the futures market, another strong signal of a possible reversal.(6)

In data going back to 1987, the American Association of Individual Investors has never before recorded 36 consecutive weeks of negative investors sentiments, 2022 is setting a new record.

Bearishness isn’t limited to individual investors either. In a recent Bank of America survey of mutual fund managers, the level of “underweight” equity” sentiment has reached levels consistent with extreme market lows (as happened during COVID and the 2008 crisis):  With extreme bearish positioning and sentiments, it’s worth remembering that predicting a recession and making money from that prediction are two very different things. A quick review of market performances immediately following prior instances of yield curve inversion shows that, on average, stock investors do surprisingly well in the months following inversion.

For what it’s worth, a naive speculative strategy involving a bet against the stock market in July 2022, when the curve first inverted, would have yielded negative returns thus far.

As history has shown repeatedly, investors are prone to herd behaviors both on the upside (buying into a frenzy) and downside (selling into a panic). While the transition away from years of unfettered money supply growth and low-interest rate will almost certainly involve recessionary periods (consistent with the yield curve signal), it’s worth remembering that there is no blueprint, no guidebook, to tell when it will start, how deep it will be, and what path markets might take leading up to it, or coming out of it.

Can we just move on?

While most of this year’s market commentaries have almost uniformly focused on the narrative of an excessively aggressive Fed destroying the economy, I believe a much different reality is taking shape as we enter 2023. In fact, many indicators suggest that the economy has remained stubbornly strong, and while the shift in central bank policy may seem scary, it is really not that dramatic when considered in the broader context. With inflation still running at 7.1%, and the Fed’s predicted “terminal rate” (the peak of its current rate rise plan) estimated at 4.75%, current policies still only make sense under the assumption of normalized inflation levels in the coming months. As for measures of broad money supply, they are still a long way away from what would be considered “normal” by any historical standard, even after recent balance sheet reduction efforts.

On the bright side, there are early signs that some of the high single-digit inflation readings of early 2022 may be starting to cool. However, as we have seen, continued strength in wage and consumer activity means that price pressures are likely to continue. From that perspective, the hope of a pivot in Fed policy may only materialize in the form of a short reprieve.

A strong consensus view has emerged around the idea that the Federal Reserve is aggressively normalizing its policy, that the recession has started, and that the next few months will now simply determine how bad things get (soft vs. hard landing). Reality, in my opinion, is much worse: there is no recession, and the Fed has not normalized its policy.

What makes this state of affairs much worse is that markets must still contend with what comes next. If this isn’t a recession, then what is? If this isn’t a normalized monetary policy, then what will normalization really look like?

Perhaps the obsessively negative mood we currently observe captures more than just recession fear. It captures the hope of a clean transition back to some form of an old normal, a way to move on: one more bout of policy tightening, one more leg down in the market sell-off, an orderly drop in corporate earnings, perhaps a few quarters of negative growth in early 2023, followed by a rebound, and a new upward trend, a sort of economic reset button. To be sure, It may very well happen that way. But as we enter 2023, the economy is still grappling with the consequences of years of monetary and fiscal largess: we’re enjoying its benefits in the form of renewed job market vigor and its increasingly intolerable costs (elevated inflation), as well as distorted markets.

We are still in the midst of the greatest monetary policy experiment of the modern central banking era, and 2022 has, at best, offered hints of what a possible resolution may eventually look like. Hopes of a clean transition out of the current regime, of an economic and monetary reset, are unlikely to materialize. Given the scale of past excesses, investors should brace for the long and winding road ahead toward anything resembling “normalization.” In all likelihood, it will involve repeated see-sawing between varying degrees of monetary tightening and loosening, and a heavy dose of fiscal policy attempting to even the playing field. From that point of view, 2023 may only mark the beginning of the process. And as much as we’d like to, we can’t just move on.

ABOUT THE AUTHOR

Headshot of financial advisor Syl Michelin in a blue suit with white button up shirt and gray background

Syl Michelin, CFA

US EXPAT FINANCIAL ADVISOR

Syl Michelin is a Chartered Financial Analyst and fee-only, fiduciary financial advisor who works with cross-border families and American expatriates.

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