fbpx
What to Know about U.S. Estate and Income Tax for Foreign Investors

What to Know about U.S. Estate and Income Tax for Foreign Investors

Disclosure: Any specific examples listed are solely intended for educational purposes and are not intended to be tax advice. Please consult with a tax professional for specific information related to your situation.

There are many reasons for foreign investors to hold investment accounts in the United States. With its long history of property rights, efficient and regulated capital markets, and plenty of affordable investment options, the U.S. consistently ranks as one of the best global destinations for wealthy international investors.

As attractive as the U.S. may seem, foreign investors also need to be aware of potential pitfalls. In this article, I will focus on investments in financial assets, such as portfolios of stocks and bonds held through U.S. institutions, as opposed to real estate. 

In principle, the U.S. is wide open to foreign investors, and there are no laws (whether federal or state) preventing foreign nationals from holding investment accounts. However, for various reasons (complexity, risk…), many brokerage firms, banks, and financial advisors may choose to limit their services to U.S. residents, or at least apply strict restrictions on services to non-U.S. clients (such as minimum asset size requirements). So finding the right investment partners already requires some familiarity with the U.S. investment landscape. 

U.S. Estate Tax for Non-Americans

Once you’ve found the right provider, your next concern should be the U.S. estate tax. Foreigners are only subject to U.S. estate tax on U.S. assets. But, in most cases, they only benefit from a measly USD 60,000 exemption (compared to USD 12.06 million for U.S.-domiciled individuals). Therefore, if a foreign account holder dies with investments in U.S. stocks worth USD 1,000,000, their potential U.S. estate tax liability would be USD 376,000, corresponding to a tax rate of 40% on amounts in excess of USD 60,000. 

As scary as this outcome may seem, it is entirely avoidable.

Investing in Non.-U.S. Situs Assets

One of the simplest ways to avoid it is not to invest in assets that are not subject to U.S. estate tax, which can be done even in a U.S. investment account. For example, investments in non-U.S. exchange-traded funds, or mutual funds (such as UCITS funds registered in Ireland or Luxembourg), are not considered U.S. situs and are not subject to U.S. estate tax upon the death of the non-resident owner. Likewise, ADRs of foreign companies, even if traded on the New York stock exchange, would not be subject to U.S. estate tax. More surprisingly, publicly-traded bonds are also not deemed to be located in the U.S. for the purpose of estate tax assessment, meaning that U.S. treasury bonds (possibly the most American of all American assets!) would not subject the owner to U.S. estate tax. 

Creating a Corporate or Trust Structure

With some careful planning, it is possible to design investment portfolios that avoid the pitfall of U.S. estate tax, even if held at a U.S. institution. If this option isn’t available, another strategy may involve the creation of some form of corporate or trust structure to hold investments. For example, many foreign nationals will choose to open their U.S. accounts in the name of an offshore investment company. Once in place, the company can invest in U.S. situs assets such as U.S. stocks. If the owner of the offshore company dies, ownership can be transferred to their heirs without subjecting their estate to U.S. taxes. The general principle at work here is that while the underlying investments may be in U.S. shares, the company itself is a foreign entity, and therefore not U.S. situs.

While these types of structures aren’t necessarily cumbersome to create, they do require careful consideration and planning, so investors should consult their legal counsel to ensure proper procedures are followed. 

Estate Tax Treaties with the U.S.

With all that said, there may be no need for clever portfolio construction, or for sophisticated corporate structures, if you happen to live in one of the 15 countries to have signed a bi-lateral estate tax treaty with the U.S. In many cases, such treaties will allow residents of the foreign nation to claim a larger U.S. estate tax exemption than the default USD 60,000. Or (depending on the specific treaty), may otherwise limit the scope of U.S. estate tax to very specific assets, such as immovable property. 

Foreign countries with estate tax treaties are:

  • Australia
  • Austria
  • Canada
  • Denmark
  • Finland
  • France
  • Germany
  • Greece
  • Ireland
  • Italy
  • Japan
  • Netherlands
  • South Africa
  • Switzerland
  • United Kingdom

U.S. Income Tax for Foreign Investors

What about income tax? Unlike U.S. investors, foreigners who hold U.S. accounts do not have to file with the IRS every year. Instead, they are subject to withholding at source on the U.S. investment income they collect in the form of dividends. The default rate of withholding is 30%, but once again, with a bit of planning and know-how, this outcome can be mitigated.

To start with, depending on where you live, the 30% at source withholding on U.S. dividends may not be much of an issue. Since many countries have a tax rate higher than 30%, many investors will be able to claim a credit on their local tax return and simply pay the difference. In this case, the U.S. withholding will not result in any net increase in the investors’ tax liability. 

If that isn’t good enough, additional relief from withholding tax may be available under the terms of the various income tax treaties between the U.S. and the investor’s country of residence. The U.S. currently has 58 such treaties with foreign countries, many of which provide reduced withholding rates on dividends. For example, an investor from Norway may avail themselves of a 15% rate (instead of the standard 30%) by making a claim under article 8.2 of the USA/Norway income tax treaty. The procedure for making the claim is fairly simple and involves completing section II of form W8Ben and submitting it to the institution holding your account. 

Finally – as was the case with the estate tax – income tax withholding can be avoided by simply not holding U.S. assets. An investor could select funds or shares specifically incorporated in foreign jurisdictions and hold them through a U.S. account.  A portfolio composed, for example, of exchange-traded funds listed on the London Stock Exchange may enjoy the dual benefit of avoiding exposure to both U.S. estate tax and U.S. income tax withholding (though various tax withholdings may take place within the fund itself, dispensing on the underlying investments…).

 

Conclusion

In summary, while foreign investors can greatly benefit from holding all or part of their investment portfolio in the U.S., there are various potential mistakes to avoid, relating to both estate and income tax. Don’t hesitate to reach out to our team at Walkner Condon to discuss your specific circumstances.

Five Critical Estate Planning Considerations Before Moving Abroad

Five Critical Estate Planning Considerations Before Moving Abroad


NOTE:  Keith Poniewaz originally wrote about Three Estate Planning Considerations for Expats Moving Abroad in February of 2019. With Stan Farmer joining Walkner Condon as Director of International Financial Planning this September, Stan and Keith thought this might be a great topic to revisit and expand upon. There are many planning considerations that take on additional complexity when individuals move abroad and their wealth becomes subject to multiple, different, and perhaps even conflicting legal and tax jurisdictions. We consider five critical areas that every expat should examine before moving abroad.

As part of the 2017 tax reform bill (Tax Cut and Jobs Act of 2017), the United States estate tax exemption amount was raised to approximately $11.58 million per individual in 2020 or $23.16 million per couple. As a result, the estate planning and financial planning concerns of most Americans have changed radically. According to the Washington Post, only about 2000 individuals per year will end up owing estate taxes under the current limits. While they should still be worried about an effective estate plan to help ensure that minor children, spouses, and family are protected, under the current regime, few Americans have to worry about effective estate planning in order to avoid future tax bills.  

However, if an American decides to move abroad, they can bring local estate or inheritance tax laws into play and, consequently, be faced with a new set of complications– especially as their U.S. estate planning tools may not necessarily work in their new country. Below are five important items any American should consider before they more or retire abroad.

IDENTIFY YOUR ASSETS AND WHERE THEY ARE LOCATED

Will you still own a house in the United States? In your new country? A business? Or will you simply own stocks and bonds? Where are those located?  The answer isn’t as straightforward as one might suspect. Instead, Americans living abroad may have to consult the Estate Tax treaty between the United States and their country of residence to determine where the assets are located (situs is the legal term for the legal location of property) for estate tax purposes.  The United States has treaties with 15 countries currently.

UNDERSTAND YOUR POTENTIAL FUTURE TAX EXPOSURES

Whether there is an applicable estate tax treaty or not, American expats should be aware that once they establish a long-term residence abroad (in the U.S., the legal term would be “domicile,” but in most foreign countries, the critical term is simply “residence”), they may have gift, estate and/or inheritance tax exposures based on the laws of their residence country, even on assets back in the United States. Those expats should then prepare a plan to handle such taxes when they come due.

Even U.S. tax exposures should not be completely dismissed for the affluent expat. Remember that the aforementioned 2017 tax reforms are due to sunset after 2025 (if they are not repealed in the interim), which means that federal gift and estate tax exemptions will be halved to the inflation-adjusted pre-2018 levels (somewhere in the $6 million range per individual and $12 million per U.S. citizen couple.  Moreover, if the U.S. expat marries a non-citizen spouse, the ownership (by sharing, acquiring, or inheriting) of U.S. situs assets by a non-citizen spouse may have dramatic implications for the couple’s overall U.S. gift and estate tax exposures. Such mixed nationality couples have distinct estate planning needs, which differ greatly depending on whether there is an applicable estate tax treaty and, if so, the specific language within each treaty regarding spouses.

MAKE SURE YOUR WILL IS RECOGNIZED WHERE YOU LIVE

The U.S. system for determining how assets are distributed by a decedent to the beneficiaries (commonly known as probate) is not universal and several countries do not allow people to simply determine to whom they wish to distribute their assets, but instead, the legal code may dictate who receives the assets.  However, in several cases, there are ways for Americans to have their wills accepted by local authorities.  For instance, in the European Union, there is regulation 650/2012 which allows for European Union residents to select their home country’s laws as those governing probate or the distribution of their assets.  Note, however, this doesn’t allow for Americans to bypass laws governing taxes! It also will require a new will in most cases, because this special EU provision and the election of U.S. probate law must be specified within the will itself.

TRUSTS DON’T TRAVEL WELL

Relatedly, not all countries recognize trusts and as a consequence, an American trust can cause large headaches from a foreign country taxation perspective.  For instance, in certain countries, distributions from the trust can be taxed both at the level of the trust and at the level of the recipient.  As a result, trust distributions taxes can approach 70% or 80%.  In other cases, a U.S. trust with a U.S. trustee may deemed to become a resident-country trust upon the trustee (e.g., the grantor of a living trust) becoming a resident of the country. When the trustee returns back to the United States, the trust itself could be liable to pay an exit tax that is effectively a realization of all unrealized gains within the trust! Consequently, Americans outside of the United States who need the protections of trusts should consider a wide variety of “trust substitutes” including direct gifting, 529 plans, or other strategies. 

Should the would-be expat try to avoid this problem by setting up a new trust upon their arrival in their adopted country?  Not so fast –This is almost certain to cause onerous U.S. taxes to be applied!  The U.S. Internal Revenue Code is particularly skeptical of “foreign trusts” with U.S. beneficiaries. Ultimately, distributions to such U.S. beneficiaries will face a very complex and punitive tax regime specifically designed to treat current-year distributions as only partially accrued income from the current year and inappropriately deferred income from prior years. The upshot is that the U.S. beneficiary will have to restate taxes over several years in each year they receive a distribution, pay ordinary income tax instead of capital gain rates (or return of capital, which would be untaxed in a domestic trust) on portions of each distribution, and interest and penalties for the portions deemed to be deferrals of income from prior years for good measure.

THE IMPLICATIONS OF INHERITING OR RECEIVING GIFTS WHILE LIVING ABROAD

While the United States taxes the donor of a gift or the decedent’s estate, in most foreign countries that tax these wealth transfers, it is the recipient of the gift or inheritance that is taxed. This simple difference in legal cultures may have extremely profound consequences for the U.S. expat who receives a gift or bequest from a parent or other family member. Will property located outside of the residence country of the expat actually subject the expat to local taxation upon receiving it through a gift or inheritance? The answer varies not only from country to country, but, in certain cases (e.g., Spain or Switzerland) may even vary depending on the region (e.g., province or canton) in which the expat resides!

The implications described here are far reaching and the key takeaway is that the expat must not only be mindful of their own estate plan before moving abroad, but also the estate plan of those family members from whom they are likely to receive or inherit wealth in the future. Besides the potential tax exposures from direct gifts or inheritances, there may again be negative consequences flowing from the expat’s present or future interest in a family trust. The expat’s own trust may not travel well, but it’s not only their own trust that an expat needs to consider.

Stan Farmer, CFP® and Keith Poniewaz