| Offshore Investments |
However, there are numerous special tax rules in the U.S. tax law that are intended to deter U.S. investors from venturing outside the U.S.
The most onerous of these rules is the tax treatment of foreign mutual funds owned by U.S. taxpayers. If a foreign corporation is a "passive foreign investment company" or PFIC, then U.S. shareholders are subject to a very punitive tax on accumulated distributions from the fund. This punitive tax can be avoided by making an election to pay taxes on the shareholder's portion of the current income of the fund -- but that election is not available unless the foreign fund is willing to divulge substantial details to the IRS and the investor. The second way to avoid the punitive test is to elect to pay taxes on the gain in the market value of the fund each year -- which is called the "mark to market" election. However, this election is only available to a very limited number of foreign funds that meet stringent requirements by the U.S. tax law.
U.S. persons who want to invest in foreign hedge funds are therefore limited to those that are organized as partnerships or are controlled by U.S. investors. Another option is to invest in a foreign variable annuity or foreign variable life insurance policy that includes a hedge fund as part of its portfolio.
The problems that U.S. investors have with foreign mutual funds leads many investors to make direct investments in various companies outsie the U.S. The U.S. tax law does not discourage such direct investments but the U.S. Securities and Exchange Commission (SEC) makes it very difficult and costly for foreign companies or brokers (banks) to sell their stocks or bonds to U.S. persons. Most foreign companies don't want to incur the cost and hassle involved in registering their securities with the SEC.
To avoid problems with the SEC, foreign brokers (usually banks) simply refunse to sell foreign securities to U.S. persons or to even respond to an inquiry from a U.S. address. But they will sell to a foreign trustee or to a foreign corporation or limited liability company. This has led many U.S. investors to form an International Business Company (IBC) or foreign trust in a tax haven country in order to invest in foreign securities.
But that leads to more problems.
The U.S. grantor and any U.S. beneficiaries of the foreign trust are required to file a Form 3520 each year they have any transactions with the trust. (The grantor must file the form every year.) In addition, the trustee of the foreign trust must file a Form 3520-A each year or the U.S. grantor will be subject to penalties.
If the U.S. investor decides to use an IBC or foreign corporation as a way to secure access to foreign securities, the taxpayer must file an annual Form 5471 for shareholders of controlled foreign corporations. This form results in passing the income of the corporation to the U.S. shareholders and it eliminates the tax benefit of any capital gains or dividend income. Even if the IBC or corporation is owned by a foreign trust, the trust grantor is treated as the owner of the assets in the trust (for tax purposes) and the trust is therefore transparent and the trust grantor must still file the Form 5471.
One way to avoid some of these problems is to form a foreign limited liability company or IBC and to elect to be treated as a disregarded entity for tax purposes. If the foreign LLC or IBC has more than one owner it will be treated as a foreign partnership and must file Form 8865. If the foreign LLC or IBC only has only one owner, it will be totally disregarded for tax purposes and the owner of the LLC or IBC will report any income (and expenses) from the LLC or IBC on his or her tax return as if the LLC or IBC did not exist.
U.S. persons who have $10,000 or more in any combination of foreign financial accounts at any time duruing the tax year must also file a form TD F 90-22.1 with the Treasury Department on or before June 30th of the following year.
This is just a very brief summary of some of the key tax issues that confront U.S. investors who venture offshore. Extensive additional details about this subject are available in my report on "Tax Angles for Offshore Investors".
Vernon Jacobs
(C) Copyright, 2004 All rights reserved.
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