US Taxation of Foreign Investments for Expats and Foreign Business Owners in Portugal
Posted on 24-03-2023 11:45 AM
Expats and foreign business owners have a unique set of US tax rules to navigate. They must understand the laws and regulations surrounding taxation of foreign investments to properly evaluate long-term investment strategies.
We discussed with US tax preparer Portugal Derren Joseph from htj.tax and summarized it here.
American investors should avoid investing in funds based offshore, known as passive foreign investment companies (PFICs). PFICs must be reported on a special tax form.
Taxes on Investment Income
Expats and foreign business owners often find themselves in a complicated situation when it comes to the taxation of their investments. Fortunately, there are a few key tax strategies to consider. These strategies can help you avoid a lot of headaches and get your finances on the right track.
The first strategy is to use the Foreign Earned Income Exclusion, which allows you to exclude any foreign-earned income from your US taxes. There are some strict guidelines to this exemption, however, so be sure to speak with a qualified tax expert to ensure you are eligible for it.
Another important strategy for expats is to take advantage of the Foreign Tax Credit, which can be used to offset taxes owed on foreign-sourced income. This can significantly reduce your overall tax bill.
Finally, expats can also take advantage of the Foreign Capital Gains Tax exemption, which protects you from paying taxes on profits derived from the sale of property abroad. This is a particularly valuable tool for expats who want to move back home, as it allows them to avoid paying a double tax on the same gains.
Investment income, such as dividends and interest from foreign-owned companies, is generally not taxable in the United States. This is because it meets the IRS definition of passive income, which is defined as a source of income that you do not actively work on.
In general, however, investors should still pay attention to the reporting requirements on their FBAR and Form 8938. Failure to comply with these filing requirements can lead to large penalties and expensive legal redress.
The US tax code is surprisingly complex and difficult to understand. This is especially true when it comes to calculating and reporting the taxation of foreign investments. This is why it is always a good idea to consult with a knowledgeable tax advisor when it comes to your foreign-sourced income, such as the H&R Block Expat Tax Services experts.
Expats and foreign business owners should also be aware of the taxation of legacy foreign assets, such as pensions, mutual funds, business interests, trusts, and cash-value insurance policies. These kinds of assets are especially tax-toxic when they are not properly reported. It’s important for all non-US citizens to have a solid plan in place to deal with these issues before they arrive in the United States, so that they can avoid severe financial complications and potentially expensive tax penalties.
Taxes on Personal Income
The IRS expects US taxpayers to report their foreign financial assets as required by the 2010 Foreign Account Tax Compliance Act (FATCA). This is done on a separate form called IRS Form 8938 which should be filed with the annual tax return.
FATCA also requires all Americans who have substantial foreign financial assets to file an FBAR with FinCEN. This must be reported by any American who has an aggregate value of $10,000 or more in a foreign bank or investment account during the calendar year, regardless of the type of financial asset.
There are certain exemptions and credits that expats may be eligible to claim for their income earned outside the United States that can reduce their tax bill if they earn enough income to qualify for them. These include the Foreign Earned Income Exclusion, which excludes 30% of an individual's foreign-earned income from taxation in the US.
In addition, there are many tax treaties that can reduce the tax liability of expats. Often these are only beneficial for a limited number of expats, however, so it is important to check with your tax adviser.
For American citizens living abroad, the new levy is likely to be a major headache. "It's really difficult for entrepreneurs to get their clients to believe they have to pay 35 percent on the money they make, and that they have to report it to the IRS," said David Tannenbaum, a partner at Deloitte Tax LLP in New York.
The new levy is a particularly bad tax for American expats who own foreign companies, he added. Those who own 10% of a controlled foreign corporation (i.e., a company that is owned by a person who is at least 50 percent of the shareholders) will be subject to the new transition tax.
Fortunately, the new levy is not a tax on dividends or interest paid by a foreign corporation. These investments are normally subject to withholding taxes at the country of residence, which can be reduced to a lower rate by a tax treaty.
For Americans who are a part owner of a foreign corporation, it's also possible for them to avoid the transition tax by transferring ownership to a non-controlling investor and obtaining an appropriate business entity structure. ACA has helped hundreds of small business owners in this regard, and we can help you too.
Taxes on Passive Investment Income
Whether you’re an expat or foreign business owner, passive investment income can be a source of income that allows you to save for your future while also providing financial security in your retirement. Passive income can be earned from a number of sources, including interest on savings accounts, dividends on stocks, and rental property earnings.
Many expats and foreign business owners are able to use their passive investment income to reduce their taxable income. For example, you can deduct expenses relating to your foreign rental property such as mortgage payments, insurance, taxes, maintenance, and repairs, which can reduce your overall taxable income.
Another way to minimize your taxable income is to invest in tax-advantaged accounts such as IRAs or 401(k)s, which can offer tax benefits based on your annual income. These investments can give you more flexibility to pursue your goals without having to worry about paying a high tax rate on your profits from active businesses or jobs.
Some passive income, such as rent from rental properties, is sheltered by depreciation and amortization and has a lower effective tax rate than ordinary income. Taking these deductions can help you avoid higher taxable rates, especially if you’re in a higher tax bracket and your passive income is more than your salary.
The IRS rules on whether passive income is subject to tax vary by tax bracket and marital status. However, the main factor is whether your passive income meets the standard of material participation, which means you have participated on a regular and continuous basis in the activity.
This test can be tricky, so you may want to consider a professional accountant or tax specialist to make sure you’re not violating any IRS rules. This is particularly important if you are planning to claim the qualified business income (QBI) deduction, which can reduce your taxes by up to $25,000 per year in passive income.
As long as your passive income is considered to be “qualified,” it will receive preferential treatment compared to short-term capital gains, which are taxed at a much higher rate than regular income. Moreover, passive income that qualifies for long-term capital gains can often be taxed at 0% to 20%, depending on your taxable income and marital status.
Taxes on PFICs
As an expat or foreign business owner you may be wondering if you need to know about the taxation of your investments in the United States. These foreign investments typically come in the form of hedge funds, money market accounts, mutual funds, pension and retirement accounts, and a variety of other investment products.
These investments are incorporated outside of the United States and are subject to strict guidelines that include reporting requirements. These investments are called Passive Foreign Investment Companies, or PFICs.
PFICs are defined under Section 1291 of the US tax code as non-US corporations that earn more than 75% of their income from passive sources (interest, dividends, capital gains and rent) or have more than 50% of their assets held for the production of passive income. This can include foreign mutual funds, exchange-traded funds (ETFs), closed-end funds, insurance products and investments in some non-US pension plans.
The default method of taxation of PFICs is through a 'Excess Distribution' regime under which dividends and capital gains are taxed as ordinary income. These 'excess distributions' are apportioned to earlier years in the holding period on a pro rata basis.
This system can be very complex. It involves calculating the average of the distributions over the three preceding tax years and then allocating a percentage of these amounts to each year as an excess distribution.
If you are an expat or foreign business owner who has an interest in a PFIC, it is important that you consult with an experienced tax professional to determine your options. The right advisor will help you select a PFIC that is most appropriate for your situation and will guide you in choosing the best reporting option.
You will also need to fill out a special form, Form 8621, to report your PFICs each year. This form needs to be filed if you own shares of a foreign mutual fund, exchange-traded fund (ETF) or closed-end fund that is considered a PFIC for US tax purposes.
PFICs are a significant source of taxation for expats and foreign business owners. They are a complicated area of tax law and require careful attention to ensure that you avoid the penalties associated with the PFIC regime.