Why US-domiciled funds are a tax danger for expatriates

It doesn't take long for expatriate investors in the UAE to get used to the idea of living in one country and having a chunk of their wealth in another.

They may have property and pensions in their home country, an apartment and savings in Dubai, and further investments in an offshore wealth platform.

This is a natural state of affairs for the internationally mobile and wealthy, but be warned, there are pitfalls.

Get it wrong and you risk a brush with the tax authorities that could cost you dearly and, in some cases, have you on the hook for taxes for a lifetime.

Nobody wants that. And you especially do not want to risk a run in with the US tax authorities, otherwise known as the Internal Revenue Service, or IRS.

The IRS are a tough bunch. Their legendary T-Men are the guys who brought down 1930s gangster Al Capone, when the FBI couldn't.

You don't want them coming after you.

Yet they could if you unwittingly invest in an exchange-traded fund (ETF) that is domiciled in the US, rather than, say, Dublin or Luxembourg.

ETFs are the heroes of the investment world. They have liberated private investors from the clutches of unscrupulous offshore financial "advisers" selling costly and complex offshore bonds and 25-year savings plans.

They have also spared investors from having their wealth drained by overcharging, underperforming mutual fund managers.

ETFs track a huge range of global indices, including shares, bonds and commodities, at minimal cost. They have no upfront charges and tiny annual fees. Two of the most popular, Vanguard S&P 500 ETF and iShares Core S&P 500 ETF, charge just 0.03 per cent a year.

What is so dangerous about that? Nothing. Unless your chosen ETF happens to be domiciled in the US and you are not a US citizen.

The US is the world's largest investment centre, inevitably, given the size and wealth of its domestic population. However, it is a land expatriate and UAE resident investors should shun for tax reasons.

Today, the IRS claims jurisdiction over the tax affairs of every US citizen and green card holder, wherever they are in the world.

As its website clearly states: “Your worldwide income is subject to US income tax, regardless of where you reside.”

US citizens can have tax obligations in the States years after they left the country and in some cases, even if they have never lived there at all.

It’s a tough line to take, but the IRS is tough. Many US expats would love to have it off their backs, and some are campaigning against its global reach. Good luck to them.

The IRS usually cannot touch non-US residents unless they unwittingly invest in an ETF that is “domiciled”, or issued in the US.

It is an easy mistake to make, but once you are aware of the danger, it is easy to avoid, too.

Steve Cronin, founder of DeadSimpleSaving.com, a non-profit site helping people invest their money sensibly by themselves, says when buying ETFs, domicile matters. "Domicile means where the fund is based for tax and regulatory purposes. It can be very different to which country or currency the fund invests in."

This means an ETF could invest in, say, the UK, Japan, the Middle East or emerging markets, while being domiciled in the US or Europe or Singapore or wherever.

Mr Cronin says that if you are a US citizen, then it is fine to invest in US-domiciled funds and stocks. “If you are not, then investing in US-domiciled ETFs will expose you to US withholding tax and estate tax.”

The UAE does not have a tax treaty with the US, and this means local expats and residents who buy a US-domiciled fund will face a withholding tax of 30 per cent on dividends paid by US-domiciled ETFs.

There’s worse. When you die, your ETF holdings may also be liable for US estate tax. Mr Cronin says this could be even more punitive, as it is charged at 40 per cent on sums above $60,000. “You do not pay US capital gains tax or other income tax, but non-US expats should still avoid buying US-domiciled ETFs.”

Have you ever seen the acronym UCITS after an investment fund, and wondered what it meant? Well it’s worth knowing, because it could spare you bother with the IRS.

UCITS stands for Undertakings for the Collective Investment in Transferable Securities, and refers to the EU regulatory framework that allows investment funds to be sold across Europe in a safe and well-regulated way.

Mr Cronin says non-US citizens should play safe by searching for funds with UCITS in the name. “Ideally, these should be domiciled in Ireland, which does have a double tax treaty with the US,” he says. That way, you avoid the US estate tax completely and only pay a withholding tax of 15 per cent on US dividends. It falls to zero on investments from other countries.

Funds domiciled in Ireland can do this while investing in exactly the same assets. They also shield you from US estate taxes. Better still, you don’t pay any local Irish taxes, such as capital gains or inheritance tax on your ETFs (unless you are actually resident in Ireland).

Mr Cronin adds: “The easiest way to find such funds is to add UCITS to your search query when you are searching for a fund.”

You may also have seen other three or four-digit acronyms after many ETFs, typically in brackets, sometimes called the ticker symbol. This also helps you identify the right domicile for your ETF. For example, Vanguard S&P 500 ETF’s ticker is VOO in its US-domiciled version listed on the New York Stock Exchange, but the Dublin-domiciled, London Stock Exchange-listed Vanguard S&P 500 UCITS ETF ticker is VUSA.

Charges on US funds tend to be slightly lower, because they benefit from economies of scale, but this is a price worth paying.

Stuart Ritchie, director of wealth advice at UAE-based wealth adviser AES International, says Luxembourg and Ireland are two of the biggest domiciles for fund managers. “Their reputations are strengthened because they arrange tax agreements with other countries, improve accessibility and offer competitive tax rates.”

However, the Luxembourg double tax treaty is less favourable, and you still pay 30 per cent withholding tax on US dividends.

To avoid tax mishaps, make sure you are using the right jurisdiction. Mr Ritchie suggests seeking expert help from a financial or tax adviser.

A spokesperson from ETF giant Vanguard echoes this view. “UAE investors should always take independent financial and tax advice before investing in any non-local products.”

You can decide what advice you need. But what you most certainly do not need, unless you are a US citizen, is to attract the attention of the IRS. So avoid those US-domiciled ETFs.