Everybody hates taxes, especially the obscure, stealthy kind that you didn’t even know you were liable for. Enter off-shore funds1 – including many ETFs and index funds – that are subject to a weird and not-so-wonderful tax regime that could land you with a nasty tax bill.
The headline is that if you own an off-shore fund that isn’t either:
- A reporting fund, or
- A distributing fund
Then any capital gain you make on that fund is taxed as income rather than capital gains, when you sell.
That’s grisly for three reasons:
- Income tax is much higher for most people than capital gains tax (CGT).
- You can’t escape the tax using your tax-free £10,100 CGT annual allowance.
- Nor can you use capital losses elsewhere to offset the gain.
CGT is liable at 18% or 28%, whereas income tax bites in much more painful 20%, 40% or 50% chunks.
The upshot is that if you’re paying capital gains at income tax rates then you could be in for a tax bombshell that completely destroys the point of investing in low cost funds.
How do I avoid paying income tax on capital gains?
First, check:
- Where your fund is domiciled. If home base is anywhere other than the UK then it’s an off-shore fund. This will also determine whether you need to take action against withholding tax. You’ll generally find domicile information in the fund factsheet, or in the fund ‘Management’ section of Morningstar.
- Make sure the fund is classified either as a distributor fund or reporting fund. If it is, then there’s nothing to worry about.
- If the funds are non-reporting / non-distributing but are safely tucked up in an ISA or pension then you can breathe a sigh of relief. Your assets are off the tax radar as far as Her Majesty’s Revenue & Customs (HMRC) is concerned.
If you’ve bought funds listed abroad, then you probably do own non-reporting or non-distributing funds.
Funds must apply to HMRC for reporting / distributing fund status. But vehicles intended for the US or other foreign investor markets are unlikely to have qualified. Why would they bother with the administrative costs if the funds aren’t aimed at UK investors?
You will be liable for income tax on capital gains in such cases – although only when you sell, and if they’re not tax sheltered.
Where does my fund hide its status?
The key info might be buried anywhere, depending on the product provider’s whim.
- The first place to look is on the fund’s factsheet or individual web page.
- Others bury reporting / distributor status in the prospectus or some other fund supplement. Even then it’s not always clear the fund qualifies, as opposed to just having sent the forms to HMRC.
- You can check a list of distributor or reporting funds maintained by HMRC.
Scroll down to the Distributing Funds and Reporting Funds sections. You’ll need to download the relevant spreadsheets, then search by company name or the fund’s ISIN number using Excel’s Find function.
Beware the order isn’t always strictly alphabetical and the lists aren’t necessarily up-to-the-minute. That’s government cuts for you!
If you’re not sure about your fund’s status then contact the product provider and ask.
Can reporting / distributor status be revoked?
It’s entirely possible for a fund to lose its reporting status, though not as likely as it used to be when distributor status was the only option. As HMRC say, in their highly entertaining 209-page manual:
A fund, once granted reporting fund status, may rely on that status going forward subject to continued compliance with the reporting funds rules, which include making reports as described above for each period of account. A fund may exit the reporting funds regime on giving notice and there are rules that permit HMRC to exclude a fund from the regime for serious breaches or a number of minor breaches, subject to an appeals process.
So it could happen, but it would be suicidal for any index tracker to fall foul of the rules, which were designed to increase the attractiveness of the UK investment market, after all.
It’s also worth noting that reporting fund status is replacing the older distributor fund designation. Currently we’re in a strange either/or transitional phase. Distributor status should have been entirely swept away by mid-2012.
For our purposes, it doesn’t matter whether a fund has reporting or distributor status, as long as it has one of them.
Ignorance is no excuse
If you’ve inaccurately filed your tax return, blissfully unaware of the implications of the offshore tax regime, then HMRC are going to want any outstanding tax back with interest. And it could tag on an inaccuracy penalty, too, if it judges you filled in your form without due care and attention.
As a passive investor, my solution is simple. Avoid non-reporting funds like ebola-carrying monkeys, unless you can hide them away in an ISA or pension.
Take it steady,
The Accumulator
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- As always I’m batting for passive investors here. Some off-shore funds are exempt from this rule, but are unlikely to form part of a passive investing strategy. [↩]
{ 14 comments… read them below or add one }
Yes, it looks like that’s not going to be a problem after 2012 (after the transition period), since all funds have either achieved reporting status or applied for one.
Is the link to list of distributor or reporting funds correct? It seems to point to a page of application forms for Investment Trusts.
From a couple of years of living in Germany I have a fund there with my local bank and I still contribute a small amount to this fund on a monthly basis. The plan is that if I move back to a Eurozone country for work then I will liquidate this fund have a starting cash amount without having to move money from the UK… As far as I’m aware for such an arrangement as long as I don’t bring the money from the fund back to the UK then I will not have the pay any tax on this…
@James – The link seems good to me? Scroll down a bit. (It may be that The Accumulator has popped along and updated the article in light of your comment, of course!)
@ Gabriela – I don’t think all funds will apply for reporting status, especially foreign-listed ones. I guess we can also assume that some funds won’t be eligible and that some could lose their status.
Maybe, but I looked through all of the ETFs available to retail investors, that trade in GBP on LSE, and there is only 1 that didn’t at least apply so far: iShares S&P Listed Private Equity.
Obviously, everyone should always check either way, but I think it will be a lot like UCITS III….They are all compliant.
Sorry, I didn’t take into consideration leveraged / inverse either.
Hmm, that leaves an awful lot of ETFs that are dollar or Euro denominated. Plus all the funds that aren’t ETFs.
Still, you may be right, it could well become as straightforward as UCITS III over time. We’ll have to see how that works out.
The bigger problem is foreign-listed funds. I primarily wrote the piece because of a mail from a Monevator reader who bought US ETFs only to find they’d fallen foul of the income gain rules.
It’s very tempting to buy US-listed products with those cheap TERs and that wealth of choice, but there are tax issues to be wary of.
Just stumbled upon this interesting thread.
I am aware of this “distributor status” business but not sure how dividends are taxed on a fund that does not have “distributor status”.
In my example, I worked in the US for many years and accumulated some savings. They suppose I invested this in the US dollar denominated Vanguard Total Stock Market Index fund (VTSMX) in a taxable account. Then I moved to the U.K permanently. I am neither a US citizen or green card holder. Now I am a UK naturalized citizen and resident. But I am non domiciled. I still have my Vanguard account in the US. Lets say I have $100,000 in the afore-mentioned Vanguard account. If I dont sell, there is no capital gains tax to pay, of course. Now, before 2008, for non-doms, it was not an issue because we would not be taxed on foreign earnings unless we remitted the money into the UK. This was known as “remittance basis”. However, as per latest rules, if the total worldwide earnings and gains is less than 2000 GBP, then nothing to worry as long as that money is not remitted. If your worldwide earnings are in the gazillions, then also nothing to worry. You just pay HMRC a 30,000 GBP “Dont bother me; Jog on” fee and they wont bother you. However, if you are average joe and fall in between, then it might make sense to report it and pay tax on an “arising basis” as opposed to “remittance basis”. This is illustrated in : http://www.hmrc.gov.uk/nonresidents/flowchart.pdf
Now my question is : coming back to the $100,000 VTSMX investment : even if I dont sell it, it would still generate dividends : let’s say it generates $4000 worth of dividends (3000 GBP) (gross), so Vanguard USA would issue me a 1099-DIV form for this. If I am taxed on arising basis in the UK, I surely need to report this to HMRC. Now, I would already pay 15% tax on this to the USA so I would get tax-credit on it from the UK. But how would the UK tax the dividends on this fund ? I am a high rate tax payer (40%), so would I get away with paying 32% tax (minus the 15% I already paid to USA) on it ? Or, would the dividends be taxed as income (40%) because the fund is not a “reporting fund” ? That would be bad, because paying 40% on dividends and paying 40% on CGT again would really suck !
It is amazing how the governments of this world make life really difficult for ordinary hardworking middle class globally mobile professionals but at the same time leaving convenient loopholes for the uber-rich. I am sure if I have money to create “trusts”, go to wealth managers etc, everything can be worked out so as to pay least amount of tax. I could set up a small company in the Virgin Islands or whatever and everything would be in the trust’s name. I would declare myself a pauper on paper. But as a PAYE average joe, government needs to be beat us with a cane every month.
If we invest in simple index funds anywhere in the world (or at least the developed world) why cant the governments of this world just tax it as capital gain ? What is not to understand about index funds ? Why do they have to create this “distributor tax” nonsense ? Not to be outdone, US also does the same with their silly PFIC rules. This is just to protect the “financial industry” so they can create yet more complicated products and fool the people. Once again, vested interests in governments are in cahoots with financial industry.
@ Blue Denim – reporting fund status affects the taxation of capital gain, not dividends. Dividends are affected by withholding taxes: http://monevator.com/2010/11/25/withholding-tax-on-dividends/
The rules change again if the fund pays over a certain threshold in interest as opposed to divis.
Bear in mind, I’m no tax expert and it sounds like you could do with one, even though you are obviously well informed already. As for the rules, yes, they only apply to those not rich enough to have them changed.
Thanks for the response. I went thru the other dividend article and I think I got the gist of it. Let me illustrate it with a small example : I hope I got it correct :
I am a 40% “high rate” taxpayer in the UK. From a US standpoint, I am what they call a non-resident alien, i.e I have no US green card or citizenship. Say I hold VTSMX in my US Vanguard taxable US account ["Now why do you keep your taxable money in the US ? Why dont you move it to UK ?" I hear you ask. Thats a diffreent story]. So, suppose I get $100 as dividends. I dont file a W8-BEN with ETrade, I have a tax accountant in the US that prepares my tax return. As per tax treaty, he says I should pay 15% to the US IRS = $15. So, when I file my UK tax return, I would pay 25% i.e $25 to the UK, but claim $15 back from the UK is it ?
However, if my total earnings in the US (Bank interest plus dividends plus gains) is less then 2000 GBP, I may wish to claim the “remittance basis” and if I do this then I believe I should be paying 30% tax on dividends to the USA. I am almost sure about this, I will see if I can find the link.
I believe there is an error in the above. The $100 US dividend has no tax taken out of it at source. So my total tax liability on it would be $32.5 not $25. I pay $15 to the U.S taxman, so when I file my UK tax return, if I pay $32.5 to the UK taxman, I should be able to get back my $15.
Thanks.
I’m somewhat confused by your comment as you say that you’re not paying tax at source but then say you’re paying $15 to the IRS. Regardless, if you’re paying 15% to the US then under the terms of the DTA you can offset that 15% against your UK tax liability. Don’t forget your UK tax credit will reduce down your tax rate too.