Busting some common myths about HMRC non-reporting funds

I agree with you, and being able to tax efficiently invest in US mutual funds is a good thing. My point was that you don't have to do the little bit of extra "due diligence" with Vanguard ETFs as they are Reporting Funds and as I'm already invested in then in the US they are a great solution for both UK and US investing. Also they can be purchased through UK brokers so are a way for the US expat without a US brokerage account to invest in a pooled investment.

I agree completely with you, nun. There are certainly a lot of reasons for a UK based investor to choose Vanguard ETFs, and I would recommend them in most cases. They make life very easy indeed. 

The slightly more complicated scenario I was more concerned about is where a US investor owns a pile of shares in US mutual funds and then decides to relocate to the UK. The advice a lot of high priced advisers give is that these individuals should move all their money into reporting funds before they become UK resident. This may be the right choice for some people. However, if the investor can find out whether their existing funds are income transparent, they should then be free to decide whether to switch investments based on the investment merits of the available options - not based on a perceived UK tax issue.

Of course, Vanguard ETFs are very good investment products so they may well come out tops on the merits alone. It is a personal choice in the end though, and there are many factors to consider.

(I say this as someone who went to a lot of trouble to get rid of investments in non-reporting funds, only to find out later that it may not have been worth the trouble!)

Yes if you have US mutual funds and are considering a move to the UK the easiest thing to do would be to ask if they distribute 100% of their income, and if they do you wouldn't need to do anything else. You'd also avoid being forces to realizing capital gains.

I don't really blame advisors for steering people towards reporting funds because it is the obvious and safest option and if they are UK based they probably have little knowledge of US mutual funds. But for the engaged DIY person I think you've simplified things quite a bit.

One question - how can you confirm whether or not the fund - say a transparent non-reporting Vanguard fund which distributes all its income to investors - has invested more than 5% by value of its assets in non-reporting funds? Any ideas?

One question - how can you confirm whether or not the fund - say a transparent non-reporting Vanguard fund which distributes all its income to investors - has invested more than 5% by value of its assets in non-reporting funds? Any ideas?

Check the fund's prospectus or annual report for details of its assets.

If it invests directly in stocks, bonds, real estate, etc., you'll be fine.

If it invests in other funds, you'd look to see if those underlying funds also qualify as transparent non-reporting funds. Because the parent fund is transparent, it's viewed for tax purposes in essentially the same way as if you held its component parts directly.

Here is the quote from the Offshore Funds Manual:

Investments by transparent non-reporting funds in other transparent non-reporting funds
–
Regulation 29(4)
There is one important relaxation to the requirements of regulation 29(2). That is, if a transparent non-reporting fund (‘TNRF1’) invests in another TNRF (TRNF2) then, where a disposal of an interest in TNRF2 would not itself give rise to an offshore income gain (under regulation 17) for a UK investor, it is ignored in determining whether TNRF1 is invested in non-reporting funds by more than 5% of the value of its assets in total. This is because in such circumstances there can be no significant roll-up of income in the underlying fund(s).

This means that a TNRF’s investments could, for example, consist wholly of interests in other underlying TNRFs that themselves held only, say, UK property. Or, a TNRF could be the top layer fund in a fund of funds structure with multiple layers of other TNRFs below the top fund, provided that each of those underlying TNRFs themselves did not hold more than 5% by value of their assets in total in other non-transparent, non-reporting funds.

In deciding whether the investee fund qualifies under this regulation this rule may be applied to the investee fund and to any funds in which it, in turn, holds investments.

I would like to add some comments to the matters raised by politicfool in relation to UK non-reporting funds.

Background rules
The UK tax system has special rules for investment funds based outside the UK.  Within these offshore fund rules, there are no special rules for funds which are US domiciled.   For most UK investors, offshore funds are domiciled either in Dublin or in Luxembourg.

The UK tax rules are concerned to remove any incentive for offshore funds to roll up income rather than pay it out to investors.  The default position under OIG (offshore income gains) rules is that gains on sales of such funds are chargeable to income tax rather than to capital gains tax.

These OIG rules can be avoided but only if the funds can demonstrate to HMRC that they have paid out substantially all of the underlying income, or have given their investors the appropriate information to include in their tax returns.  It is not sufficient that suitable income distributions are made.  This needs to be evidenced to HMRC.

Transparent funds   
Politicfool comments on the position of “transparent funds” under the OIG rules.

The concept of transparent funds is perhaps best understood by considering the position of a private trust.  Suppose an individual is entitled to 20% of trust income.  Under UK case law, the individual is assessable on 20% of the underlying trust income (net of appropriate expenses).  This tax liability arises irrespective of whether the income is paid by the trustees to the individual. There is a second aspect which is less important in the context of these rules but which is significant in other respects.  This is that the individual is taxed according to the nature of the underlying income, which is typically dividends, interest or rental income.

This type of trust and its tax treatment also applies to some commercial trusts. These are referred to as Baker trusts, following the name of a tax case.  This would cover in particular unit trusts and certain arrangements of a contractual nature.  The key point is that the holder of the interest in the fund has a direct legal entitlement to a share of the fund’s underlying income.   

It is only these types of arrangement outlined above that are “transparent” in terms of the OIG rules.

Other structures
Some offshore funds are structured as open ended investment companies or OEICs.  This is common for Dublin based ETFs.  The investor owns shares in a company.  The investor then receives dividends from the company.  This, however, would not be a transparent fund for OIG purposes.

It might be that the Memorandum and Articles of the OEIC require payment of dividends.  This, however, does not make the fund transparent.  It may also be that there would otherwise be tax penalties if suitable dividends were not paid.  Again, of itself that would not make such an arrangement a transparent fund.

I do not know the legal structure typically used by US domiciled funds.  I am therefore unaware as to whether there would be a structure of the type that qualifies for the description of being transparent under the above principles.
 
Implications
The comments made by politicfool about transparent funds may or may not be applicable to US domiciled funds.  This would require an understanding of their legal structure.

I would be interested in views of others in this matter.

Thanks to Dunedin for some very interesting points! I'm at work so will respond to these as time permits.

These OIG rules can be avoided but only if the funds can demonstrate to HMRC that they have paid out substantially all of the underlying income, or have given their investors the appropriate information to include in their tax returns.  It is not sufficient that suitable income distributions are made.  This needs to be evidenced to HMRC.

I just re-read the Offshore Funds Manual, and it makes many references to transparent funds but doesn't appear to mention any requirement to submit evidence to HMRC to prove transparency. Could you provide a source to support your interpretation?

Background rules
The UK tax system has special rules for investment funds based outside the UK.  Within these offshore fund rules, there are no special rules for funds which are US domiciled.   For most UK investors, offshore funds are domiciled either in Dublin or in Luxembourg.

The UK tax rules are concerned to remove any incentive for offshore funds to roll up income rather than pay it out to investors.  The default position under OIG (offshore income gains) rules is that gains on sales of such funds are chargeable to income tax rather than to capital gains tax.

A US investor should avoid non-US funds because of the IRS PFIC rules which also seek to remove the tax advantages of funds that the roll up income. Hence, US domiciled funds are the only ones that a US investor should consider. If a US citizen invests in a non-US fund the IRS requires an 8621 form to be filed which is a serious burden.

These OIG rules can be avoided but only if the funds can demonstrate to HMRC that they have paid out substantially all of the underlying income, or have given their investors the appropriate information to include in their tax returns.  It is not sufficient that suitable income distributions are made.  This needs to be evidenced to HMRC.

Does HMRC have the equivalent of an 8621 form? Is Politicfool's note on a SA form sufficient, what if he sent the prospectus as well . US funds are regulated by the SEC and are also required to distribute dividends and capital gains so my initial though would the that they to comply with the OIG rules. So how do you prove that to HMRC, do you have to file for reporting fund status yourself. My solution remains the same, just invest in Vanguard ETFs that are reporting funds and that provide you with all the information you need to file your UK taxes.

https://advisors.vanguard.com/iwe/pdf/TIDQAUK.pdf

I would like to add some further thoughts, following the comments from politicfool and nun.

Proof of Transparency
The basis of UK income tax is self assessment.  If an investment is made in a transparent fund, there is in the first instance no need to “prove” this.  It is only in the event that HMRC ask for further information that an investor may need to demonstrate that the fund is transparent.  Some transparent funds, in particular those organised in the Channel Islands, have statements on their website making it clear that they are constituted as Baker trusts.  Generally, HMRC might be expected then not to make any further enquiry.

Form 8621
HMRC does not have the equivalent of a US form 8621.  There is no reporting requirement on a year by year basis by an investor who holds an offshore fund within OIG rules.  It is only on the sale of the investment that the investor must self assess himself, either to capital gains tax or income tax because of the OIG rules. 

Reporting Status 
The fundamental aspect of the UK tax rules is that a non-transparent offshore fund is deemed to be within OIG rules unless it is a reporting fund.  It is not sufficient that the fund actually makes distributions of all of its income.

It is for the fund to choose whether or not to register with HMRC.  If it chooses to do so it needs to send extensive information about the fund.  On an annual basis the manager then requires to send HMRC accounts drawn up on a suitable accounting basis together with a computation of its reportable income, as well as giving appropriate tax information to the fund’s investors.  An investor needs the fund to have reporting status for every year on which his investment is held, if it is to be outside the OIG rules. 

It is not possible for an individual investor to himself obtain reporting status for a fund.  The rules simply do not allow for this possibility.

Further, in my view, a note on a self assessment return showing that a fund makes full distributions of underlying income is not sufficient to take the fund out of the OIG rules.  The only exceptions to this are transparent funds where the underlying income is automatically taxable on the investor.  Regrettably, I think it is wishful thinking to believe that a note  on an individual’s tax return can alter the fund status under the OIG rules.

US domiciled funds
I am not aware of how US domiciled funds are constituted.  For instance, are they in the form of a trust or are they more similar to an open ended investment company?   Is there a possibility that some or all of them are the equivalent of Baker trusts, and so are transparent?

US domiciled funds
I am not aware of how US domiciled funds are constituted.  For instance, are they in the form of a trust or are they more similar to an open ended investment company?   Is there a possibility that some or all of them are the equivalent of Baker trusts, and so are transparent?

The biggest issue is determining the exact status of the investment fund so that crossborder tax rules can be applied. Most US funds are open ended collective investment schemes, I would not want to even consider whether one in a Baker or Garland trust because I'm just not qualified.

From the Vanguard link I sent it's plain that some US ETFs do not distribute all their income, but at least Vanguard ETFs are UK reporting and give the investor the information to comply with HMRC rules.

If you are a US expat don't seat this too much, just invest in US domiciled Vanguard ETFs. They are good low cost funds and satisfy both the IRS and HMRC making you tax life a lot simpler.

One of our clients recently made us aware of this online conversation and we felt compelled to respond. By way of background, our wealth management firm, MASECO is based in London and we have been serving US ex-pats in London since 2001.  We can be contacted at enquiries@masecopw.com.

When the UK tax laws changed on April 6 2008 that required all non-doms to file taxes on an arising basis (or pay the remittance charge), we needed to completely change the investments our clients made to avoid Offshore Income Gains (OIG). We have researched this topic extensively in conjunction with some of the largest mutual fund and accounting firms in the world and believe there is a consensus view across firms. We are not tax advisors, but strongly believe that replies 19 and 22 have the correct view on this matter - you need to 'demonstrate to HMRC that they (funds) have paid out substantially all the underlying income...'. We do agree, however, that most (if not all) US mutual funds and ETFs would qualify if they did file with the HMRC, but most do not file. Another problem for an individual is that the fund needs to file for reporting status, not the investor. You can download our whitepaper on this subject at newcomer link: http://www.masecoprivatewealth.com/new2010/pubs/mutualfunds.pdf [nonactive]

We have been using some US funds with reporting/distributor status for more than 6 years (offshore trusts required distributing funds before April 6 2008) and have over the years been instrumental in adding some Dimensional (DFA) and Templeton funds to the HMRC reporting fund list. The problem with this list is that some funds (like the Vanguard S&P500 fund and Templeton Growth Fund) have gone on and off the list over the years. So you might buy a fund today that is on the list, but is not reporting when you go to sell it which would mean you could pay UK OIG on the gain. As a side note, some of the Vanguard funds on the HMRC list of reporting funds are ETFs and some are Mutual Funds - so be careful and buy the correct fund/ETF if you go that route. We mostly use DFA funds because in our opinion they do a better job than index funds (like Vanguard) at capturing asset class exposure and because there are a few other advantages that are beyond the scope of this conversation. That being said, these are institutional funds and you can only access them through DFA approved advisors - which makes it more difficult for small investors to access (in which case Vanguard does almost as good a job - in our opinion). Also, Vanguard is somewhat limited. For example we are strong believers than investors should consider sustainable investments and our clients have been investing in US equity and non-US equity sustainable funds that are on the list for years.

Another point that inhibits the publicity of these funds is that most US fund companies are not permitted to 'promote' their funds to UK residents. The same is true of US Financial Advisors - most are not regulated in the UK to perform 'regulated activities'. This makes it technically difficult for US based fund companies and US based advisors to promote US/UK tax compliant investments to UK residents - so don't count on that much help from US based firms if you are an investor.

Another issue (until recently) was the FCA UCIS rules which significantly impacted the promotion of investing in US reporting funds. Recently our company had a number of meetings with the FCA about how US funds are regulated and why they should be exempt from the UCIS legislation. Post our discussions, the FCA agreed to exempt the promotion of US funds to US tax payers. This means a UK based advisor can now promote US funds to US tax payers (if they can get you access to DFA, Templeton and Vanguard) and if they meet the requirements of the relevant FCA exemption. We have recently started advertising on this topic (see our new ad coming out in American in Britain magazine). We also have strong relationships with other advisory firms who now feel comfortable 'promoting' US funds if they meet the exemption.

In response to reply 21: Our view is to avoid PFICs unless you can get all the financial information and make it a Qualified Electing Fund. We have access to a few of these, but most clients are happy to use US based Mutual Funds (which tend to be cheaper) and easier to purchase/sell.

If you are not sure that what you are currently investing in or what you intend to invest in is tax efficient, there are a few wealth management firms and accounting firms that specialize in this area. We get introduced to many Americans living in the UK every week who have PFIC and OIG issues - so this is very real and common problem.

Unfortunately, these investing mistakes can be very, very costly so be careful as we have found there is a lot of incorrect information on some of these and other posts.

We hope this post is helpful to the greater US ex-pat community in the UK.

The last post was nicely comprehensive. However, I am not aware of any Vanguard mutual funds on HMRCs reporting list, they all seem to be EFTs.

While DFA funds have low expenses and good returns the investor will have to pay an advisors fees to gain access to them. For the US expat DIY investor, Vanguard ETFs are, IMHO, the best solution and offer a more than adequate diversity.

One important point is that if you don't already have a US brokerage account you will not be able to open one if you are not a US resident or at least have a US address. Vanguard will deal with non US residents of they already have an account with them. You can buy some US based funds through UK providers like Hargreaves and Lansdown, but the choice is very limited and you have to check the CUSIP numbers to make sure you are really buying the US domicile fund. If you go with a UK based financial advisor make sure you understand all the fees and expenses and that you stay involved in your asset allocation and investing decisions. Nobody cares more about your money than you. The bottom line here is that you need to plan ahead if you want to invest as a US expat and open appropriate US based accounts before you leave the US if you are to minimize your costs and maximize your options. Investing in the UK is more expensive than it can be if you go directly with a US brokerage. The least expensive option I know of is to use the Vanguard brokerage to buy Vanguard ETFs, low low expenses and no trading fees. You can choose your ETFs to match your investing style from couch potato to something a bit more along DFA's lines.

Very interesting thread, and thanks to politicfool for his contacting Vanguard.  While I am not averse to selling my Vanguard funds in favor of their ETF's I would prefer not to as that will mean a substantial CG and I currently use one of their balanced funds, Wellesley, for income in retirement.

I just read the prospectus for Wellesley and compared the relevant section on distribution of income to the Total Bond ETF.  They read the same, stating that "Each Fund distributes to shareholders virtually all of its net income (interest less expenses) as well as any net capital gains realized from the sale of its holdings. "


From VG Total Bond ETF:

Fund Distributions
Each Fund distributes to shareholders virtually all of its net income (interest less expenses) as well as any net capital gains realized from the sale of its holdings. For holders of the Fund’s ETF Shares, income dividends are declared and distributed monthly. Capital gains distributions, if any, generally occur annually in December. In addition, the Funds may occasionally make a supplemental distribution at some other time during the year.

From VG Wellesley Income Fund:

Fund Distributions
The Fund distributes to shareholders virtually all of its net income (interest and dividends, less expenses) as well as any net capital gains realized from the sale of its holdings. Income dividends generally are distributed quarterly in March, June, September, and December; capital gains distributions, if any, generally occur annually in December. You can receive distributions of income or capital gains in cash, or you can have them automatically reinvested in more shares of the Fund.

Very interesting thread, and thanks to politicfool for his contacting Vanguard.  While I am not averse to selling my Vanguard funds in favor of their ETF's I would prefer not to as that will mean a substantial CG and I currently use one of their balanced funds, Wellesley, for income in retirement.

The issue with HMRC and non-reporting funds only arises if you own funds outside of retirement accounts recognized in  the treaty. So you can own any US funds inside IRA, 403b, 401k etc with no nasty UK tax consequences.

If you own Wellesley outside of a retirement fund I see two problems. Wellesley is not very tax efficient if held outside of a retirement account and if you are UK resident you will have to convince HMRC that it reports all its income. While I imagine it would satisfy HMRC reporting regulations it is not on the reporting funds list and you might have an interesting time convincing HMRC. Maybe if enough UK residents owned US funds and made the argument HMRC would give a general exception from the offshore funds regime. But that's a big ask and when I become UK resident I will sell my non-retirement Vanguard mutual funds and buy the equivalent ETFs. If you do own Wellesley as a UK resident you could just use your US tax information and the treaty to pay US tax and resource any excess to the UK and have your argument about income distribution ready if HMRC comes calling insisting you pay tax on dividends and CGs at your income tax rate. Of course they might not even bother you.

Here is some excellent information about the distributions from US Vanguard ETFs for uK tax purposes. Note none of the Vanguard mutual funds are mentioned....so obviously Wellesley is not there.

https://advisors.vanguard.com/iwe/pdf/TIDQAUK.pdf

Thanks for the info Nun.  Since retiring 4 years ago Wellesley has been providing all the funds we need to top up my non-COLA pension.  This year almost half the distributions were long term gains so if it was in an IRA all the withdrawals would be taxed as regular income.  (Prior to retiring we sold our house and put the proceeds into Wellesley since we wanted a retirement with lots of travel and a "lock and leave" apartment, which has worked out great as each year we have traveled for 6 months of the year).  Also, we still aren't eligible yet to withdraw from IRA's without penalty or arranging a 72(t).

With the apparent certainty of ETF's being on HMRC's approved list then I'll plan on liquidating over the next few years and buying a mix of index ETF's.  I wanted to keep things simple for easy handover to DW who doesn't want anything to do with managing an AA of a mix of funds, and there are no balanced or target VG ETF's I can see. (Unlike VG Funds where there are plenty to choose from).

ETA
The after tax funds will be all owned by DW who doesn't have any other income so come the dual residency situation, her filing with HMRC will keep her well within the 20% tax band. At least this is the plan.