When Investors Cross Borders

Question: A cousin of mine who lives in another country said she is interested in investing through the same U.S.-based brokerage I use. Is this even allowed, and could I invest through brokerages in her country if I wanted?

Answer: The rules governing investing and citizenship are complex, but in general it pays to invest through financial institutions in the country of which you are a citizen, even if what you're investing in resides elsewhere. Doing so greatly simplifies the process and tax treatment while still typically allowing exposure to foreign markets. With this in mind, let's explore the answer to your question.

Tax Implications for Investors From Other Countries
For non-U.S. citizens living in other countries, investing through U.S. brokerages requires navigating tax rules that can be complicated and potentially onerous. U.S. brokerages are required to withhold taxes on interest and dividend income from the accounts of nonresident aliens who use their services. (Nonresident aliens are those who do not have a green card or meet certain qualifications for time spent in the U.S.) The default tax rate for nonresident aliens is 30%, though the rate is lower for citizens of the more than 50 countries that have tax treaties with the U.S. Countries with which the U.S. has tax treaties include Canada, China, Germany, India, Israel, Japan, Mexico, Russia, and the U.K. (A full list of these countries and effective tax rates starts on Page 39 of this IRS document.) Capital gains are also taxed at 30% (or lower if a tax treaty applies), but they might be waived for nonresident aliens who spend fewer than 183 days in the U.S. during the tax year in question. However, nonresident aliens might still have to pay capital gains taxes in their home countries. Resident aliens and those with green cards are subject to the same tax treatment as U.S. citizens.

Nonresident aliens investing through U.S. brokerages are required to fill out an IRS tax form in which they declare their country of residency as well as any tax-treaty benefits that might apply. One purpose of tax treaties is to reduce the effects of double taxation on investment income that is paid from one country to a resident of another.  

Some large U.S. fund companies and brokerages also have affiliates in other countries, allowing investors in those countries to have access to their services directly while avoiding U.S. tax requirements. However, fund lineups might vary from country to country, so just because a firm's U.S. affiliate offers a mutual fund or an exchange-traded fund doesn't mean it will be available outside the U.S. and vice versa.

Investing Through Foreign Financial Institutions
Now let's look at the other side of the equation: U.S. citizens investing through fund companies or brokerages based overseas. Although some overseas brokerages might be only too happy to have you invest through them, keep in mind that doing so carries with it added risk. Overseas brokerages are not regulated by the SEC nor insured by the Securities Investment Protection Corporation, not to mention the added complexity of tax reporting, time zone and language differences, and other difficulties that might arise. Be aware, too, that other countries might have their own regulatory entities and that these may vary significantly in effectiveness. You can read about some of these variations in Morningstar's Global Fund Investor Experience report. 

Also, the federal government discourages U.S. citizens from investing in non-U.S.-based mutual funds and other pooled investment vehicles, classifying them as Passive Foreign Investment Companies, or PFICs, and applying a prohibitive capital gains tax structure equal to the highest regular income tax rate (currently 35%) regardless of how long the investment is held. That's much higher than the current long-term capital gains rate for U.S.-based funds of 15% for taxpayers in higher brackets. To top it off, PFIC investors also might have to pay interest charges on taxes deferred during the holding period of the investment. Another option available to investors is to reclassify a PFIC as a qualified electing fund, or QEF, which might reduce the tax rate but adds undistributed income to tax calculations.

Further complicating the idea of investing in foreign-based funds for U.S. citizens are new federal rules aimed at cracking down on tax evaders that are set to take effect next year under the Foreign Account Tax Compliance Act. These rules include a requirement that some U.S. taxpayers holding foreign financial assets worth more than $50,000 in total report those assets to the Internal Revenue Service or face steep penalties, while foreign financial institutions will be expected to report to the IRS information on accounts that U.S. investors hold.

As you can see, investing through a foreign-based fund or broker is probably more trouble than it's worth for most individual investors. Between the tax complications, logistical problems, and record-keeping challenges, you're likely better off keeping things simple, especially given the incredible variety of investment options--both foreign and domestic--available through U.S.-based financial-services firms.

The Curious Quandary of U.S. Investors Living Abroad
One final wrinkle worth mentioning involves U.S. citizens living overseas, who are in a somewhat precarious position in that some U.S.-based brokerages will not provide them with services unless they are already existing account holders. Doors are often closed to those living abroad who try to open new accounts (exceptions might be made for those serving in the military or at U.S. embassies, or if the investor can provide a U.S. postal address). At the same time, some foreign financial institutions, leery of increasing U.S. tax-compliance rules, are declining their business, as well.

American Citizens Abroad, a Switzerland-based advocacy group, charges that the U.S. tax code effectively discriminates against U.S. citizens living in other countries. The group proposes a system in which U.S. citizens would pay income tax only in the country in which they live. The U.S. is the only country in the world that taxes its citizens who live abroad, according to the group.

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