Global Tax Forum: Mutual Funds Can Be a Taxing Proposition to Foreigners

To foreigners, a U.S. mutual fund's distribution is a lot like an egg roll. Regardless of what's thrown into it, you get the same agita every time.

That's because income that is not taxable to foreigners when generated by stocks and bonds is taxable when distributed by a mutual fund. As a result, nonresident aliens may be better off, taxwise, owning individual stocks and bonds rather than shares of a mutual fund.

Tax rules encourage overseas investment in U.S. stock and bond markets but, strangely, not mutual funds. That's reflected in the fact that less than 1% of the $5.9 trillion invested in U.S. mutual funds comes from foreigners. Granted, investment considerations shouldn't be based solely on tax considerations. But they're hard to ignore.

In general, a nonresident alien -- someone who isn't a citizen of the U.S. and doesn't have a residence here -- pays no taxes on capital gains or portfolio interest. Dividends are taxable, and the tax is usually withheld at a 30% rate before the dividend is distributed to the foreigner. (See a previous Tax Forum for more withholding details.)

But the rules are different for mutual funds. Regardless of whether a mutual fund's distribution is interest or capital gains, it's all rolled up into a dividend and therefore becomes entirely taxable to foreigners, says Bruce Reynolds, a partner in the international tax services group at Deloitte & Touche in Washington.

So if a nonresident alien buys a U.S. bond, for example, he will not owe U.S. tax on any interest the bond generates. In addition, he will not pay tax on any capital gains when the bond matures or gets called.

But put that same bond in a mutual fund and the interest and capital gains are treated and taxed as dividends. That income is now subject to withholding.

The same goes for gains generated by equity funds. When a nonresident alien sells an appreciated stock, the gain is not taxable. But when a mutual fund sells holdings in its portfolio, it generates capital gains that are passed on to shareholders. To U.S. citizens, they may be taxable at capital-gains rates. But for nonresident aliens, they are treated as dividends subject to withholding.

The mutual fund industry is trying to fight this inequity. Within the smorgasbord of tax cuts being considered by Congress is a proposal to make mutual fund ownership more foreigner-friendly. The industry is asking Congress to support this "investment competitiveness" legislation and allow funds to pass on distributions in their true character. That is, interest would be passed on as interest, and capital gains passed on as capital gains.

"Absent this change, foreign investors seeking to enter the U.S. capital markets will continue to have a significant U.S. tax incentive not to invest in U.S. funds," according to testimony submitted to the Senate Finance Committee by the Investment Company Institute, the mutual fund industry's trade group.

But as typical with most tax-cut proposals, this provision is part of a much larger wish list. So it's very hard to tell what's going to make it into law and what will just end up on the cutting room floor.

For now, when choosing from the U.S. investment menu, foreigners may be better off avoiding the mutual fund egg roll and sticking to stock-and-bond soup.

Tax on Portfolio Interest?

I am a nonresident alien living in Kuwait. I have an account in the U.S. with an online discount broker (Datek). Do I have to pay tax on the interest I'm getting on the cash in my account?

I have been paying 30% tax on dividends and 30% on the interest on the cash in my account. I suspect I am not required to pay tax on the interest. Should I contact the IRS and get a refund? Please clarify portfolio interest. Is that the interest I receive on the cash in my account at the discount brokerage? Please note that Datek is not a bank. Does this matter?

-- Ahmed Mohammed

Ahmed,

I am assuming that you are trading for your own personal account -- not a trade or business account. If this is true, then you don't owe tax on the interest.

Portfolio interest is basically any interest, including original issue discount, that you receive from your investments, according to Section 871(h) of the U.S. tax code. That also includes any interest from U.S. bank accounts or investments held in brokerage accounts.

You can amend your U.S. tax returns to recover any excess taxes you paid in the past three years. But you need to weigh the costs. Make sure your refund is worth more than the time and money you're going to spend to amend those returns.

Here's a tip: If 30% of your interest is being withheld, file Form W-8 -- Certificate of Foreign Status with your broker. This form will remind your broker that you're a nonresident alien who is not subject to withholding on portfolio interest.

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Do you have any other questions concerning the impact of U.S. tax laws outside our borders? Send them to [e-mail]. Please include your full name and resident country. Global Tax Forum appears every other Wednesday.