How Can US Citizens Living In The UK Invest Without Falling Foul of US Tax Rules

The US taxes its citizens wherever they live. Moving to London, Edinburgh or anywhere else in the UK does not change that - you are still expected to file a US tax return every year and report your worldwide income and gains.

At the same time, the UK taxes its residents on their worldwide income and gains. Once you are UK resident, your US accounts do not sit outside the UK tax net simply because they are held in America.

The result is one financial life governed by two sets of rules. A US account can have UK tax consequences, while a UK account or investment can have US tax and reporting implications.

The US/UK Double Taxation Treaty and foreign tax credits prevent most salary from being taxed twice, but investments are where the two systems most often disagree - on what counts as tax-free, how gains are taxed and which savings wrappers or investments are recognised at all.

Getting it wrong can be costly. Penalties for missed US reporting, such as the FBAR and FATCA disclosures for non-US accounts, can be significant even when no tax is owed. And a failure to consider your financial affairs from the point of view of both jurisdictions can negatively impact your financial planning over the long term. 

A typical UK approach to wealth creation looks something like this: use your ISA allowance each year, contribute to a workplace pension and build a diversified portfolio of UK funds, ETFs and investment trusts. For a UK taxpayer, that is sensible financial planning.

For a US citizen, almost every part of it needs a second look. The ISA is not recognised by the IRS, most UK and European funds fall into a punitive US tax category, and the paperwork multiplies with every holding.

The reverse is also true. A standard US investment strategy does not automatically work in the UK either:

• US-listed funds and ETFs that are not on HMRC's reporting fund list can see gains taxed at income tax rates of up to 45%, rather than as capital gains.
• 529 education plans, which grow tax-free in the US, are not recognised in the UK and are often viewed by HMRC as trusts. Not every UK university is set up to accept them, so they can be a poor fit for American children who will study here.

This is why advice from only one side of the Atlantic can be risky. A US-based manager may assume your American accounts are sheltered from UK tax, which is not the case.

A UK wealth manager unfamiliar with the US system may assume you are no longer liable for US tax because you live in the UK - and fill your ISA with investments that create problems with the IRS.

ISAs: Useful UK Wrapper, But Not Automatically Tax-Free in the US

The ISA is one of the most familiar and efficient savings wrappers in the UK. Unfortunately, the US does not recognise it, and the tax treaty does not cover it. As far as the IRS is concerned, an ISA is simply a taxable investment account.

That means interest from a cash ISA, and dividends and gains in a stocks and shares ISA, should all be reported on your US return each year. Because ISAs are tax-free in the UK, there is no UK tax to credit against the US liability.

Another risk is what sits inside the ISA. If your stocks and shares ISA holds UK or European funds, you may be exposed to the US rules on Passive Foreign Investment Companies, which can turn a modest gain into an expensive tax bill.

PFIC Considerations

A Passive Foreign Investment Company, or PFIC, is broadly any fund or ETF that is not domiciled in the US. The IRS sees these as opaque structures and taxes them harshly. Any gains are taxed as income at the highest US rate, with an interest charge added on top, and higher earners may also pay the 3.8% net investment income tax. Taken together, gains on PFICs can potentially be taxed at over 50%.

For most US citizens, the most sensible approach is to avoid PFICs from the outset. If you already hold them, unwinding them takes care, because the timing of any sale affects both your UK and US tax position.

UK Funds and ETFs

UK funds and ETFs sold widely on UK platforms are generally PFICs for US purposes. US-domiciled funds and ETFs avoid the PFIC problem, but to work in the UK they also need to be on HMRC's reporting fund list.

Individual shares in ordinary trading companies are generally fine for Americans living in the UK, because operating companies are taxed in much the same way wherever they are based. The complication comes with shares that look like an ordinary company but are not - investment trusts and some real estate investment trusts, for example, can be PFICs. It is important to understand what a share actually is and what it holds.

Pensions

Pensions are one of the only structures recognised as tax-deferred by both the US and the UK under the tax treaty. That makes them one of the most effective retirement vehicles for US citizens living in the UK, particularly where an employer is contributing.

There are still details to get right, and interpretations can vary, so tax advice is important. The treatment of US accounts such as IRAs and 401(k)s while you live in the UK, and of the UK's 25% tax-free lump sum for US taxpayers, both need careful thought.

US/UK-Compliant Portfolios

A US/UK-compliant portfolio works under both tax systems at the same time. Building one means looking at two layers: the wrapper and the investment inside it.

• Pensions are protected by the tax treaty.
• ISAs do not automatically remove US tax obligations, so the tax advantages that benefit a UK citizen may not apply.
• There may be tax to pay on gains made in a UK ISA and in addition, any investments held within an ISA wrapper need to be US tax compliant because IRS because they look through the wrapper and tax the holdings within it. 
• US brokerage and retirement accounts need checking from the UK side, to ensure that investments are suitable for a UK resident. Americans can own US listed funds and ETFs but they need to be on the HMRC approved offshore reporting funds list.

For US citizens living in the UK, some accounts may be fine as they are. Others may need restructuring. A cross-border specialist can work out which are which.

Once the cross-border position is understood, the investment fundamentals still matter:

Currency risk: If you live, earn and spend in sterling but hold most of your wealth in dollars, currency movements alone can erode your returns. Many Americans assume that because they can only hold US-listed funds, they are stuck with dollar exposure. That is not the case. UK government bonds, sterling-based UK shares and US-listed funds with multi-currency underlying exposure can all help. You can even buy a US-listed FTSE 100 tracker, giving you exposure to the UK's largest companies while keeping the investment US compliant.

Concentration risk: US portfolios are often heavily weighted towards the US stock market, which is itself heavily weighted towards technology. Recent volatility in tech shares is a reminder of the risk of having too much in one place.

Household planning: If your spouse or partner is from the UK and not a US citizen, holding some assets in their name can be very effective. They can use ISAs fully, hold UK government bonds and certain corporate bonds that are free of UK capital gains tax, invest in UK funds and pay into a pension - without the US complications. This needs planning, including around US gift tax rules for transfers to a non-US spouse.

Estate planning: US citizens are subject to US estate tax on their worldwide assets, and UK inheritance tax thresholds are considerably lower than the US exemption. Both need to be part of the picture.

The good news is that being a US citizen in the UK need not stop you achieving your goals. There are usually several ways to get there - it is a question of choosing the right route. Taking professional advice from a UK/US cross-border specialist will ensure that you avoid any of the common pitfalls of US expatriates living in the UK.

Many dual citizens were born in the US or to an American parent and have grown up in the UK. Some only discover their US filing obligations when a bank asks about their citizenship.

If you are at the start of your investing life, a few early steps can save a great deal of trouble later:

• Make sure you have a US Social Security Number and understand whether you should be filing US returns
• If you are behind on filing, the IRS has procedures designed to help non-wilful filers catch up. Sorting this out before you build wealth is far easier than fixing it afterwards.
• Think carefully before opening a Lifetime ISA or filling a stocks and shares ISA with UK funds. A portfolio built up over 20 years in the wrong investments can be expensive to unwind.
• Join your workplace pension and take the employer contributions. It is often the simplest and most efficient place to start.
• Parents of US-citizen children should check how Junior ISAs and 529 plans are treated before contributing.

Some dual citizens consider giving up their US citizenship to simplify things. This is a significant and irreversible decision with its own costs, and it should never be made without specialist advice.

Six important questions need to be addressed when US citizens move to the UK and reassess their financial planning strategy:

1. What citizenships and tax residencies apply?
2. What accounts and wrappers do you hold?
3. What investments sit inside each account?
4. Where do you expect to live long term?
5. Which currencies will fund future spending?
6. Which decisions need coordinated advice?

How long you plan to stay is key as the answer shapes how much the rules matter to your portfolio.

Short-term stay: If you are in the UK on a short assignment, you may be able to keep your portfolio in the US and focus mainly on US compliance, using UK rules such as the Foreign Income and Gains (FIG) regime - that can shelter foreign income and gains for a limited period. 

Long-term stay: If you plan to retire here, or your children will go to university in the UK, both tax systems need to be considered. You will always be liable for US tax, so US compliance is permanent. UK compliance becomes essential the longer you stay.

Uncertain: If you are not sure, a more cautious approach usually makes sense - making sure your investments are UK compliant in case your stay turns out longer than expected.

Investing as a US citizen in the UK is entirely possible - it simply needs a different approach from the one most UK investors take. The earlier you put the right structure in place, the more options you have and the less you risk paying tax you did not need to pay.

A US/UK Cross-Border Investment Review with Hoxton Wealth maps your ISAs, pensions, US accounts and investments against both tax systems, highlights anything that needs attention and sets out a long-term strategy built around your plans. 

Get in touch to arrange yours.