Harvey Jones
09.09.2020

Avoid US-domiciled ETFs unless you want to end up like Al Capone
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Nobody wants to mess with the US Inland Revenue Services. These are the guys who took down legendary mobster Al Capone, remember.

Plenty of expats have good reason to fear the IRS, and they aren't all US citizens, either. You could have a run-in with them, simply for buying the wrong type of exchange traded fund (ETF) inside your offshore trading account. It doesn't matter which country you originally come from, or which jurisdiction you are now living in, the IRS could come gunning for you all the same. Although you are unlikely to end up serving time in Alcatraz, like Capone, buying the wrong ETF could still cost you dear.

Here’s why.

The guys who took down Capone

The IRS has a long reach. It nailed Capone in Chicago, but today it claims jurisdiction over the tax affairs of every US citizen and Green Card holder, wherever they are in the world. As its website warns: “Your worldwide income is subject to US income tax, regardless of where you reside.” US citizens can have tax obligations in the States years after they left the country, or even if they have never lived there at all. It’s a tough line to take, but that’s the IRS for you. This is the attitude that helped bang up Capone, when the FBI couldn’t touch him for murder. US citizens living overseas know this (and many are campaigning against the law). What many expats who have no ties to the US fail to realise is that they can unwittingly get caught in the IRS tax net, by investing in an ETF that has its "domiciliary" in the US.

Don’t risk a tax sting

Every private investor gets a kick out of ETFs. They're more popular than a gin cocktail at a speakeasy. They allow you to track almost any global index you care to think of, such as stocks, bonds, property or commodities, at minimum cost. ETFs have no initial upfront charges when you buy them, while their annual underlying charges are as low as can be. Two of the most popular, Vanguard S&P 500 ETF and iShares Core S&P 500 ETF, charge just 0.03% a year. However, you should not just look at the fees when deciding which ETF or mutual fund to buy. You must also check where the fund is domiciled, or issued. If the answer is the US, then non-US investors, also known as non-resident aliens (NRAs), should stand well back, or risk a double tax sting.

Withholding your dividends

If you are an expat living in a country that does not have a tax treaty with the US, for example the UAE, the IRS will impose a withholding tax of 30 per cent on any US-domiciled fund or stock that pays a dividend. This will even apply if the underlying securities in the fund, such as company stocks, are based outside the US.

That isn't the end of it.

When you die, your ETF holdings may be liable for US estate tax. This is even more punitive, charged at 40 per cent on sums above $60,000. You can see why Al Capone was so keen to avoid paying his due to the IRS. You can avoid it too, but without breaking the law. In fact, it is quite simple. All you have to do is check the domiciliary of any ETF or mutual fund before you buy it. The problem is that many expats do not realise this is an issue, and get caught out. Ideally, you should stick to ETFs that are domiciled in Europe. If they have UCITS in their name, you can breathe easily. This stands for Undertakings for the Collective Investment in Transferable Securities, and is a cross-European regulatory framework for mutual funds. Seeing UCITS gives you peace of mind, as they should be safe and well regulated. This applies to funds domiciled in EU countries, including Luxembourg and Ireland.

The Irish connection.

Top US ETF providers such as iShares and Vanguard also domicile their ETFs in Dublin, Ireland, which are then traded on the London Stock Exchange. If you buy an Irish-domiciled ETF, the withholding tax on US securities falls from 30% to 15%. It falls to zero on investments from other countries. That’s because Ireland has a tax treaty with the US, and does not add on any local withholding tax on UCITS funds. Funds domiciled in Ireland also shield you from US estate taxes. Better still, you will not be liable for Irish gift tax, capital gains or inheritance tax on your ETFs, unless you are actually resident in Ireland. To help you identify the right domiciliary for your ETF, check the ticker symbol. For example, Vanguard S&P 500 ETF’s ticker is VOO in its US-domiciled version, but the Dublin-domiciled Vanguard S&P 500 UCITS ETF’ ticker is VUSA.

Don’t mess with the T-men

Even if you avoid US-domiciled funds, you still have a massive range of ETFs to choose from, more than enough for most investors. And you can still buy ETFs denominated in US dollars, if that is your preferred currency. One downside is that charges on US funds are slightly lower, because they benefit from economies of scale. So Vanguard S&P 500 ETF (VOO) charges just 0.03%, while Vanguard S&P 500 UCITS ETF (VUSA) charges 0.07%. The extra cost is more than offset by the tax benefits, though. Al Capone literally got away with murder after the St Valentine's Day massacre, when his men shot and killed seven members of rival mobster Bugs Moran’s gang. In 1932, IRS “T-Men” got him jailed for 11 years on 22 counts of federal income tax evasion. The T-Men may not come after you with the same urgency, but you should still avoid US-domiciled ETFs, just in case.

Harvey Jones has been a UK financial journalist for more than 30 years, writing regularly for a host of UK titles including The Times, Sunday Times, The Independent and Financial Times. He is currently the personal finance editor of the Daily Express and Sunday Express, and writes regularly for The Observer and Guardian Unlimited, Motley Fool and Reader’s Digest.

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