The Offshore Mutual Fund and Insurance Loopholes The most popular investments for U.S. investors in recent years have been mutual funds and insurance products. For the internationally minded investor, there are offshore versions of these products available. In some cases, they offer even more benefits to U.S. investors than do their domestic counterparts. The IRS and other elements of the U.S. government apparently do not believe in offering international opportunities to U.S. citizens, however, so in some cases these investments are less attractive to U.S. investors than to residents of other countries. The main obstacle standing in the way of many foreign opportunities is the U.S. securities laws. Any "investment contract" sold in the United States must be registered with the Securities and Exchange Commission and with its counterpart in each of the states. This is a very expensive process. U.S. securities laws require far more disclosure than do those of most foreign countries and also require different accounting practices. Therefore, many offshore mutual fund companies decide that whatever income they might eventually earn would be inadequate compensation for the time and expense involved in attempting to comply with U.S. securities laws. In fact, several of the mutual funds and hedge funds with the top performance records are run from the United States by U.S. residents but do not accept investments from U.S. residents. To reduce registration costs and avoid other restrictions, the funds are made available only to foreigners. Fortunately, U.S. citizens can get around this obstacle through bank accounts or trusts. Basically, you can travel overseas to buy the shares in person, you open a foreign bank account and invest through the account, or you can establish a foreign trust. Only then will these opportunities be open to you. Offshore mutual funds To diversify your portfolio internationally, you could invest in the international funds of a U.S.-based mutual fund company. This approach has satisfied many U.S. investors. But offshore mutual funds (or unit trusts, as they are known overseas) have been around longer than U.S. funds and have some outstanding long-term performance records. U.S. funds only recently got into the international investment markets, while the offshore funds have existed for some time. You probably will find more experienced management at the offshore mutual fund companies. Also, because the offshore funds do not have to meet U.S. securities laws, they are likely to have lower operating costs. These qualities do not exist for all offshore funds, but a number of them do have these advantages. If you choose to invest in an offshore mutual fund, you will find very attractive treatment under foreign tax laws and some unpleasant treatment under U.S. tax law. Most offshore mutual funds are of a type called accumulative, or roll-up, funds. Under U.S. tax law, a mutual fund avoids taxes on its income and gains by making distributions to the shareholders at least annually. The shareholders then are taxed on the earnings. But most foreign countries do not impose this restriction on their funds. The funds can retain and compound all income and gains. So while the U.S. investor has his investment funds depleted by taxes each year, the overseas investor can let the investment compound tax-deferred. Even a U.S. investor who has distributions reinvested in shares each year must include those distributions in gross income and pay taxes on them. A foreign country taxes the accumulated income and gains only when shares are redeemed. In addition, many foreign countries do not tax capital gains at all or tax them at rates far lower than those imposed by the United States. The U.S. taxpayer who invests offshore will reap the benefit of such tax breaks. In addition, any taxes imposed by the foreign country on the redeemed shares might be exempt from tax withholding under a tax treaty between the United States and that country. The bottom line is that there are tremendous advantages to investing in an offshore mutual fund. In addition to the international diversification and experienced management you can expect, your investment gains compound tax-free until you redeem shares. Foreign countries essentially treat all mutual funds as nondeductible IRAs with no investment limit. Some of these advantages disappear when you consider the U.S. tax aspects of offshore mutual funds, but there are some ways to overcome these tax aspects as well. A few years ago, the United States taxed U.S. shareholders of foreign investment funds the same way the foreign countries did. No taxes were due until shares were redeemed. Then this country decided that treatment should apply only when more than 50% of the shareholders were foreigners. In 1986, Congress changed the rules again so that no U.S. shareholders of offshore mutual funds would get beneficial tax treatment. The current rules are that you have two choices of how to treat the offshore mutual fund on your U.S. tax return. The first choice is to invest in a "qualified electing fund." This is an offshore investment company that elects to have its shareholders taxed on their pro rata shares of all earnings each year. An established offshore mutual fund is unlikely to be a qualified electing fund, and you would lose all the benefit of tax deferral if it were. The next option is to not pay any taxes until shares are redeemed. But if you take advantage of this approach, you get hit with the regular income tax plus a penalty tax. The penalty tax is an interest charge for not paying taxes on the income and gains each year as they accumulated in the fund. In other words, you pay interest on the tax that would have been paid if the earnings had been distributed each year. For example, suppose you buy shares in an offshore fund for $1,000 on January 1, 1992. You have the shares redeemed for $2,000 on December 31, 1996. You will be deemed to have earned the $1,000 gain equally over the four years, for $200 of gain each year. The gain for 1996 is included in your 1996 gross income. The other $800 of gain is taxed at the highest rate that applied in each of the years you held the shares, and an interest charge is added to the tax. The tax and the interest charge sound oppressive and initially discouraged Americans from considering offshore mutual funds at all. But if you examine the situation a little closer, you'll find that offshore mutual funds still can be attractive. The interest rate charged is 3% more than the federal short-term rate, and it is not imposed until after the shares are redeemed or an "excess distribution" is received. So you still get tax- deferred compounding. If the mutual fund earns a high enough return, the tax-deferred compounding will more than offset the taxes plus the interest charge. The longer you plan to hold the shares and let the gains compound, the more attractive the offshore mutual fund looks. You might also have the shares owned through decontrolled foreign corporation, an offshore corporation with substantial non-subpart F income, or some other entity that will not have the income pass through to U.S. shareholders. This might avoid the interest charge if set up properly. Another option is to invest in an offshore mutual fund and never redeem the shares. Let your heirs inherit them. The heirs then will get the tax basis of the shares increased to their fair market value on the date of your death. It is not clear from the tax code how the compounded gain will be treated when your estate or your heirs sell the shares. Congress apparently did not contemplate this action when it wrote the law. So it is possible that the heirs will not have to pay the penalty tax after the shares are sold. Since the tax basis to the heirs will be the new fair market value of the shares, there will be little or no capital gain to pay taxes on. Another possibility is to have the shares owned by an offshore trust, that you have established and never sell the shares during your lifetime. After you die, the trust no longer has a U.S. person as grantor. That should mean that the trust can redeem the shares after your death and the gain will not have to be passed through to you or your estate if the trust is set up properly. The trust then could reinvest the income. The tax rules are technical and sometimes rather murky for this option, so be sure to get advice from a U.S. tax adviser before trying to implement it. If offshore mutual funds appeal to you, one fund you will want to consider is the Assetmix fund of the Royal Trust Bank of Canada. This is an umbrella fund with 14 subfunds that have different investment objectives. You can allocate your account among the subfunds however you want and switch the investment allocation whenever you want at no additional fee. This type of investment option usually is available only to the very wealthy. But Assetmix is available for a $20,000 minimum initial investment, with a minimum $2,500 to each subfund. Offshore annuities A better way to get international diversification with less-complicated tax consequences could be an annuity from an offshore insurance company. As with the offshore mutual funds, we are not talking about fly-by-night, shell companies that might take your money and disappear (though there are many of those available if you are interested). We are talking about annuities sold by Swiss and British insurers who have been in business for hundreds of years. Unlike many of their U.S. counterparts, offshore insurance companies are financially sound. In 130 years not a single Swiss insurance company has failed, which is a claim that the United States cannot make. So safety definitely is available in offshore insurance policies. Offshore annuities (and whole life insurance) have essentially the same advantages of their U.S. counterparts. You get tax-deferred compounding of income until withdrawals from the policy begin. The annuity payments are taxed the same as payments from a U.S. annuity policy. Just be sure that the insurance company selling the annuity has an opinion letter from a U.S. tax lawyer stating that the annuity meets the tax-deferral requirements of U.S. tax law. If the company is not willing to provide an opinion letter or does not have one, it probably has little experience working with Americans and you will want to find another insurance company. Annuities also offer offshore tax advantages. Switzerland, for example, encourages the purchase of annuities. A nonresident will not pay income taxes, capital gains, or inheritance taxes on the annuity. In addition, insurance contracts are exempt from the 35% Swiss withholding tax on interest payments. Offshore annuities offer some non-tax advantages as well: * International diversification. Some will let you select the currency in which the annuity is denominated; others, however, offer only one currency, so you gain or lose depending on currency swings. * Privacy. True annuities are not be reportable as foreign bank accounts on your tax return. * Protection from legal judgments. U.S. creditors will find it difficult or impossible to first locate your annuity and then try to collect against it. Again, ask for a legal opinion. Some advisers say that the offshore annuity offers little asset protection. When a creditor asks for a list of your assets, you must list the annuity or you will be guilty of perjury. Though the U.S. court system doesn't have jurisdiction to seize the annuity or order the insurer to transfer the assets to a creditor, some lawyers say that the court could order you to liquidate the annuity and give the assets to your creditors. The likelihood of this will vary from state to state and from contract to contract. A few states fully protect annuities from creditors; others give annuities little or no special protection. Swiss annuities have covered this by protecting annuities when an irrevocable beneficiary has been named. * High returns. Returns vary between policies, of course, and you should compare several of them. But you should be able to get an offshore annuity that credits your account with income based on market returns. The main problem with the offshore annuity will be the currency risk. If you are planning to retire in the country in which you bought the annuity, that probably is not a problem. Otherwise you might want to hedge the currency risk with an offsetting investment in a U.S. annuity, for example. Insurance annuities Swiss annuities minimize the risk posed by U. S. annuities. They are heavily regulated, unlike in the U.S., to avoid any potential funding problem. They denominate accounts in the strong Swiss franc, compared to the weakening dollar. And the annuity payout is guaranteed. Swiss annuities are exempt from the 35% withholding tax imposed by Switzerland on bank account interest received by foreigners. Annuities do not have to be reported to Swiss or U.S. tax authorities. They are not a foreign financial account for the purpose of U.S. reporting requirements. A U.S. purchaser of an annuity is required to pay a 1% U.S. federal excise tax on the purchase of any policy from a foreign company. This is much like the sales tax rule that says that if a person shops in a different state, with a lower sales tax than their home state, when they get home they are required to mail a check to their home state's sales tax department for the difference in sales tax rates. The federal excise tax form (IRS Form 720) does not ask for details of the policy bought or who it was bought from -- it merely asks for a calculation of 1% tax of any foreign policies purchased. This is a one time tax at the time of purchase; it is not an ongoing tax. It is the responsibility of the U. S. taxpayer, to report the Swiss annuity or other foreign insurance policy. Swiss insurance companies do not report anything to any government agency, Swiss or American -- not the initial purchase of the policy, nor the payments into it, nor interest and dividends earned. Earnings on annuities during the deferral period are not taxable in the U.S. until income is paid, or when they are liquidated, following exactly the same tax rules as for annuities issued by U.S. insurance companies. Swiss annuities can be placed in a U. S. tax- sheltered pension plans, such as IRA, Keogh, or corporate plans, or such a plan can be rolled over into a Swiss-annuity. (To put a Swiss annuity in a U.S. pension plan, all that is required is a U.S. trustee, such as a bank or other institution, and that the annuity contract be held in the U.S. by that trustee. Many banks offer "self-directed" pension plans for a very small annual administration fee, and these plans can easily be used for this purpose.) Investment in Swiss annuities is on a "no load" basis, front-end or back-end. The investments can be canceled at any time, without a loss of principal, and with all principal, interest and dividends payable if canceled after one year. (If canceled in the first year, there is a small penalty of about 500 Swiss francs, plus loss of interest.) A new Swiss annuity product (first offered in 1991), SWISS PLUS, brings together the benefits of Swiss bank accounts and Swiss deferred annuities, without the drawbacks -- presenting the best Swiss investment advantages for American investors. SWISS PLUS, is a convertible annuity account, offered only by Elvia Life of Geneva. Elvia Life is a $2 billion strong company, serving 220,000 clients, of which 57% are living in Switzerland and 43% abroad. The account can be denominated in the Swiss franc, the U.S. dollar, the German mark, or the ECU, and the investor can switch at any time from one to another. Or an investor can diversify the account by investing in more than one currency, and still change the currency at any time during the accumulation period -- up until beginning to receive income or withdrawing the capital. If you are not familiar with the ECU, it is the European Currency Unit, a new currency created in 1979. It is composed of a currency basket of 11 European currencies, and its value is calculated daily by the european Commission according to the changes in value of the underlying currencies. The ECU is composed of a weighted mean of all member currencies of the European Monetary System. Since the ECU changes its balance to reflect changes in exchange rates and interest rates between these currencies, the ECU tends to limit exchange rate risk and interest rate risks. Although called an annuity, SWISS PLUS acts more like a savings account than a deferred annuity. But it is operated under an insurance company's umbrella, so that it conforms to the IRS' definition of an annuity, and as such, compounds tax-free until it is liquidated or converted into an income annuity later on. SWISS PLUS accounts earn approximately the same return as long-term government bonds in the same currency the account is denominated in (European Community bonds in the case of the ECU), less a half- percent management fee. Interest and dividend income are guaranteed by a Swiss insurance company. Swiss government regulations protect investors against either under-performance or overcharging. SWISS PLUS offers instant liquidity, a rarity in annuities. All capital, plus all accumulated interest and dividends, can be freely accessible after the first year. During the first year 100% of the principal is freely accessible, less a SFr 500 fee, and loss of the interest. So if all funds are needed quickly, either for an emergency or for another investment, there is no "lock-in" period as there is with most American annuities. Upon maturity of the account, the investor can choose between a lump sum payout (paying capital gains tax on accumulated earnings only), rolling the funds into an income annuity (paying capital gains taxes only as future income payments are received, and then only on the portion representing accumulated earnings), or extend the scheduled term by giving notice in advance of the originally scheduled date (and continue to defer tax on accumulated earnings). According to Swiss law, insurance policies -- including annuity contracts -- cannot be seized by creditors. They also cannot be included in a Swiss bankruptcy procedure. Even if an American court expressly orders the seizure of a Swiss annuity account or its inclusion in a bankruptcy estate, the account will not be seized by Swiss authorities, provided that it has been structured the right way. There are two requirements: A U. S. resident who buys a life insurance policy from a Swiss insurance company must designate his or her spouse or descendants, or a third party (if done so irrevocably) as beneficiaries. Also, to avoid suspicion of making a fraudulent conveyance to avoid a specific judgment, under Swiss law, the person must have purchased the policy or designated the beneficiaries not less than six months before any bankruptcy decree or collection process. These laws are part of fundamental Swiss law. They were not created to make Switzerland an asset protection haven. In the Swiss annuity situation, the insurance policy is not being protected by the Swiss courts and government because of any especial concern for the American investor, but because the principle of protection of insurance policies is a fundamental part of Swiss law -- for the protection of the Swiss themselves. Insurance is for the family, not something to be taken by creditors or other claimants. No Swiss lawyer would even waste his time bringing such a case. Contact information The only way for North Americans to get information on Swiss annuities is to send a letter to a Swiss insurance broker. This is because very few transactions can be concluded directly with foreigners either with a Swiss insurance company or with regular Swiss insurance agents. When you contact a Swiss insurance broker, be sure to include, in addition to your name, address, and telephone number, your date of birth, marital status, citizenship, number of children and their ages, name of spouse, a clear definition of your financial objectives (possibly on what dollar amount you would like to invest), and whether the information is for a corporation or an individual, or both. So far only one Swiss firm specializes in dealing with English speaking investors, and everybody in the firm speaks excellent English. They are also familiar with U. S. laws affecting the purchase of Swiss annuities. Contact: Mr. Jurg Lattmann. JML Swiss Investment Counsellors, Dept. 212, Germaniastrasse 55, 8033 Zurich, Switzerland; tel. (41-1) 363-2510, fax: (41-1) 361-4074, attn: Dept. 212.