OFFSHORE MUTUAL FUNDS 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 many 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. One offshore fund group that has partially solved this problem is the Third World Funds, based in Panama (address is in the offshore funds listing in the next section). They are unable to sell to smaller investors, but can sell to U.S. citizens who meet the Securities & Exchange Commission definition of accredited investors, and who register the shares to a non-U.S. address. 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 in some countries) 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. Most 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. Prudent ways for Americans to buy offshore funds Eventually one gets to a need to make a direct foreign investment. Buying U.S.-based global or international mutual funds is a very useful currency diversification, and a useful way for the smaller investor to get started. But since these funds are still a U.S. asset, such fund investments do not help to diversify your assets in an asset protection sense - - protection against lawsuits, forfeitures, possible future exchange controls, or any other contingencies. It is not illegal for Americans to buy offshore mutual funds (called unit trusts in some countries) or any other security that is not registered for sale in the United States. Most foreign securities that are not mutual funds can be bought through any good stock broker, although you can do better if you select a broker who specializes in foreign securities. But he can't sell you a foreign mutual fund. That doesn't mean that there is something dirty or illegal about it -- it merely means that the fund is not registered for sale in the U.S. There are a number of reasons for this. Expense is one -- successful foreign funds don't need the American market and see little reason to pay the outrageous fees of our litigious society. (Some of the best foreign cars cannot be purchased in the U.S. for a similar reason -- the makers of $100,000 custom cars are not about to give the federal government ten free cars per year for destruction testing.) Some of the funds cannot meet U.S. legal requirements because they charge investors a performance fee rather than a management fee based on a percentage of assets. But many investors would actually prefer a fund manager whose only compensation is a share of the profits instead of a fee based on the total investments in the fund. The manager's goals are different. It is illegal for a foreign securities issuer, such as a mutual fund, to sell an unregistered security in the U.S. To be completely safe most, but not all, of them refuse to sell to an American citizen or resident even if he is residing abroad. They'd rather stay away from anything to do with Americans. To protect themselves, they require a statement on the application that the purchaser is not a resident or citizen of the U.S. Some advisors suggest using a mail forwarding service in a foreign country, and simply signing a false declaration. It is probably quite safe to do so, but such dishonesty could turn out not to be prudent later. To take an extreme example (at least we hope it is an extreme example) some other country could suddenly adopt American-style forfeiture laws, and decide that securities procured by fraud were forfeitable to the government. (The false declaration is clearly a fraudulent statement, even if there is no financial loss to the seller.) This example could seem extreme, but a recent U.S. case presents a scary analogy. A mortgage applicant in 1986 made an allegedly false statement as to his employment. In 1992 the house was confiscated by the federal government, on the grounds that the false employment statement was fraud on a federally insured bank, even though the mortgage had been paid. The householder claimed that he had worked for the company off the books, but the payroll records did not support his claim. The U.S. Court of Appeals ruled in 1993 that the house was subject to administrative forfeiture by the government, that he was not entitled to a hearing or trial, and was not entitled to present his defense to a court. Looked at in another way, although the purchase of the securities by an American is not illegal, it would not be impossible for the U.S. government to argue that the securities are subject to forfeiture on the grounds that the purchaser committed mail fraud by mailing a false declaration of citizenship. The U.S. Supreme Court has long ruled that mail fraud need not involve a monetary loss, but only the mailing of a false statement with an intangible gain (in this example, the ownership of a security that could not have been obtained without the false statement). Thus all the legal elements of proof for a mail fraud case would have been met. More likely than a mail fraud prosecution however would be a civil forfeiture of the security, similar to the mortgage example above. And why contaminate an honest investment by taking even the slightest risk of acquiring it in an illegal manner. There is no reason to do so, when the entire transaction can be conducted honestly, legally, and properly. These horror stories may be far-fetched examples, but the house seizure case would suggest that they may not be. So how can an American purchase these securities legally? There are two possible routes that would meet the legal requirements. The first is to use a foreign bank or trust company as a nominee holder. In this example the nominee holds the security under a simple agreement for the true owner. This is technically a form of trust, but is normally limited to a one or two paragraph standard agreement form used by the bank. This strategy would not be valid if the form required by the offshore fund included a statement that the beneficial owner is not an American. Most of these fund statements do not go that far, but some of them do -- in particular the Fidelity group offshore-based funds, because they are part of an American parent company. The second strategy is simply a more sophisticated version of the first. A very simple trust is created, with the foreign bank or trust company acting as trustee, and the beneficiary being the U.S. holder, with a spouse or children being contingent beneficiaries in case of death. Now the trust itself is the legal and the beneficial owner, and the requirements of the fund will have been met. The fact that the trust has American beneficiaries is not legally the same as the shares being beneficially owned by an American. Such agreements are usually very simple, and most major foreign banks can deal with them. For example, banks in Canada, Britain and Hong Kong will usually charge only around $500 to set up a trust, and around $50 or $100 per year per security for nominee agreements. A Swiss bank could also act as a nominee. Canada and Britain have been mentioned in the example for a reason. It is not necessary to go to a tax haven for this kind of service. Very few countries are interested in taxing a trust in which the assets are foreign and the beneficiaries are foreign, so even a high tax country will usually qualify for this type of simple trust or nominee arrangement. The bank will be able to tell you the local tax position for such an arrangement. The banks in the high tax countries tend to be far cheaper -- this is as routine as asking your local bank's trust department to hold a share certificate for your children -- and you avoid the high trust formation fees that most tax havens charge. In theory a Swiss bank could be a trustee, rather than just a nominee, but this gets into some exotic legal questions of civil versus common law countries, because the IRS will only recognize a common law trust. By using either of the approaches outlined, and staying in a common law country (essentially Britain and the countries that inherited the British legal system, including the U.S., Canada, Hong Kong, etc.) the trust is neutral or transparent for tax purposes. The value of this is that you can then claim a U.S. tax credit for any foreign withholding taxes paid by the trust, although normally the point of offshore funds is that there are no withholding taxes. One of the best ways to purchase offshore mutual funds, or make any offshore investment, is a brand-new Swiss product called BankSwiss. Jurg Lattmann, founder of JML Swiss Investment Counsellors, has teamed up with an excellent Swiss bank, Ueberseebank, to create "BankSwiss," an account designed specifically for foreign investors. The Firm of Marc M. Harris, a Panama-based accounting firm which is discussed in more detail in the section on offshore trusts and corporations, is also very qualified to help Americans arrange fully legal purchases of offshore funds. Because Marc Harris is certified to practice in the U.S., he is fully familiar with U.S. legal and tax requirements.