Regulation To Take Away Investors' Profits If They Make Any

Otherwise known as taxation. As the removal of capital controls (mostly during the 1980s) opened up international investment opportunities, regulators and national tax authorities were faced with a rapid growth in offshore assets which were outside national tax nets, but in the ownership of their citizens. These assets were a mixture of bank deposits, fund investments, property assets and shareholdings, and were held through a variety of mechanisms, the most important being direct ownership, trusts, and holding companies.

With varying degrees of speed and efficiency, the rich (highly-taxed) countries moved to stop up the loopholes through which tax on offshore assets is 'lost', as they put it. The mechanisms include:

• Controlled Foreign Company (CFC) legislation or equivalent, which imposes tax on the undistributed profits of a foreign company controlled by a resident in a high-tax country;

• Anti-avoidance legislation aimed at removing the tax advantages of trust settlements;

• Taxation of foreign gains as income even if they are capital in nature (especially nasty, this one);

• Pressurising offshore jurisdictions to agree to 'exchange of information' and mutual assistance treaties.

• The taxation of savings interest income for European residents via the introduction, in 2005, of the Savings Tax Directive.

As an example of how bad it can get, here is a description of how the US effectively prevents its residents from holding foreign fund assets.

US legislation introduced in 1986 imposed taxation of the accumulated income of Passive Foreign Investment Corporations (PFICs). An offshore fund is a PFIC if 75% of its income is passive income, or if 50% of its assets produce passive income. Passive income includes dividends, interest, royalties, rents, annuities, net gains on disposals of passive-income-producing assets, gains from foreign currency and commodity transactions. Can you think of anything they left out? In fact, it is hopeless for a fund to try to escape.

A US resident holding only a small proportion of a PFIC's assets (effectively, almost all investors other than extremely wealthy people) is charged with US income tax at the top rate on the increase in the fund's assets each year (and US income tax rates are higher than capital gains tax rates). The tax is not payable until the fund shares are disposed of, but interest is charged on the annual tax assessments, which are calculated retrospectively by allocating the final gain equally to the years since acquisition. A taxpayer can make a QEF election (with permission!) to pay tax annually on the gain in the fund's asset value (usually excluding unrealised capital gains) but a fund with QEF-election shareholders faces a massive task in providing the shareholders with the information they need to satisfy the IRS.

You can see that between the dangers of accepting US investors in the first place, and the administrative overhead and loss of privacy involved in satisfying QEF-election information requirements, many funds would think that US investors are more trouble than they are worth, unless a fund is designed from the ground up to accommodate them.

Although the US PFIC legislation is very nasty (and far more complicated than the highly simplified account given above), the rules in most OECD countries are much less extreme, and in many high-tax countries there are plentiful tax-planning opportunities for residents who want to make offshore investments. So don't give up! But do take advice from competent professionals - there are traps in tax legislation, and financial or criminal penalties for those who get it wrong.