In this article, we review investments by individuals in mutual funds, also known as unit trusts in the UK and undertakings for collective investments in transferable securities (UCITs) in the EU as a whole. They are usually publicly listed and regulated but there are also less regulated private equity funds.
Surprisingly, the tax side is not always crystal clear, as discussed below. Before proceeding with any investment you should consult qualified experienced investment and tax advisers in each country concerned.
Whatever you call them, mutual funds are big business.
It is currently estimated that around $20 trillion are invested worldwide in these vehicles. As an alternative to direct investment, investors buy units in a mutual fund in the hope that the mutual fund will expertly select and invest in securities for the benefit of the investors. Of course, some funds do better than others and the markets can rise or fall over time.
Israeli mutual funds: If an Israeli investor buys units in an Israeli mutual fund, the Israeli tax rate is generally 20%. But there are two types of Israeli mutual funds - taxable and exempt. A taxable Israeli mutual fund pays the 20% tax and the investor is exempt from further tax. An exempt Israeli mutual fund pays no tax of its own but it withholds 20% tax at source from distributions to investors. Foreign investors may enjoy an exemption in certain circumstances.
If a taxable Israeli mutual fund paid foreign tax on foreign investment income it may credit it against the 20% Israeli tax. If an exempt Israeli mutual fund paid foreign tax, the foreign tax credit is generally not passed on to the taxable investor, resulting in potential DOUBLE taxation on foreign investment income in the case of an "exempt" Israeli mutual fund! Therefore, you may want to consider a taxable Israeli mutual fund for investments abroad or a foreign mutual fund (see below).
Different rules and tax rates apply to investments made by individuals before January 1, 2003 and to all investments made by securities dealers and other businesses.
Foreign Mutual Funds: At the international level, tax issues arise. For example, investors in country A (for example Israel) buy units in a mutual fund based in country B (for example, a Luxembourg or Swiss fund), which in turn invests in securities in country C (for example the US) and other countries. Here's a selection of the international tax issues that may occur:
* Israeli tax (country A tax): Israeli resident individual investors are generally taxed in Israel on dividends, interest and capital gains from any foreign mutual fund if the investment was made on or after January 1, 2005 (not 2003). A 35% tax rate generally applies in Israel to pre-2005 income and gains from foreign mutual funds, calculated on a prorata time basis.
* Country B tax: This will depend on whether the country is onshore (imposes regular taxes) or offshore (imposes little or no tax). Many mutual funds that invest internationally are based in an offshore jurisdiction, but check this in specific cases.
* Country C tax: Country C may tax foreign investors on dividends, interest and capital gains derived from sources and companies in that country. Some countries, like the US, refrain from taxing foreign investors on "portfolio interest" (as defined in the US Internal Revenue Code) and capital gains but still tax them on dividends, generally at rates of up to 30% of the gross dividend. This tax is often withheld at source in Country C.
* Tax treaty relief in Country C? To enjoy a lower tax rate in Country C, it is usually necessary to request to apply a tax treaty rate, for example, 25% under the US-Israel tax treaty or 15% under the Israel-Netherlands tax treaty. But which tax treaty, if any?
* Funds organized as companies: A number of mutual funds are organized as a separate legal entity such as companies. In this case, the tax treaty (if any) between country B and country C ought to apply. However, country C may have anti-avoidance rules ("limitation of benefits") in its domestic tax law or its tax treaties that deny tax treaty relief to a mutual fund in country B if the investors reside in other countries.
* Funds organized as partnerships or trusts: Some mutual funds are organized as trusts or partnerships. In this case, country C may perhaps treat the fund as "transparent" and tax instead the investors under its tax treaty with the investors' country of residence, Country A. But there may be many investors from many countries who come and go rapidly. In practice, this can be a bureaucratic nightmare, especially if there is a chain of intermediaries involved - such as brokers, securities custodians and even other mutual funds (fund of funds).
* Foreign tax credit in Country A: Suppose a mutual fund secures the correct tax treaty withholding tax for each of its investors (e.g. 25% for dividends paid up the line by a US corporation, or 15% by a Dutch company, to an Israeli resident investor). Will the Israeli tax authority grant a foreign tax credit against Israeli tax (20% usually as mentioned above) based on tax paid according to the mutual fund's printout? Or will the Israel tax office of an investor request confirmation directly from the US or Dutch tax authority?
* Estate tax: Often overlooked, there may be exposure to estate or inheritance tax on investments in countries B or C for investors from country A. For example, the US imposes 18%-45% estate tax on most investments of non-US investors (but see below). How is it collected? Sometimes a fund or a bank or an intermediary freezes an account when it discovers its client has passed away, until the estate tax is sorted out.
Given the above, various international bodies (OECD, EU, G30) are now reviewing how to streamline the grant of tax treaty relief to international mutual funds. And there are reported to be cases alleging tax discrimination against foreign mutual funds pending before the European Court of Justice.
In the meantime, the US has introduced a system of forms. You may be asked by to fill out a W8 form if you are not a US person (citizen, green card holder, resident) or a W9 form if you are. (Filling out the wrong form is considered perjury!).
Practical tips to consider
You may choose to simply invest directly in country C via an Israeli taxable mutual fund.
Alternatively, if you choose a mutual fund in Country B which invests in several other countries, such as the US, check if the fund aims to derive income that is exempt in the source country (country C) for foreign investors - for example capital gains or portfolio interest in the US (not dividend income).
If you choose to invest via a local Country C mutual fund, check if there is estate tax exposure (for example - in the US - but see below).
In any event, you should retain all tax related paperwork, including end-of-year summary statements from mutual funds, certificates of foreign taxes paid, etc. This should help you report your income and credit foreign tax paid against Israeli tax.
There are also detailed tax payment and disclosure rules in Israel and elsewhere that tax you if you invest and park profits abroad via a passive offshore "controlled foreign corporation" (CFC) and the Israeli tax rate will be 25% rather than 20% generally.
If you are an Israeli resident AND a US citizen or green card holder, you may enjoy a system of foreign tax credits under the tax laws of each country, or an interlocking foreign tax credit formula under special provisions in the Israel-US tax treaty. Such people should also consider investing in US based mutual funds - otherwise there are complex PFIC (passive foreign investment company) provisions in the US to deal with.
As for estate taxes, investors who are not US citizens or green card holders may avoid US estate tax by investing in parallel non-US based mutual funds (for example, in Luxembourg). Some are related to the larger US mutual funds. Alternatively, for investments in the US, UK and elsewhere, consider using an Israeli "family company" - ask your CPA for details.
The above is extremely brief and general. As always, consult experienced tax and investment advisers in each country at an early stage in specific cases.
Leon Harris is an International Tax Partner at Ernst & Young Israel.