Capital Gains, Franking Credits, Mutual Funds and Unit Trusts
Capital gains, franking credits, mutual funds and unit trusts for US citizens in Australia all present different challenges and carry with them different taxation requirements. We have a look at these four areas below to make it easier for you to understand.
If you’ve got a property in Australia, what’s the big deal if the property’s value sees a sudden increase?
This is the type of situation where you can be liable to pay capital gains tax (the tax on an asset that you’ve sold for a profit). Right now, it’s quite common in Australia to make a profit on property. There are certain markets, particularly in Sydney, where property value has increased significantly in recent years. There you might find that a house you bought a few years earlier has shot up in value in today’s market, especially when you throw in market fluctuations and exchange rates.
In Australia when an Australian sells a property, they’re typically not going to have any capital gains taxes to pay. That’s because there’s an exemption for Australians where the gain comes from the sale of their main residence. However, the US doesn’t give the same blanket exemption, which can be a nasty shock for US tax residents living in Australia. If you are a US resident taxpayer, even if your property is located outside of the US, you can still be held subject to some level of capital gains tax. You can end up in a situation where your $250,000 USD or $500,000 USD gain exclusion (depending on your filing status) doesn’t cover the whole gain that’s calculated.
What options do I have if I fall into this category?
The key is advanced tax planning. You need to give yourself and your tax planner enough time to plan through the different options.
There are lots of factors to consider. For example, these sorts of taxes vary geographically in Australia, where states have their own stamp duty rules. This means it’s often a case of working out whether it’s better to pay the US capital gains tax owed, or to pay the Australian stamp duty. A way you could achieve the latter is to transfer the property to your non-resident spouse.
So, is adding your non-resident spouse to your tax returns advisable?
You’ve got to weigh up the pros and cons. There certainly can be benefits to adding your non-resident spouse, a major one being that if you file jointly then you get the higher gain exclusion of $500,000 USD. However, there are also advantages to filing separately. If you choose to file separately, and you and your non-resident spouse jointly own the property, you don’t need to put 100% of the sales price and cost basis on your tax return. That allows you to put a reasonable allocation on your non-resident spouse, which could bring the capital gain calculation below the standard $250,000 USD exclusion. The general rule in Australia where a couple buys a property together is that the cost is allocated 50/50 (unless you’ve done anything specifically at the time of purchase); the US will see it the same way.
So in short, the answer is, while you will see opportunities for savings by adding your non-resident spouse to your tax return, it is really important to carefully look at all the options before making that decision. Once you add your non-resident spouse to your tax returns, you’ll have to keep including them from then on, so it might not be the best decision long term.
Keeping on the Capital Gains topic, how does it affect any stocks that I may have and how can I best avoid paying a lot of tax here?
A lot of it comes down to when the stocks were bought. For instance, did you buy them before you arrived in Australia? If so, the Australian government is likely to price the stocks at the level that they were at when you arrived in the country, rather than when you bought them. This can affect the tax owed, for better or for worse.
The other thing to consider is whether you are deemed to be a temporary resident or a permanent resident. If you’re temporary, you’re unlikely to be taxed at all by the Australian government.
One of the possible answers is that the US can actually, under its own domestic rules, say that the level of Australian tax paid is high enough. That allows us to treat the sale of this stock as foreign sourced gains, allowing you to claim a credit. So, while you might have to pay the ATO, you can get a credit note to offset the US side.
The key is to make sure you’re communicating with your US tax preparer and your Australia tax preparer. It’s important that both do things the same way to help avoid any unnecessary double taxation.
What about inheritance? If I am a US citizen, married to an Australian, and we inherited money or property from the Australian side, am I liable to taxation?
Typically, not in this scenario.
If the inheritance exceeds a certain amount (usually $100,000 USD) you will need to report this via the 3520 form as a recordable transaction, but it is not a taxable transaction.
Does the same apply to financial gifts?
It runs on a similar concept to the question above: it is not usually taxable, but it is recordable. So again, you would need to file the 3520 form.
It’s important that you do file this form as it’s one of those informational forms that, if not done, incurs fines and penalties that can be quite extensive. If you file it, you can avoid any nasty surprises, but only if it’s filed on time: late forms also bring with them a hefty fine!
Franking credits – what are they?
Franking credits is quite an enlightened approach that has been adopted by Australia. In Australia there is an understanding that a dividend is where a company has generated a profit, some of which they want to give back to their shareholders. Before they do, there are going to have to pay tax on that profit at the corporate level.
To give an example, say your company had a profit of $100 AUD and got taxed $30 AUD, you would then give $70 AUD to your shareholders. In Australia, that $30 AUD is called a franking credit and on an Australian tax return, for someone who is a resident of Australia, the amount that is reported as income is the full $100 AUD. The $30 AUD franking credit is taken as an actual tax credit so that you avoid double taxation.
Is the same rule offered in US?
Unfortunately, not and just because Australia offers it, it doesn’t mean that the US changes its rules for Australian dividends.
The good news though is whilst the franking credit is not deemed creditable in the US as a foreign tax payment, it’s also not deemed to be income to the individual because in the example above the individual did not get that $30 AUD. So, the best way to think about it is that franking credits are just basically ignored in a US tax return and you’re just taxed on the $70 AUD in the example above.
While it’s possible to have a tax liability in the US from these franking credits, we often see that it does not result in taxes to be paid to the US.
Explain a bit about unit trusts and mutual funds for US citizens, living in Australia, set up in Australia. What should I be aware of here?
Of all the laws that the US has in place, a lot fall under the heading of ‘lots of paperwork but not necessarily a lot of impact’. However, when you’re dealing with investments in Australian Mutual Funds (called “Managed Funds” in Australia), ETFs, Unit Trusts etc, the impact can be quite substantial as they are deemed a passive foreign investment company (PFIC). At their best, PFICs can be a bit of a nuisance, but at the worst they can be a real problem for US citizens living in Australia.
The basic idea when this law was passed was that the US was upset that Americans were investing in funds that were set up overseas. There was no reporting to the IRS, so the assumption was that those Americans were ‘sheltering’ their income, something that’s looked on negatively. The PFIC legislation can therefore be quite punitive.
To use an example, you could have a fund which accumulates over a few years and finally distributes. The US acknowledges that you’re doing your distribution now, but decides that in reality you should’ve been reporting this over the last few years – even though you didn’t get any distribution during those years – and they tax you at the highest level possible as a result, as well as assigning penalty interest for failing to report this ‘distribution’ over the previous years. This can mean you’re taxed on income that you’ve never seen or even known about, without the benefit of foreign tax credits, and with the tax at the highest rate and the penalty interest; this can be a very nasty sting.
There are planning opportunities available for PFICs, e.g., if it is publicly traded on exchange it can give some help, and in some cases if it’s closely held privately then there is the ability to get some good reporting done for you to help. There’s a lot to consider in achieving the best outcome. It’s therefore best to have a chat with a tax advisor right at the start so you can avoid any nasty penalties down the line.
It’s important to remember that these tax complexities don’t mean you shouldn’t invest in PFICs. With the right tax planning, you’re forewarned and forearmed: you can get the right investment outcome at the outset.