Understanding Trusts and Family Trusts: A Comprehensive Guide for US tax purposes
What is a Managed Investment Scheme or Fund?
A managed fund is an investment that is managed by a professional fund manager.
How Does It Work?
When you invest in a managed fund, your money is pooled together with that of other investors. This collective pool of funds is then used to invest in a diverse portfolio of assets, such as stocks, bonds, and other securities. Here’s a more detailed breakdown:
Pooled Investments: Your money is combined with funds from other investors, creating a larger investment pool. This pooling allows for greater diversification and investment in a broader range of assets.
Ownership: As an investor, you own a proportionate share of the total fund. Your ownership is represented by units or shares in the fund.
Investment Rules: The fund operates under a set of rules that dictate how the money can be allocated across different types of investments. These rules are designed to align with the fund’s objectives and strategy.
Fund Manager's Role: A professional fund manager is responsible for selecting and managing the investments within the fund. They make decisions based on market analysis, research, and the fund’s guidelines.
Fund Strategy: Each managed fund has a specific strategy that outlines its investment approach. This strategy determines:
Types of Assets: The assets the fund will invest in, such as equities, fixed income, property, etc.
Risk Level: The level of risk associated with the fund's investments.
Expected Returns: The anticipated financial returns for investors.
Management Costs: The fees and expenses associated with managing the fund.
By pooling resources and leveraging the expertise of professional fund managers, managed funds offer investors the potential for diversified and strategic investment opportunities.
What kind of returns can you expect?
Expected Returns from Managed Funds
The returns you can expect from a managed fund depend largely on the fund's composition and the performance of its underlying assets. Here’s a detailed overview:
Capital Returns: These are expressed as a change in the value of the fund's units over time. If the value of the underlying assets increases, the value of your investment rises, resulting in capital gains.
Cash Returns: These consist of interest and dividends earned from the assets within the fund. Cash returns are usually reinvested in the fund to buy more units, which can help grow your investment over time.
Types of Assets and Expected Performance
Growth Assets:
Examples: Shares (stocks) and property.
Characteristics: These assets have the potential for higher returns over the long term, but their performance can be more volatile. This means the value of your investment may fluctuate significantly in the short term.
Risk and Reward: Higher risk but potentially higher returns in the long run.
Income Assets:
Examples: Bonds and cash.
Characteristics: These assets generally offer more stable returns and lower volatility. However, the long-term returns are typically lower compared to growth assets.
Risk and Reward: Lower risk and more stable returns, but potentially lower growth over time. Note that the price of bonds can fluctuate, so your capital may not be fully guaranteed.
When can you sell your managed fund?
To get your money out of a managed fund, you must
notify the fund manager that you would like to sell all or part
of your investment. Some fund managers allow same-
day sales, while others have less frequent options.
The fund manager is responsible for ensuring there is
enough money available to pay you when they receive
your request.
To get your money out of an Exchange-Traded Fund (ETF), you must sell your
shares on an exchange (the same way you buy them).
This relies on there being a buyer when you want to sell.
KiwiSaver funds are managed funds.
KiwiSaver funds are a form of managed fund, but with a slightly different set of rules designed to help New Zealanders save money for retirement or a first home.
Exchange-traded funds (ETFs) are a type of managed fund.
They share many of the characteristics of managed funds, but differ in the following ways:
1. They are listed on a regulated market (you can buy into an ETF in the same way you would buy shares).
2. They usually track a market index and are known as a passive investment (providing a market return). This is a simpler fund management strategy, so fees on ETFs are usually cheaper.
3. They tend to be single-asset class funds (for example, shares, property (Real Estate Investment Trusts or fixed income).
US Tax Treatment of New Zealand Managed Invesment Schemes
Investing in New Zealand managed funds can offer attractive opportunities, but it’s essential to understand the U.S. tax implications. By staying informed and seeking professional advice, U.S. taxpayers can make informed decisions and manage their tax obligations effectively.
1. Classification
New Zealand managed funds are generally classified as Passive Foreign Investment Companies (PFICs) for U.S. tax purposes. This classification subjects them to specific tax rules and reporting requirements.
A Passive Foreign Investment Company (PFIC) is a foreign corporation that meets one of two criteria:
1. Income Test: At least 75% of the corporation's gross income is passive income. Passive income typically includes dividends, interest, rents, royalties, and capital gains.
2. Asset Test: At least 50% of the corporation's assets produce passive income or are held for the production of passive income.
The PFIC rules were established to prevent U.S. taxpayers from using foreign investment vehicles to defer or avoid U.S. taxation.
2. Reporting Requirements
U.S. taxpayers with interests in New Zealand managed funds must comply with several reporting requirements:
Form 8621: This form is used to report income from PFICs, including New Zealand managed funds.
Form 3520 and 3520-A: If the managed fund is considered a foreign trust, for example, a KiwiSaver scheme, these forms may need to be filed to report ownership and transactions with the trust.
Form 8938: Highest values of New Zealand Managed funds need to be considered for determining the filing threshold for Form 8938.
Form 8938, also known as the Statement of Specified Foreign Financial Assets, is used to report foreign financial assets, including foreign managed investment funds, if the total value of those assets exceeds the applicable reporting threshold.
3. Taxation of Income
The income from New Zealand managed funds is generally taxable in the U.S. However, taxpayers may be entitled to a foreign tax credit for taxes paid to New Zealand. The tax calculation can be complex, especially if the fund is classified as a PFIC.
There are three methods to calculate income from PFICs as explained below.
1. Excess Distribution Method (Default Method)
2. Mark-to-Market Method
3. Qualified Electing Fund (QEF) Method
4. Professional Advice
Given the complexity of U.S. tax laws and the potential for significant tax liabilities, it is advisable for U.S. taxpayers with interests in New Zealand managed funds to seek professional tax advice. A tax professional can help navigate the reporting requirements, ensure compliance with U.S. tax laws, and develop a tax-efficient investment strategy.
There are three primary methods for calculating and reporting income from Passive Foreign Investment Companies (PFICs) for U.S. tax purposes:
1. Excess Distribution Method
The PFIC Excess Distribution Method is one of the ways to calculate the tax liability for U.S. taxpayers who invest in Passive Foreign Investment Companies (PFICs). Here's a breakdown of how it works:
1. Determine Total Distributions: Calculate the total distributions received from the PFIC during the current year.
2. Calculate the Average Distributions: Add up the total distributions received from the PFIC during the three prior years, divide by three, and then multiply by 1.25.
3. Identify Excess Distributions: Subtract the average distributions from the total distributions received in the current year. The result is the excess distribution for the year.
Example Calculation
Let's say you received $10,000 in distributions from a PFIC this year. Over the past three years, you received $8,000, $9,000, and $7,000, respectively.
1. Total Distributions for Current Year: $10,000
2. Average Distributions for Prior Three Years: ($8,000 + $9,000 + $7,000) / 3 = $8,000; $8,000 * 1.25 = $10,000
3. Excess Distribution: $10,000 (current year) - $10,000 (average) = $0
In this example, there would be no excess distribution for the current year.
Tax Implications
Excess distributions are taxed at the highest U.S. tax rate, and the taxpayer may also be subject to interest charges on any deferred tax liability. This method can result in a higher tax burden compared to other methods, such as the Qualified Electing Fund (QEF) election or the Mark-to-Market election.
2. Mark-to-Market Method
The PFIC Mark-to-Market Method is an optional tax election available to U.S. shareholders of Passive Foreign Investment Companies (PFICs). Here's how it works:
Overview
The Mark-to-Market election allows U.S. shareholders to treat their PFIC investments as if they were sold at fair market value (FMV) at the end of each tax year. This method can simplify tax reporting and potentially reduce tax liability compared to the default PFIC rules.
Key Points
1. Eligibility: This election is only available for PFIC stock that is considered "marketable stock," meaning it is regularly traded on a recognized market.
2. Income Inclusion: Any unrealized gain in the PFIC stock during the tax year is included in the shareholder's income as ordinary income. If the stock has lost value, losses can be deducted, but only to the extent of previously included gains.
3. Basis Adjustments: The adjusted basis of the PFIC stock is increased by the amount included in gross income and decreased by any deductions allowed.
4. Deemed Disposition: When the election is made, it is treated as if the PFIC stock was sold for its FMV on the last day of the tax year. This means that any gains are taxed as ordinary income for the current year.
5. Annual Reporting: Once the election is made, it remains in effect for all subsequent years, and Form 8621 must be filed annually.
Example
Let's say you own shares in a PFIC that are worth $50,000 at the end of the tax year, and your adjusted basis is $30,000. By making the Mark-to-Market election, you would include $20,000 ($50,000 - $30,000) as ordinary income for the year.
Benefits and Considerations
• Simplification: This method can simplify tax reporting by avoiding the complex calculations required under the default PFIC rules.
• Tax Efficiency: It can potentially reduce tax liability by treating gains as ordinary income, which may be taxed at a lower rate than the excess distribution method.
• Compliance: It requires careful tracking of basis, gains, and losses, and timely filing of Form 8621.
3. Qualified Electing Fund (QEF) Method
The Qualified Electing Fund (QEF) Method is an election that U.S. shareholders of Passive Foreign Investment Companies (PFICs) can make to simplify their tax reporting and potentially reduce their tax liability. Here’s how it works:
Overview
The QEF election allows U.S. shareholders to report their share of the PFIC's annual income and capital gains directly on their tax returns, similar to how they would report income from a U.S. mutual fund.
Key Points
1. Income Reporting: By making the QEF election, shareholders report their proportionate share of the PFIC's income and capital gains each year. This includes dividends, interest, and capital gains.
2. Basis Adjustments: The shareholder's basis in the PFIC shares is adjusted annually to reflect the income and gains reported.
3. Avoiding Excess Distribution Tax: The QEF election helps avoid the complex and often punitive excess distribution tax regime that applies to PFICs.
4. Form 8621: To make the QEF election, shareholders must file IRS Form 8621 with their tax return and check the box indicating the election.
Example
Let's say you own shares in a PFIC that has $100,000 in income and $20,000 in capital gains for the year. If you own 10% of the fund, you would report $10,000 in income and $2,000 in capital gains on your tax return.
Benefits and Considerations
• Simplification: The QEF election simplifies tax reporting by treating the PFIC like a U.S. mutual fund.
• Tax Efficiency: It can potentially reduce tax liability by avoiding the excess distribution tax.
• Compliance: Shareholders must ensure they meet the filing requirements and deadlines to maintain the QEF election.