UK Financial Products that causes headaches to American citizens - Bonds, VCTs, EIS, SEIS

Most British advice to expats in the UK is inherently “UK-centric,” designed for individuals whose tax obligations begin and end with HMRC. This presents a significant disconnect for US citizens, who remain firmly tethered to the Internal Revenue Service (IRS) tax reporting requirements on their worldwide income and assets. Consequently, popular and seemingly straightforward UK financial products can transform into administrative nightmares and unexpected tax traps for Americans, leading to costly mistakes if not approached with a deep understanding of both jurisdictions’ tax rules and cross-border advice. Look at the rest of our site for views on ISAs.

Let’s explore some UK financial products and the unique challenges they present to Americans.

The PFIC Predicament: A Central Concern

The anchor for most headaches is the Passive Foreign Investment Company (PFIC) regime. This punitive US tax regime is designed to discourage US persons from deferring US tax on passive investment income earned through certain non-US entities. The core issue is that many standard UK investment vehicles, which are perfectly normal and tax-efficient for UK residents, are treated as PFICs by the IRS.

When a US person holds an interest in a PFIC, they are subject to complex and often unfavourable tax treatment, including:

Excess Distributions: Distributions from a PFIC are generally taxed at the highest ordinary income tax rate in effect for the year, plus an interest charge to “compensate” the US government for the tax deferral.
Mark-to-Market Election: While an election can sometimes be made to mark the PFIC to market annually (taxing unrealized gains as ordinary income), this adds complexity and can lead to significant annual tax liabilities even without distributions.
Complex Reporting: Owning a PFIC necessitates filing Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” which is notoriously complex and time-consuming.

Probably the largest drama for US Citizens with PFICs is the annual reporting administration.

PFIC Reporting

The reporting obligations for Passive Foreign Investment Companies (PFICs) are complex and burdensome for US citizens. The primary vehicle for this reporting is IRS Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.”

Here’s a breakdown of the key reporting obligations and what US taxpayers need to know:

1. Who Must File Form 8621?

Generally, a US person (which includes US citizens and green card holders, regardless of where they live) who owns shares, directly or indirectly, in a PFIC must file Form 8621. This applies in several scenarios:

Direct or Indirect Ownership: If you directly own shares in a PFIC. Indirect ownership also counts, for example, if you own a foreign partnership that holds PFIC shares, or if your PFIC is held through another non-US entity or account (like a UK investment bond that invests in collective funds).
Receiving Distributions: If you receive any direct or indirect distributions from a PFIC.
Recognising Gain on Disposition: If you recognise a gain on the direct or indirect disposition (sale, exchange, or other transfer) of PFIC stock.
Making Elections: If you are reporting information with respect to a Qualified Electing Fund (QEF) or a Section 1296 Mark-to-Market election (more on these below).
Meeting Thresholds: Even if you don’t receive distributions or dispose of shares, you generally must file if the aggregate value of all your PFIC holdings exceeds certain thresholds. For single filers or married filing separately, this is typically $25,000 at year-end or $50,000 at any time during the year. For married filing jointly, it’s $50,000 at year-end or $100,000 at any time during the year. For US persons living abroad, these thresholds are higher: $200,000 ($400,000 for joint filers).

2. When and How to File

Annual Filing: Form 8621 must be filed annually with your federal income tax return (e.g., Form 1040 for individuals).
Separate Form for Each PFIC: This is a critical point of complexity. You generally need to file a separate Form 8621 for each individual PFIC you hold. There is no aggregation allowed for different PFICs, even if they are held in the same account or through the same wrapper. So, if you hold a UK investment bond that invests in three different collective funds, and each of those funds is a PFIC, you could potentially need to file four Form 8621s (one for the bond itself if it’s considered a PFIC, and one for each underlying PFIC).
Attachment to Tax Return: Form 8621 is attached to your primary tax return (Form 1040, etc.) and is due by the same filing deadline, including extensions.
No Income Tax Return Requirement: If you are not otherwise required to file an income tax return for the year, you may still need to file Form 8621 directly with the IRS Service Centre.

3. Information Required on Form 8621

The form itself is multi-part and requires detailed information:

Part I: Shareholder Information: Your personal details and identification of the PFIC (name, address, country of incorporation, EIN if any).
Part II: Elections: This is where you declare which (if any) election you are making to mitigate the punitive default PFIC tax rules. The three main options are:
- Qualified Electing Fund (QEF) Election: This is generally the most favourable election if available. It allows you to include your pro-rata share of the PFIC’s ordinary earnings as ordinary income and its net capital gains as long-term capital gains on your US tax return each year, regardless of whether you receive a distribution. This avoids the punitive excess distribution rules. Crucially, to make this election, the PFIC must provide you with an annual information statement with the necessary tax data. Many UK funds do not provide this.
- Mark-to-Market (MTM) Election: This election is available for “marketable stock” (generally, stock traded on a regulated market). It allows you to include in gross income any increase in the fair market value of the PFIC stock at year-end over its adjusted basis. Any decrease is generally deductible as an ordinary loss, but only to the extent of previous mark-to-market gains. This also avoids the excess distribution rules, but you’re taxed on unrealised gains.
- Excess Distribution Method (Default): If neither a QEF nor MTM election is made (or can be made), this is the default and most punitive method. Under this method, “excess distributions” (which include most distributions and all gains on disposition) are allocated ratably over the period you held the PFIC. The portion allocated to prior years is taxed at the highest ordinary income tax rate for those years, plus an interest charge. The portion allocated to the current year is taxed at your ordinary income rate.
Part III: Income from a Qualified Electing Fund (QEF): If you made a QEF election, this section reports your share of the PFIC’s ordinary earnings and net capital gains.
Part IV: Mark-to-Market Election: If you made an MTM election, this section details the gain or loss recognised.
Part V: Gain on Disposition or Excess Distribution: This section is used to report gains from the sale of PFIC stock or to calculate the tax and interest charge on excess distributions under the default method.
Part VI: Summary of Annual Information: General information about the PFIC.

4. Penalties for Non-Compliance

While there isn’t a direct monetary penalty specifically for failing to file Form 8621 in the same way there are for FBAR or Form 8938, the consequences can be severe:

Indefinite Statute of Limitations: The most significant consequence is that your entire tax return for that year remains open indefinitely for audit by the IRS. Normally, the IRS has three years to audit a return. However, if Form 8621 is not filed when required, the statute of limitations for that tax year does not begin to run with respect to the PFIC and any tax liability related to it. This means the IRS can come back years later to audit and assess taxes, interest, and other penalties.
Higher Tax Liabilities: If PFIC income or gains are discovered during an audit, they will be subject to the punitive excess distribution rules by default, leading to significantly higher tax bills and interest charges than if proper elections were made.
Difficulty in Making Elections: If you fail to make a QEF or MTM election in the first year of PFIC ownership, making a “late” election often requires a “purging election,” which can trigger a deemed sale of the PFIC and immediate taxation under the excess distribution rules.
Increased Audit Risk: Failure to file required international information returns like Form 8621 can flag your tax return for increased IRS scrutiny and a higher likelihood of an audit.

5. Importance of Record Keeping

Taxpayers must maintain accurate records of their PFIC investments, including:

Purchase dates and cost basis.
Fair market value at year-end.
All distributions received.
Any PFIC Annual Information Statements (if a QEF election is desired).

Given the complexity and the severe consequences of non-compliance, it is highly advisable for US citizens with any foreign investment accounts or products to consult with a US tax professional specialising in international taxation. They can help identify potential PFICs, determine reporting obligations, advise on appropriate elections, and ensure proper compliance with US tax law.

UK products caught in the PFIC net

1. Onshore and Offshore Investment Bonds (Single Premium Investment Bonds/Capital Redemption Policies)

What they are: These are typically single-premium life assurance contracts, often referred to as “investment bonds” in the UK. Life insurance companies offer them and are popular for their tax-efficient growth within the UK, allowing investments to grow largely free of immediate UK income or capital gains tax until a chargeable event (like a withdrawal exceeding certain limits or maturity/surrender). They can hold a variety of underlying investments. “Onshore” bonds are issued by UK-resident life companies, while “offshore” bonds are issued by non-UK resident companies (often in jurisdictions like the Isle of Man or Dublin).

Issues for Americans in the UK: Both onshore and offshore investment bonds are almost universally treated as PFICs for US tax purposes. The underlying investments within the bond are generally disregarded by the IRS; instead, the bond itself is viewed as a foreign corporation holding passive assets. This means:

PFIC Reporting: US holders will likely need to file Form 8621 annually.
Adverse Tax Treatment: Any gains, whether from withdrawals or ultimately surrender, will be subject to the punitive PFIC tax rules, often leading to significantly higher tax liabilities than anticipated and an interest charge. The UK’s tax deferral benefit is entirely negated for US tax purposes, and the tax treatment is far worse than if the underlying assets were held directly.
Loss of UK Tax Benefits: The UK’s tax-efficient wrapper is effectively ignored by the US, making these bonds highly inefficient for Americans.

2. Collective EIS (Enterprise Investment Scheme) and VCT (Venture Capital Trust) Schemes

What they are: These are UK government-backed schemes designed to encourage investment in smaller, higher-risk trading companies by offering generous tax reliefs to UK investors.

EIS: Investors directly subscribe for shares in qualifying unquoted companies and can receive income tax relief, capital gains deferral, and capital gains exemption on disposal (after a holding period).
VCT: These are companies listed on the London Stock Exchange that invest in a portfolio of qualifying smaller companies. Investors receive income tax relief on new shares, tax-free dividends, and tax-free capital gains.

Issues for Americans in the UK: Despite their attractive UK tax benefits, collective EIS and VCT schemes are almost always considered PFICs for US tax purposes.

Collective Nature: The “collective” aspect is key here. While direct investment in a single qualifying EIS company might avoid PFIC status if the company is actively trading and not itself a passive entity, the structures that pool investments across multiple EIS companies or the very nature of a VCT (which is essentially an investment company) will trigger PFIC treatment.
PFIC Reporting and Taxation: As with investment bonds, holding shares in a collective EIS fund or a VCT will necessitate complex PFIC reporting and expose any gains or distributions to the punitive PFIC tax regime, effectively nullifying the intended UK tax advantages for US persons.
Limited Utility: The primary benefit of these schemes for UK residents is tax efficiency, which is completely eroded for US taxpayers due to PFIC rules. This makes them largely unsuitable for Americans, despite their popularity among UK investors.