The obligation for registered investment companies (RICs) to pay foreign capital gains tax is not new by any means, but it is gaining more attention lately, making it imperative for fund management to take note.
Foreign tax withholding on interest and dividends has been and continues to be the responsibility of the fund custodian, monitoring and remitting taxes based on a specific country’s legislation. Foreign capital gains tax, on the other hand, traditionally has been the responsibility of fund management. The custodian is not responsible for tracking tax basis of investments; therefore, it does not have the information to appropriately pay the foreign capital gains tax.
However, fund management may find it challenging to determine the amount of tax due and actually remit it to the appropriate taxing authority, as many foreign countries previously did not enforce foreign capital gains tax obligations. As a result, many do not have a means by which these taxes can be remitted — meaning having an office in charge of collection or forms to submit — making the administrative aspect of paying the tax a challenge. Consequently, paying the foreign capital gains tax often falls pretty low on the priority list for many funds. But lately, many foreign countries with the tax in place are viewing it in a different light, seeing it as an untapped and much-needed source of income. As such, the risk of being penalized is increasing for funds not paying their fair share.
The consequences of non-compliance may seem rather innocuous considering there often is no means to pay the tax, or the tax is not monitored closely by the country in question. But as foreign countries continue to look for new sources of income, coupled with technological improvements to help track the tax and the variation in statute of limitations, a fund could find itself open to multiple years of potential taxation. While the dollar value in question may seem paramount to identify, the impact on shareholders’ net asset value could have greater ramifications depending on when the gains occurred and the shareholders associated with those transactions.
Funds that invest outside of the U.S. who want to minimize their exposure need to monitor capital gains throughout year, not just at year-end. Here are some best practices to follow:
On at least a quarterly basis, look at the list of countries in which the fund is invested. Conduct a country-by-country analysis and determine if the country has a foreign capital gains tax, its rate, etc. Just a few of the countries with foreign capital gains tax exposure include Argentina; Czech Republic; Dominican Republic; India; Finland and Portugal (investment in “land rich” companies only).
Assess tax obligations based on the sum of current capital gains tax exposure – including realized and unrealized gains. Even though tax may not be owed today, if a fund has unrealized gains in the portfolio, it must recognize the related tax liability in the form of an accrual on the financial statements.
Evaluate exposure for all open tax years. Open tax years or statute of limitations vary from country to country, but generally look back two to five years.
Document, document, document! Documentation related to foreign capital gains tax exposure is very important. Understanding and properly reporting the uncertain tax position of the fund is imperative to present accurate financial statements.
American Depository Receipts are not necessarily exempt. Be aware that while many countries provide an exemption for American Depository Receipts (ADRs), not all countries have this exemption in place.
If your fund is investing in foreign markets, securities and even ADRs, taking the time to fully assess the potential for foreign capital gains tax is a must. Financial implications aside, net asset value errors can create a major administrative headache for management. Steps taken should be documented in the Accounting Standards Codification Topic 740 Accounting for Income Taxes (ASC 740) analysis to help ensure all uncertain tax positions have been identified by the fund.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.
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