Never mind the obscene secret commissions, bogus bonus units, phony account values, and insidious fee structures.
U.S citizens and green card holders who have been scammed by ILAS products could be in for an even worse surprise: tens of thousands of US dollars in fines (at least) and possibly imprisonment.
The problem arises when ignorant or dishonest financial advisers (i.e., commission-hungry insurance salesman) tell US persons that ILAS policies and investment gains arising within those policies do not have to be reported to the US tax authorities—because ILAS is “life insurance”.
In fact, most ILAS products don’t qualify as life insurance under US law, and even policies that do qualify must still be reported. Failure to report an ILAS account and underlying investment gains could lead to devastating penalties, charges of tax fraud, and ultimately, imprisonment.
Many Chinese Could Be Affected
The word “American” may conjure up images of white people, but in Hong Kong, many Americans are ethnically Chinese and have both US and Chinese citizenship.
In 2009, 60,000 American citizens were estimated to be living in Hong Kong. The number does not include green card holders.
In 2012, the US Census Bureau reported that approximately 220,000 Americans were born in Hong Kong (but not necessarily still living there).
US tax reporting obligations apply not just to Americans, but may also apply to people who are married to Americans.
Advisers Often Misrepresent ILAS as “Tax Efficient”
Advisers promote ILAS as a “tax efficient” investment, but many don’t know what they are talking about. They are not qualified to give tax advice to citizens of their own country, let alone foreign countries. They’re just repeating what they’ve read in policy brochures:
For many nationalities, ILAS is no more tax efficient than an offshore brokerage account. ILAS thus provides no additional tax advantages.
For Americans, ILAS is an unmitigated tax disaster.
Normally, long-term capital gains are only taxed at a rate of 20% or less. With ILAS, gains can be taxed at a rate of 50% or higher.
But that’s not the worst part. The real nightmare comes from the reporting obligations.
For example, if an American owns a portfolio bond, each fund within the policy has to be reported separately on multiple different forms. If the adviser was churning funds in order to generate commissions, each churn necessitates additional tax forms.
Due to the complicated layers of fees and bonuses, currency fluctuations, and lack of information provided by the insurance companies and fund houses, calculating investment gains and losses is nearly impossible for the average person. The US tax authority (the IRS) estimates that one tax form, 8621 for PFICs, takes over 20 hours to fill out. Each fund in a portfolio bond requires its own 8621 form. In order to save time and avoid making mistakes, policyholders are often left with no choice but to hire an accountant, which can cost thousands of dollars or more.
Due to the headache and high costs which are involved, Americans should never invest in ILAS. It is guaranteed to be a money-losing, time-wasting fiasco.
WARNING: Many ILAS brochures advise prospective customers to discuss tax issues with their financial adviser before making a decision. This is dangerous advice. Investors should discuss tax issues with a tax professional—not a poorly-regulated, unaccountable, commission-driven insurance salesman, who might be tempted to lie to close a sale.
The IRS annually publishes a list of “dirty dozen tax scams“. Offshore life insurance is listed every year under “Hiding Income Offshore”.
FATCA Will Expose Those Who’ve Failed to Report
FATCA, the Foreign Account Tax Compliance Act, went into affect on July 1st of this year. All foreign financial institutions, including insurance companies that issue ILAS products, are now required to hand over the account information of their US clients to the US government (unless the accounts have a value of less than $50,000 USD). This means the IRS will soon discover which ILAS policyholders have not been reporting their ILAS policies.
Even if policyholders failed to report because they thought they didn’t need to (because that’s what their so-called financial advisers told them), they will still face severe penalties. They’ll have to pay all their unpaid taxes, interest on the unpaid taxes, and gargantuan fines. They might also be charged with tax fraud.
Lawsuits Already Emerging
This blog post was inspired by the story of an American family that recently sued their adviser for mis-selling them some ILAS products. The case was settled out of court.
Before the case was settled, the family had racked up hundreds of thousands of US dollars in legal and accounting bills. (Their accountant had to prepare nearly 50 separate 8621 forms!) The family still doesn’t know how much they’ll need to pay the IRS in penalties.
The family’s adviser, a British man, had promoted himself as a specialist in tax planning. Unfortunately, neither he nor anyone at his company knew anything about the tax implications of ILAS for Americans. In defending its recommendation to the family, the company admitted that it had sold ILAS to hundreds of other Americans, but it claimed that none of those other clients had any tax problems.
More likely, none of the clients knew they had any tax problems.
As part of the settlement, the family had to sign a confidentiality agreement to never talk about their case again.
The author of this blog obtained a copy of the court documents before the case was settled. At the family’s request, he has agreed to not reveal any specific details about their case.
He has also been in contact with other American ILAS victims and has knowledge of a separate ongoing lawsuit.
If any other American victims find this blog post and want to know more, send an email to Lindell at email@example.com.
ILAS isn’t the only product with punitive tax consequences for Americans. Any fund based outside the US is potentially problematic—including Hong Kong’s MPF schemes. See the comments at the bottom of THIS article.
The crucial implications of FATCA for U.S. Citizens in Hong Kong (Hong Kong Business – July 25, 2013)
“The implications are profound for any U.S. citizen, green card holder or tax resident who has non-U.S. financial accounts or other financial assets, such as life insurance, retirement plans and the like.”
“The failure to comply with [reporting] requirements can have significant, even potentially catastrophic consequences, including potential criminal prosecution for willful violations and substantial civil money penalties.
A willful FBAR violation can result in a penalty of 50% of the balance of any unreported account(s) per year, and the IRS is increasingly aggressive about this penalty. Even non-willful conduct can result in substantial monetary sanctions, and the assessment of tax and interest.
FATCA will largely eliminate bank secrecy for Americans worldwide and enable the IRS to engage in computerized matching of FATCA-compelled data against the IRS’s database of tax and other filings. Where the information does not match, the taxpayer is at risk for a civil examination or even a criminal investigation.”
Handling New IRS Foreign Reporting Requirements Without Doing Jail Time (Forbes – March 6, 2011)
“The penalty for failing to file an FBAR is $10,000 for each non-willful violation. If you willfully did not file an FBAR, the penalty can be much higher: the greater of $100,000 or 50 percent of the amount in the account for each willful violation. Plus, each year is treated separately. The $10,000 threshold for FBAR reporting is in the aggregate, not per account.”
“Here’s the problem with these foreign pension plans. If the IRS says your plan doesn’t qualify, annual income inside the plan is therefore taxable. This means you probably haven’t reported some foreign income each year. You inadvertently triggered the need for the IRS voluntary disclosure compliance program. That regime of penalties is very stiff and to be avoided whenever possible.”
A foreign accounting quagmire
“Deciding to come clean and enter the IRS voluntary compliance program isn’t easy, but it may be the easier part. It can be a nightmare to figure out the accounting and tax treatment when reporting the hidden income, gains and losses.”
“If you haven’t reported both foreign accounts and income deposited or earned in those accounts, consider joining the IRS voluntary compliance program. By doing so you may get to keep a small or large fraction of your offshore money and avoid criminal prosecution. Plus, you will sleep better at night.” [Note: This article is a bit dated. The IRS modified its voluntary disclosure program in June 2014. See article below.]
Life in a Post-FATCA World (Cross Border Planning – Sept. 2014)
“FATCA is indeed a game changer. In the past, when some overseas Americans were confronted with their non-compliance, they would question, “how will the US Internal Revenue Service (IRS) know”? FATCA now provides a clear answer.”
“Now is the time for those faced with non-compliance to address their situation no matter if that involves non-reporting of bank accounts or other financial assets or not filing past tax returns. Especially now that on June 18, 2014, the IRS has modified the Offshore Voluntary Disclosure Program (OVDP) and the streamlined filing compliance procedures. These changes are intended to ease the burdens and help taxpayers come into compliance.
One thing remains constant in the face of so much change; it is always better to come forward and into compliance than to be found out and receive demands from the IRS.”
PFIC, FBAR, FATCA (Mark Plummer, Acuma Hong Kong Ltd. – Sept. 11, 2014)
“As of July 1, 2014, pretty much all financial institutions including banks and insurance companies will report either directly to the US government or indirectly via their own government, all accounts in the name of US Persons over US$50,000.
There are estimated to be about 7 million US citizens residing abroad and it is a criminal offence not to file an annual tax return even if you owe nothing. One estimate is that only 7% of these are filing. That’s 6.5 million non compliant!”
“If you invest in any non US Investment Fund or offshore insurance bond or regular savings plan, then that will qualify as a Passive Foreign Investment Company (PFIC) and these are taxed at income tax rates plus penalty interest rather than the less punitive capital gains tax rates with mountains of paperwork for reporting and whilst in the past, you might have hidden it, not anymore will that be possible unless it’s below $50,000 and even then, some financial institutions will just play safe and report every dollar.”
US Tax Disaster – Offshore Funds, Life Policies, Portfolio Bonds (AngloInfo – April 23, 2012)
“Many American investors are confused by sales pitches of expat investment advisors who are unfamiliar with US tax laws. While it is true that no tax may be payable in the fund’s jurisdiction (Isle of Man, Guernsey or the UAE, for instance), significant US taxes are payable by the American owner. Confusion abounds when Americans invest in foreign mutual funds, life policies, savings plans, portfolio bonds and similar fund arrangements as compared to when they invest in US-based funds.”
“According to Vince Truong, a U.S. CFP® with Holborn Assets in Dubai, the investment that is most often touted by advisors, and which should cause the most concern for US taxpayers, are regular savings plans marketed as an alternative form of pension. “These are not pensions but rather a contractual form of investing where the client is putting aside monies on a monthly, quarterly or some regular frequency, which then are invested into a variety of mutual funds.””
“A US investor in a PFIC must file various information and tax forms (e.g., Form 8621, Form 8938, FBAR). Record-keeping and preparation time for the Form 8621, alone, is extremely complicated and a separate Form must be filed for each PFIC owned. The IRS estimates that the time required with regard to Form 8621 for each PFIC investment is at 22 hours per year! The tax preparation costs may certainly outdo the value of the investment. To avoid possible penalties, the investor should examine the proper tax treatment and filings with a tax professional.
Just in case a taxpayer thinks of ‘ignoring’ the rules regarding self-reporting on PFICs, please note that under new tax legislation commonly referred to as FATCA, commencing 2014, ”foreign financial institutions” will be required to report directly to the IRS about assets held by US persons with that institution. The FATCA rules will make it very easy for the IRS to cross-reference the information provided by the foreign financial institution with the taxpayer’s Form 8621 to determine whether taxes and reporting on the foreign fund have been properly undertaken.”
U.K. 101% Life Policies-Lump Sum or Savings – Tax and Reporting Problems and Tax for Americans (cfo2go – Oct. 31, 2012)
“U.S. Persons who Purchased a Retirement Plan, Savings Plan issued from the Isle of Man, Dublin, Guernsey or U.K. Life Insurance Company are holding a British Style Life Policy (lump sum or savings plan) which requires annual reporting as a PFIC and suffers annual taxes on the growth of 36.9% and huge annual penalties if not reported. The “U.K. Style Financial Advisor who sold thousands of these products had their clients sign a disclaimer that it is not a IRC 7702 or IRC 72 – BUT, they did not tell the customers “WHAT IT IS!”
It is a Passive Foreign Investment Company (PFIC)
The IRS knows what it is and will find U.S. Persons who have those policies because:
The Isle of Man, Dublin, Guernsey and all of the United Kingdom have signed an agreement to notify the IRS of all their U.S. clients and quite frankly the IRS knows what a U.K. Style 101% policy is; a British IFA Offshore Investment Products.”
American Expats: Don’t Get Caught by U.S. Tax Rules on Foreign Investments (Creveling & Creveling – April 10, 2013)
“Unlike U.S.-incorporated mutual funds, where capital gains are deferred until realized and which are subject to preferential long-term capital gains rates, PFICs are subject to a particularly punitive taxation regime by default (unless you actively choose the “mark-to-market” accounting method outlined below).
- All distributed income is taxed as ordinary income at the highest ordinary federal tax rate (currently 39.6%).
- Capital gains are converted to ordinary income and taxed at the highest current tax rate (currently 39.6%), regardless of your marginal tax rate.
- Deferred gains, which are basically undistributed unrealized gains, are subject to a special non-deductible penalty interest charge that is compounded over the deferral period.
As a result, annualized tax rates on PFIC income can exceed 50% or more.”
I have a client with an “Off Shore” insurance policy. Is it a PFIC? (LinkedIn Forum – Feb. 2, 2012)
Offshore insurance policy tax treatment (Fairmark Forum – Apr. 26, 2010)