Because of the many devastating rulings issued by the National Futures Association in Rule 2-43 that eliminated hedging, limit orders, open and closing positions and replaced with OCO (One Cancels the Other) and FIFO, first lot in must be the first lot out, many traders are bailing out of their United States accounts and heading to what they feel are greener pastures overseas because other nations are not mandated by rulings of the National Futures Association. This means traders are able to hedge, use limit orders, use stop loss and trailing stops, use open and close positions. All traditional trading would remain the same. While many traders appear to have made an emotional judgement, I thought focusing on the tax implications for accounts held in the United Kingdom, specifically England would be quite informational. Please note the following information was derived from extensive research by a researcher, trader and not a tax advisor.
Because the United Kingdom has a Double Taxation Agreement with the United States and 100 other nations, United States residents are exempt from paying capital gains taxes twice. Instead Capital gains taxes are paid once to the resident nation, the United States. The key to the agreement is Article 23 where tax avoidance is available to “qualified persons”. In the eyes of United States tax law, a “qualified person” can be considered a Limited Liability Company. So for those that trade under an LLC, this is legal and accepted by the United States and treated the same as if the account were held in the United States. This agreement was agreed in 2002 and enforced in March 2003 with a renewal in 2009.
To further determine residency and non residency for tax liability in the United Kingdom, IR 20 forms have been replaced by Her Majesty’s Revenue and Customs Office forms 6, HMRC 6. Two important aspects is you don’t pay capital gains on foreign currency for personal use outside the U.K. and further to Article 23, capital gains are excluded from Gilt purchases. Gilts are the equivalent to our Treasury Bonds. For U.S. residents, the United States taxes its residents based on their worldwide income so U.S Citizens are exempt from any Certificate of Overseas residence demanded by the U.K.
Instead the IRS may ask traders to file Form 6166, a residency certification.
It is assumed that traders will denominate their currency trades in United States Dollars. This is not mandated upon the trader. Traders can denominate their trades in any currency as they desire. If a trader for example denominates their trades in British Pounds, conversion to United States Dollars would be converted based on an average daily spot rate according to HMRC. The IRS and HMRC assumes traders will use the yearly average rate.
The most important of all forms to be filed is the Report of Foreign Bank and Financial Accounts, known as FARB. This falls under the purview of U.S. Code Title 31. To file a FARB, traders must file TDF 90-22.1 especially if the account has or will transfer $10,000 and above. This form must be filed by June 30th of the following year or when the account has met the $10,000 threshold. No extensions are permitted.
This form is a separate document from normal tax forms and must be sent to the Department of the Treasury in Detroit Michigan and declared on IRS form 1040. Failure to file TDF 90-22.1 can result in civil penalties and /or criminal prosecution with a maximum of 5 years in jail. For example, a negligent violater will be assesed up to $500, non willful violations can cost up to $10,000 for each violation, patterns of neglect can cost no more than $50,000 and willful violations can cost a trader up to $100,000 or 50 percent of the account. TDF 90-22.1 records must be maintained for 5 years. Failure to do so can result in criminal and civil penalties. According to USC 31 531405, flagrant violations of these rules can cost a trader a penalty in excess of their account. For a husband and wife whose names are joint on the account, only one TDF 90-22.1 form item 14, Part 3 needs to be filed.
In the eyes of the IRS, how do you know when you achieved the $10,000 threshold.
Calculate the maximum value of the account based on the last quarterly statement or the highest value during the year. If a different denomination of currency other than U.S. Dollars is used, use the exchange rate at the end of the year. The $10,000 figure is derived from the 1971 Bank Secrecy Act. Civil and criminal penalties have strengthened in recent years with Anti Money Laundering and Patriot Act laws due to the focus on terrorism and unlawful criminal dealings by major actors.
Questions of Power of Attorney must be addressed in the FARB document as well. Suppose two American citizens engage in a power of Attorney arrangement where an American grants Power of Attorney over another account. Both must file a FARB report.
Those that wish to trade under an LLC, a FARB report must be filed because the United States recognizes an LLC as a “person”, a U.S. citizen. This person qualification is in line with the Double Taxation Agreement agreed to with the UK’s version as a “qualified person.” Further, a person, a U.S. Citizen according to IRS publication FS 207 issued February 07 states a person is a partnership, corporation, estate or trust. This includes Sub Chapter S Corporations.
Sub Chapter S Corporations are legal entities that can be used to trade overseas accounts. No tax on income for Sub Chapter S Corporations. Instead, income, losses and credits are passed to shareholders. Form 1120S are the official forms for filing returns on Sub Chapter S Corporations. Shareholders must file Schedule K-1 1120S.
Partnerships are not taxable entities. Income, gains, losses and credits are passed through to the partners according to IRS publication 541. Returns are filed on K-1. Gains are reported on Schedule D, IRS Form 1040 while ordinary income is filed on Schedule E, Form 1040. A husband and wife can elect, if they file a joint return, to form as a qualified joint venture instead of a Partnership. Each must file separate on Schedule C or Schedule C-EZ on form 1040.
What if a trader holds positions for long periods and earns carry interest. US Company 2002 Forms SI 2002 is used by U.S. companies, mutual funds, pensions or trusts receiving interest from the U.K.. For filing purposes, traders must attach IRS form 6166, an exclusion from taxes form and fill out Parts A and B, Part C, Part F then claim full relief from taxes.
Capital gains and losses are treated just as they were in prior years for U.S. tax purposes. Gains and losses are reported on Schedule D, Form 1040 but transferred to line 13 on the 1040 form. More information can be found in IRS Publication 550. Publication 505 says you must estimate your taxes if you still owe for the prior year. Currently, 2008 capital gains tax rates are 0, 15 %, 25%, and 28 %. Losses can be deducted up to $3,000, $1500 if filing separately. But we are addressing currency trades and the old 988 and 1256 elections. This point has been debated endlessly by the best of tax professionals but still without resolution. The IRS allows for less than a $200 gain in foreign currency transactions is not report able. Over $200 is the threshold of reporting.
Another debate able question is should currency traders file IRS form 255, foreign earned exclusion forms. The speculative answer is no because we are not earning capital gains by sale of houses, properties and dividends from foreign stocks or some tangible asset.
The next question is are U.S. citizens subject to Non Resident Alien taxes in England, HMRC Form P85. The speculative answer is no due to treaty obligations. Then are U.S. citizens subject to Stamp Taxes. If currency traders were bond or stock investors, the answer would probably be yes.
One aspect of vital importance is the speculation that President Obama’s 2010 budget calls for the strengthening of foreign reporting and strengthening of brokers. Will this pass? Don’t know.
In the end, currency traders are subject to the same taxing standards as well as the ability to trade the markets as they desire.
July 2009 Brian Twomey
Brian Twomey is a currency trader and Adjunct college Professor of Political Science at Gardner-Webb University.