Domestic Mutual Funds Vs. Offshore Mutual Funds

Many investors look abroad for top-drawer fund management.

Many investors look abroad for top-drawer fund management.

A mutual fund allows you to spread your risk among multiple investments and place your capital in the hands of a professional manager. Although thousands of "domestic" mutual funds are based in the U.S., investors can also look offshore for investment opportunities. The Internal Revenue Service is interested in any capital gains or income the fund generates and imposes disclosure rules on offshore companies.

What Offshore Means

An "offshore" mutual fund is based outside of the United States. It pays taxes and reports results according to the revenue laws of its own country and can ignore mutual fund rules set by the U.S. Securities and Exchange Commission. Popular offshore fund domiciles include the Bahamas, the Cayman Islands, Bermuda and the Channel Islands of Great Britain. In these jurisdictions, shareholders escape the payment of local taxes on their gains, as long as they're not local residents.

Local Funds

A domestic fund is based in the U.S. and is subject to SEC guidelines and tax rules set by the IRS. For a potential investor, the main difference between offshore and domestic funds is that domestic funds have stricter disclosure rules. Domestic funds must report their expense ratio -- the percentage of fees they charge shareholders. And the SEC enforces rules on naming conventions, meaning that the name of a domestic fund must indicate its investment strategy. Domestic funds must reveal their portfolio managers and offer a prospectus detailing fund performance and holdings.

Restrictions on Ownership

The SEC prohibits offshore funds from soliciting customers in the United States. In addition, the IRS requires any offshore company with U.S.-based investors to disclose shareholder names and financial information to the agency, a rule that deters many offshore funds from accepting U.S. investors in the first place. However, if a U.S.-based investor can establish an offshore account or business, she has more freedom to invest in other countries. Income derived from the investments -- no matter where it comes from -- is still subject to U.S. taxes on interest income, dividends and capital gains. The only way a U.S. citizen or legal resident can completely escape taxation on foreign-earned income is to remain outside the U.S. for at least 330 days in a tax year.

Taxes and Mutual Funds

If the mutual fund rewards its shareholders with a gain, tax consequences follow. In the United States, federal law requires all mutual funds to distribute capital gains and dividends to investors at least once a year. Even if the shareholder chooses to reinvest that income into new shares, the mutual fund must report the payout and the shareholder will owe taxes on it. Many offshore funds "roll up" or reinvest their gains automatically and are not required to make the annual payouts. Thus, investors only report a single capital gain or loss when they redeem their shares. This is a crucial advantage at tax time and the reason many U.S. investors put their money in offshore mutual funds.

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