Question about mutual funds, capital gains tax and foreign investment for CPA types

[Chuck Bao]

I understand that if you sell mutual fund units and make a profit, you are subject to a capital gains tax when you file your own personal income tax (assuming that it is not part of an IRA or 401k plan).

My question is whether the mutual fund (and in this case, we are assuming they did quite well, allowing you to make profit on selling your units) had already paid a capital gains (or profits tax) when the fund sold the shares or instruments in the fund’s investment portfolio. Is this right? In effect, are you paying capital gains taxes twice, or am I missing something here?

Okay and what if you were investing in a developing market fund and that particular developing market fund was investing in a foreign country that has a double taxation treaty with the US and one of the provisions of the tax treaty is that capital gains earned on trading shares in a market in that particular country are not subject to capital gains taxes.

Does the US-based fund then not have to pay capital gains tax in the US? Then why would you need to pay capital gains tax on profits on selling the fund. Or if you still have to, then why not invest directly and skip out on the capital gains tax altogether?

My accountant has never heard of double taxation treaties with foreign governments involving capital gains. And, double taxation treaties should be public information.

I understand that tax loopholes shouldn’t be advertised. But, surely someone can clarify this issue.

[CtheB]

I don't believe that a mutual fund is a taxpaying entity, just merely a consortium of investors. The fund itself does not pay tax, but distributes its earnings to its individual investors, who bear the tax. The earnings are distributed net of the fund manager's expenses.

I think this should answer all of your questions.

As for foreign taxes, the mutual fund merely invests in foreign stocks that pay foreign dividends. Many countries require there to be a withholding of the country's tax on the earnings derived in that country, hence the foreign tax you see reported on your 1099.

As a US citizen, you are required to pay report your worldiwide income to the IRS (generally), regardless of where it is earned. You are then allowed a credit against your federal income tax for the tax paid to the foreign country on same earnings.

Let me know if this is still not clear.

[Chuck Bao]

I don't believe that a mutual fund is a taxpaying entity, just merely a consortium of investors. The fund itself does not pay tax, but distributes its earnings to its individual investors, who bear the tax. The earnings are distributed net of the fund manager's expenses.

I think this should answer all of your questions.

As for foreign taxes, the mutual fund merely invests in foreign stocks that pay foreign dividends. Many countries require there to be a withholding of the country's tax on the earnings derived in that country, hence the foreign tax you see reported on your 1099.

As a US citizen, you are required to pay report your worldiwide income to the IRS (generally), regardless of where it is earned. You are then allowed a credit against your federal income tax for the tax paid to the foreign country on same earnings.

Let me know if this is still not clear.

It does answer most of my questions. Thanks CtheB.

It also helps explain why hedge funds, being totally free from tax on trading gains, can be so aggressive. May be the unintended side effect is channeling money into higher yield and more risky investments.

Do you have any idea about double tax treaties?

[SoonerAcesUp]

From what I know about mutual funds:

Most mutual funds have capital gains distributions that are reported to you on your 1099s. For the most part, these capital gain distributions are reinvested into the fund to buy more shares of the mutual fund so you never really see this money other than to buy more shares. When you sell the mutual fund itself you should add to your original cost basis whatever capital gain distributions that were reinvested. Dividends from mutual funds usually work much the same way.

[CtheB]

The United States does have a number of tax treaties with foreign governments, but generally these treaties apply to specific types of transactions and yes, many of them are intended to avoid the double taxation of a transaction.

[Chuck Bao]

So, is there an online source about these tax treaties? Because I can't find anything.

And, would you know if these treaties have a time limit? Like 5 years or 50 years or until declared void.

I remember writing 20 years ago about the attractiveness of the Thai stock market and that Americans don't have to pay capital gains tax due to the tax treaty.

As an aside, there are a lot of treaties between the US and Thailand. During the Vietnam War, Thailand signed a special treaty giving US citizens the right to own property in Thailand. No other nationality has been given this right. And, it's not well publicized.

I'm not even sure it would hold up in Thai court. Thailand has had about 10 new constitutions written since then and with the supreme law of the land re-written so many times, I'm not so sure about the validity of previous treaties. It's all a bit dodgy and murky.