Foreign Investors in U.S. Mutual Funds: The Trouble with Treaties

69 Pages Posted: 15 May 2016

Date Written: May 12, 2016


The United States is generally a tax haven for foreign portfolio investors: the United States exempts from tax most U.S. source interest and capital gains, but taxes dividends from U.S. companies; tax treaties generally eliminate U.S. tax on interest and reduce the 30% statutory rate on dividends.

Foreign investors in U.S. mutual funds have not been treated as favorably. Fund distributions (other than of net capital gains) were originally treated as taxable dividends, regardless of the fund’s underlying income. Interest or short-term capital gains earned by the mutual fund — which would have been tax exempt if directly earned by a foreign investor — were converted into taxable dividend income when distributed.

To encourage foreign investment in U.S. mutual funds, Congress in 2004 modified the mutual fund distribution rules to exempt from tax fund dividends that are attributable to the fund’s U.S. source interest income or short-term capital gains. The stated goal of the legislation was to tax foreign investors on the same basis as if they had directly earned their share of a fund’s income.

These provisions fail to fully achieve this goal by denying pass-through treatment for foreign source interest and dividends. This policy appears to be aimed at preventing foreign investors from using a U.S. mutual fund to obtain U.S. treaty benefits.

Foreign source income should retain its source and character when distributed to foreign shareholders. This tax treatment is consistent with the tax results a foreign investor realizes when he or she invests directly or through a partnership and encourages foreign investment in mutual funds that invest globally. The treaty shopping concerns may be illusory. To address potential treaty abuse, Congress could consider limiting the pass- through of foreign source income to treaty residents.

Suggested Citation

Colon, Jeffrey Miguel, Foreign Investors in U.S. Mutual Funds: The Trouble with Treaties (May 12, 2016). Virginia Tax Review, Vol. 35, p. 481, 2016, Fordham Law Legal Studies Research Paper No. 2779233, Available at SSRN:

Jeffrey Miguel Colon (Contact Author)

Fordham University School of Law ( email )

150 West 62nd Street
New York, NY 10023
United States

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