Why your ISA is a US tax problem

Figures relate to tax year 2025 (US) · 2025-26 (UK)

Every UK financial adviser gives the same good advice: use your ISA allowance. For an American in the UK, following it can be one of the more expensive things you ever do — not because the ISA is bad, but because the IRS does not recognise it and treats what is inside it harshly.

The wrapper means nothing to the IRS

An ISA is a UK tax wrapper. The US has no equivalent concept and simply looks through it to the assets inside. Interest, dividends and gains that are invisible to HMRC are ordinary taxable income to the IRS, reported annually on your 1040 whether you withdraw anything or not.

For a cash ISA, that is mildly annoying: you pay US tax on interest that the UK ignores, usually offset by foreign tax credits from elsewhere. For a stocks-and-shares ISA, it gets considerably worse.

Enter the PFIC rules

Nearly every UK-domiciled fund, ETF and investment trust meets the US definition of a passive foreign investment company. The PFIC regime was written to stop Americans deferring tax through offshore funds, and it is deliberately punitive.

Under the default treatment, gains and large distributions are spread back across your entire holding period, taxed at the highest ordinary rate in force for each of those years, with an interest charge on top for the deferral. Hold a fund for a decade and the effective rate can consume the majority of the gain. There is no long-term capital gains rate here, and no allowance.

The wrapper is tax-free in one country and the contents are penalised in the other. It is the purest example of two systems that were never introduced.

The alternatives, and why they rarely help

• A qualified electing fund election gives near-normal treatment, but requires annual statements UK retail funds almost never produce.
• Mark-to-market is available for regularly traded holdings and taxes each year's paper gain as ordinary income — better than the default, still not good.
• Each fund needs its own Form 8621 each year, so a diversified portfolio becomes a stack of forms.

What to do instead

The durable answer is to hold assets that are not PFICs. Direct shares are fine — including inside an ISA. US-domiciled funds are fine, though UK platforms rarely offer them to retail investors. A UK pension is the notable exception where funds are generally protected by the treaty, which makes pension contributions unusually attractive for Americans in the UK.

If you already hold PFICs, do not panic-sell. The tax cost depends on gain, holding period and which regime applies, and staging disposals across tax years is often materially cheaper than one exit. Get the number first, then decide.