Foreign Pension In 2024–The Latest On U.S. Taxes And What You Need To Know
There is confusion for many U.S. taxpayers about the reporting requirements for foreign pension plans. The IRS has posted information regarding The Taxation of Foreign Pension and Annuity Distributions. But, the average taxpayer still has difficulty comprehending and understanding the content available. Comparable to many other tax laws affecting U.S. taxpayers abroad, the reporting requirements are complex. And, the penalties for failure to comply can be harsh.
Participation In A Foreign Pension
U.S. taxpayers who participate in a foreign pension plan are subject to additional reporting requirements on their U.S. income tax return and FinCEN Form 114 (the FBAR), if applicable. A foreign pension is generally the establishment and management of any retirement plan outside of the United States. There is typically an employer-employee relationship, through which each contributes at a set rate.
However, some countries offer their residents the ability to participate in a retirement plan where the only contributor is the owner. These are personal or private pensions. A foreign pension plan does not include ‘Social Security’ type program benefits provided by a foreign government. Those Americans and U.S. taxpayers living abroad and foreign persons moving to the U.S. who are participants in a foreign pension should ensure compliance with all reporting requirements.
Many Americans participate in qualified retirement plans prior to moving abroad or at least understand the basic U.S. tax implications that apply to those plans. U.S. retirement plans typically enjoy many benefits, such as tax-free contributions, deferral of accrued income within the plan, ability to roll over the funds in a tax-free transaction, and reduced reporting requirements for the participant. Many Americans abroad assume their foreign pension qualifies for the same benefits. However, this is not necessarily the case.
Guidance from the IRS regarding the taxation of foreign pensions is not abundant. Still, after a close examination of past rulings and the internal revenue code, the conclusion among many is that the IRS will view a foreign pension as a trust. The definition of a trust under the internal revenue code is “an arrangement if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit”. The next determination is whether or not the trust qualifies as an exempt trust for U.S. tax purposes.
Are Foreign Pensions Taxable In The US?
Only U.S. qualified plans are eligible for the tax benefits under the Internal Revenue Code (IRC). The plans must meet specific requirements listed in Section 401 of the IRC to be eligible as an exempt trust. The main requirement relevant for those participants in a foreign country, among others, is that that trust is “created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries.” This requirement of being created or organized in the United States will prevent any foreign pension from gaining exempt status using this part of the code.
Also, the plan must satisfy minimum participation standards and nondiscrimination requirements. In general, these standards require that the plan must pass one of the following tests:
- The plan benefits at least seventy percent of the employees who are not highly compensated (percentage test).
- Plan benefits a percentage of non highly compensated employees. At least 70 percent of the percentage of highly compensated employees benefiting under the plan (ratio test).
- The plan must benefit a classification of employees that does not discriminate in favor of highly compensated employees. And, the average benefit percentage of the non-highly compensated employees must be at least 70 percent of the average benefit percentage of the highly compensated employees (average benefit percentage test).
Highly Compensated Employee
The term highly compensated employee generally means “any employee who was a five-percent owner at any time during the year or the preceding year. Or for the preceding year had compensation from the employer above $80,000 (adjusted for inflation 2017 – $120,000), and if the employer elects the application of this clause for such preceding year, was in the top top-paid group of employees for such preceding year.”
These standards apply to plans created or organized in the United States. But, will be relevant when determining if a foreign pension qualifies for partial benefits (discussed later).
There are additional rules and requirements a pension plan must meet to satisfy Section 401(a) requirements and qualify for exempt status. Some of these major requirements are:
- Limitations on contributions
- Participation and coverage rules
- Minimum distribution requirements
- Certain prohibited transactions
- Minimum vesting and funding standards
Exceptions to the Rule
Like many of the provisions outlined in the Internal Revenue Code, a taxpayer should always look for applicable exceptions that may legally reduce their tax liability or reporting requirements.
The first exception comes in Section 402(d), which allows, “for purposes of subsections (a), (b), and (c), a stock bonus, pension, or profit-sharing trust which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a).”
At first glance, it may seem like this will apply to participants in a foreign pension plan. However, upon further inspection, the requirements of those plans that are exempt are extensive (see above explanation). While many foreign pensions likely have similar characteristics, they will be infrequent to satisfy all the requirements. Further, it is questionable whether an individual participant could practically make such a certification. Even if the necessary information is available.
Considering U.S. Requirements
Many foreign pensions do not consider U.S. requirements during the formation. So it is safe to assume that the IRS will consider the vast majority non-exempt trusts. The taxability of non-exempt trusts depends on a few factors. The significant determinate being whom the IRS deems the owner.
In the case of a foreign pension plan whereby an employee and employer make contributions, “a beneficiary of a trust… may not be considered to be the owner under subpart E, part I, subchapter J, chapter I of the Code of any portion of such trust which is attributable to contributions to such trust made by the employer after August 1, 1969, or to incidental contributions made by the employee after such date.”
Under this regulation, an employee participant would not be the owner as long as their contributions to the trust are incidental. The code further explains that “contributions made by an employee are not incidental when compared to contributions made by the employer if the employee’s total contributions as of any date exceed the employer’s total contributions on behalf of the employee as of such date.” These types of trusts are an employees’ trust in the code. The IRS considers the employer to be the owner of such trusts, rather than the U.S. beneficiary.
Employees’ Trust and U.S. Taxation
A non-exempt employees’ trust is the classification that most foreign pensions typically qualify for. The primary requirements to be an employees’ trust are:
- Employee contributions must not exceed fifty percent
- The individual is not a employee with high compensation (see above) and
- The plan must not be discriminatory (as determined under Section 401(a)(26) or 410(b)).
If the trust fails to meet these general requirements, it will likely be a foreign grantor trust. And, the U.S. owner would be subject to additional reporting requirements and income recognition for the portion of the trust they own. A U.S. owner of a foreign grantor trust is subject to reporting requirements on Form 3520, 3520-A, FinCEN Form 114, Form 8938, and potentially Form 8621 if the trust invests in foreign mutual funds. The topic of foreign mutual funds and the rules applicable to PFIC is explained in-depth in this article. Since many investment vehicles come in the form of a fund, participants in a foreign pension likely have some foreign mutual fund ownership.
Benefits Of A Qualified Exempt Trust
An employees’ trust has a few of the tax benefits a qualified exempt trust enjoys. The major benefits being:
- Deferral of tax on the accrued income until distribution.
- Fewer reporting requirements.
Unlike a qualified retirement plan, participants in a employees’ trust must include their employer’s contributions in their gross income on their U.S. tax return. It is important to note that there is no inclusion of employer contributions within foreign earned income for the foreign earned income exclusion. Also, contributions made by the employee are not tax-deductible. An exception exists for contributions that have not been funded or vested.
Distributions are ultimately subject to taxation as annuity income when there is a distribution or available for distribution. Amounts are available when the participant reaches retirement age, disability, or dies.
Foreign Pension Grantor Trust and U.S. Taxation
A foreign grantor trust generally has no benefits of a qualified exempt trust. And is potentially subject to significant reporting requirements and compliance costs. There is no tax deferral on the accrual of income within the trust nor deduction of contributions.
The U.S. owner must generally file Form 3520 and 3520-A annually to report ownership, contributions, and distributions. The IRS has stated that these reporting requirements apply to any foreign pension scheme classified as a trust for U.S. tax purposes.
A Form 8621 requirement will generally apply for any investments that fall under the passive foreign investment company (PFIC) definition. The tax treatment of PFICs is punitive, complex, and requires disclosure on Form 8621. This is the case for each investment that meets the definition and does not qualify for an exemption. These investments have proportional attribution and ownership by the trust beneficiaries. The attribution does not apply to participants in an employees’ trust.
The FBAR and Form 8938
A foreign pension plan typically qualifies as a foreign financial account for the FBAR. Also, as a specified foreign financial asset subject to FATCA and reporting on Form 8938. Many taxpayers overlook their foreign pension(s) balance when applying the thresholds related to the FBAR and Form 8938.
Guidance is not clear whether an employee’s trust is a requirement for reporting on the FBAR and Form 8938. As a result, it is best to include these foreign pensions on the FBAR and Form 8938. The penalties for failing to include such assets can be substantial, and the inclusion will not generate income tax. The additional time and effort to gather the necessary information to report on the FBAR and Form 8938 is insignificant in comparison to the potential penalties.
International Tax Treaties
The IRS currently has tax treaties with several foreign countries. Not all tax treaties are the same. So, careful examination of the specific treaty that applies to your situation is necessary. Depending on the treaty and other factors, a foreign pension can be subject to U.S. taxation in different ways. Some treaties allow participants to obtain the same benefits as if the plan was a U.S. qualified plan. In contrast, others allow partial or no benefits. Article 18 of the Model Treaty allows a participant in a foreign pension to defer income accrued, deduct contributions from income, and exclude employer contributions from income.
All treaties include a Savings Clause. This protects the United States’ right to tax its citizens as if the tax treaty was not applicable. This Savings Clause location is generally within Article 1 of the treaty. Article 18 in the Model Treaty regarding foreign pension benefits generally qualified for exemption from the Savings Clause. It is important to thoroughly read the tax treaty and applicable Savings Clause since the Model Treaty does not apply consistently across all income tax treaties. There are generally variations.
UPDATE: IRS Revenue Procedure 2020-17
On March 16, 2020, the IRS published Revenue Procedure 2020-17. The Treasury Department and the IRS have determined that, because applicable tax-favored foreign trusts generally are subject to written restrictions, such as contribution limitations, conditions for withdrawal, and information reporting, which are imposed under the laws of the country in which the trust is established, and because U.S. individuals with interest in these trusts may be required under section 6038D to separately report information about their interests in accounts held by, or through, these trusts, it would be appropriate to exempt U.S. individuals from the requirement to provide information about these trusts under section 6048.
Qualified taxpayers can use this exemption to exclude themselves from information reporting requirements under section 6048 of the Internal Revenue Code. It applies to certain U.S. citizen and resident individuals (U.S. individuals) concerning their transactions with, and ownership of, certain tax-favored foreign retirement trusts and certain tax-favored foreign nonretirement savings trusts. Only eligible individuals (generally U.S. individuals who have been compliant for their income tax obligations related to such trusts) may rely on this revenue procedure.
Also, the IRS established procedures for eligible individuals to request abatement of penalties that have been assessed or a refund of penalties that have been paid under section 6677 for the individuals’ failure to comply with the information reporting requirements of section 6048 concerning an applicable tax-favored foreign trust. Eligible individuals may request relief following instructions in the revenue procedure.
This includes mailing completed Form 843 to the IRS unit that processes Form 3520 & Form 3520-A (Internal Revenue Service, Ogden, UT 84201-0027). Eligible individuals should write the statement “Relief pursuant to Revenue Procedure 2020-17” on Line 7 of the form. Also, Line 7 should explain how the eligible individual meets each relevant requirement and how the foreign trust meets each applicable requirement. This revenue procedure is effective as of March 16, 2020. It also applies to all prior open taxable years, subject to the statute of limitations.
The revenue procedure does not affect any reporting obligations under section 6038D or any other provision of U.S. law. As such, taxpayers must still report on FinCEN Form 114, FBAR, include on Form 8938 if applicable. They should also properly report income attributed to the tax-favored foreign retirement trust or non-retirement savings trusts. This may include the preparation of Form 8621 to disclose the ownership of any PFICs owned within the trust and properly calculate income attributed to such investment during the year.
If you are unsure about the U.S. tax reporting requirements for your foreign pension or trust, you should consult with a tax professional to see if Revenue Procedure 2020-17 is applicable.